The Accounting Equation 1

The Basic Accounting Equation

All the process in an accounting system must observe the equality of the accounting equation,
which is basically an algebraic equation. The basic accounting equation is shown below:

Assets = Liabilities + Equity

ASSETS – are the resources you control that have resulted from past events and can provide
you with future economic benefits.

Essential elements in the definition of asset

a. Control – you don’t necessarily need to own the resource for it to be considered your
asset. What is important is that you control the economic benefits from the resource.
Control means you have the exclusive right to enjoy those benefits or you can prevent
others from enjoying those benefits.

Example 1: Resource owned but not considered an asset

You own a building that you rent to various tenants. However, every time you visit the
building, the security guard shoots at you. So the tenants are actually remitting rentals, not
to you, but to the guard.

Analysis: In here, the building is not your asset because, even though you “own” the
building, you do not control the economic benefits (i.e., rentals) from it.

Example 2: Resource not owned but considered an asset

You acquired a cellphone from a telecommunications company on a 2-year installment
plan. The agreement states that if you miss an installment payment, the telecommunications
company can get the cellphone back.

Analysis: Upon taking possession, the cellphone becomes your asset even if you do not
actually own the cellphone yet until you have fully paid the installment price. This is
because you control the economic benefits from the cellphone through possession and use.

b. Past events – the control over a resource have resulted from a past event or transaction.
Therefore, resources for which control is yet to be obtained in the future do not qualify
as assets in the present.
For example, you have an intention of purchasing a cellphone next year. Right now,
the cellphone is not yet your asset. It becomes your asset only after you have purchased
it and have taken possession over it.
Physical possession, however, is not always necessary for control to exist. For
example, the money you deposit to a bank remains your asset even if you have
transferred physical possession. This is because you still control the economic benefits
by withdrawing it or spending it through electronic means.

c. Future economic benefits – “Future” means the resource is expected to provide

economic benefits over more than one accounting period. If it provides economic
benefits only in one accounting period, it is not asset but an expense.
“Economic benefits” means the potential of the resource to provide you, directly or
indirectly, with cash. For example, the resource can be:
i. Sold or exchanged for other assets;
ii. Used singly or in combination with other assets to produce goods for sale;
The Accounting Equation 2

iii. Used to settle a liability; or

iii. Distributed to the owners.

LIABILITIES – are your present obligations that have resulted from past events and can
require you to give up resources when settling them.

Essential elements in the definition of liability

a. Present obligation – means that right now, you have a responsibility to pay someone
because of an obligating event that has already transpired.
An obligating event is an event that creates either (a) a legal obligation or (b) a
constructive obligation

A legal obligation arises from:

a. A contract;
b. A law; or
c. Other operation of law.

A constructive obligation arises from your past business practices or published

policies that have created a valid expectation on the part of others that you will pay
them.

Examples:

Present obligation arising from past event

You have an intention to purchase a cellphone in the future.

Analysis: Right now, you don’t have any liability yet because you have not yet entered
into purchase transaction.
Obligating event – legal (contract)
You purchased a cellphone on credit. You took possession over the cellphone but have
not yet fully paid the purchase price.

Analysis: You have a liability which is the legal obligation to pay the purchase price.
The obligation is created when you entered into the purchase contract and took
possession over the cellphone.

Obligating event – legal (law)

You earned income during the period but have not yet paid the tax due to the
government.

Analysis: You have a liability which is the legal obligation to pay tax. The law
requires you to pay tax when you earn taxable income.

Obligating event- constructive

Your business has a “money-back guarantee” policy for customers who are not
satisfied with their purchases. Your past experience shows that about 5% of your sales
are returned

Analysis: You have a liability which is the constructive obligation to return the money
of dissatisfied customers. Your “money back guarantee” policy has made a valid
The Accounting Equation 3

expectation on your customers that you will return their money if they are not satisfied
with your product.

b. Giving up of resources (or Outflow of economic benefits)- means that settling an

obligation necessarily would require you to pay cash, to transfer non-cash assets, or to
render a service.

EQUITY – is simply assets minus liabilities. Other terms for equity are “capital,” “net assets,”
and “net worth.”

Illustration 1:
You decided to put up a barbeque stand and have estimated that you will be needing P2,000 as
start-up capital.
You then went to your closet and broke Mr. Piggy Bank which you have been saving for
quite some time now. Alas! You only have P800. You went to your Mama and ask her to give
you P1,200 but she told you that she has been feeding you for far too long. Oh man! But don’t
give up hope yet, Mr. Bombay is just around the corner.

As of this point, your accounting equation is as follows:

Assets = Liabilities + Equity
800 = 0_ + 800

Notes:
✓ Your total assets are P800 – the amount of resources that you control.
✓ You don’t have any liability yet because you are still negotiating with Mr. Bombay.
✓ Your equity is also P800 (800 assets – 0 liabilities = 800 equity).

After a lengthy negotiation, Mr. Bombay agreed to lend you P1,200.

As of this point, your accounting equation is as follows:

Assets = Liabilities + Equity
2,000 = 1,200_ + 800

Notes:
✓ Your total assets are now P2,000 - the amount of resources that you control (P800 from
Mr. Piggy plus P1,200 from Mr. Bombay)
✓ Of your total assets of P2,000:
a. P1,200 represents your liability, the amount you are obligated to pay Mr. Bombay in
the future.
b. P800 represents your equity (i.e., P2,000 assets – P1,200 liabilities).
Notice that from Mr. Piggy to Bombay, the accounting equation remains balanced.
Please DO NOT forget this concept my friend! The equality of the accounting equation
must be maintained in all the accounting processes of recording, classifying and
summarizing. If the accounting equation doesn’t balance, there is something wrong!
As mentioned earlier, the accounting equation is basically an algebraic equation.
Therefore, we can make variations from it. Analyze the variations below:

Original form of the equation:

Assets = Liabilities + Equity
2,000 = 1,200_ + 800
The Accounting Equation 4

Variation #1:
Assets = Liabilities + Equity
2,000 = 1,200_ + 800

Variation #2:
Assets = Equity + Liabilities
2,000 = 800_ + 1,200

The Expanded Accounting Equation

We can expand the basic accounting equation by including two more elements – income and
expenses. The expanded accounting equation shows all financial statement elements. The
expanded accounting equation is as follows:
Assets = Liabilities + Equity + Income - Expense

Notice that the income is added while expenses are deducted in the equation. These are
because income increases equity while expenses decreases equity.

INCOME – are increases in economic benefits during the period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to investments by the business owners.

EXPENSES – are decreases in economic benefits during the period in the form of outflows or
depletions of assets or increases of liabilities that result in decreases in equity, other than those
relating to distributions to the business owners.

The difference between income and expense represents profit or loss.

➢ If income is greater than expenses, the difference is profit (‘profit’ means ‘kita’ or
‘tubo’ in Filipino)
➢ If income is less than expenses, the difference is loss (‘loss’ means ‘lugi’ in Filipino)

We can make another variation to the equation above as follows:

Assets = Liabilities + Equity + Profit/-Loss

Profit increases equity while loss decreases equity.

Illustration 2: (Continuation of ‘Illustration 1’ above)

During the period, you earned income of P10,000 and incurred expenses of P6,200.
At the end of the period, your total assets increase from P2,000 to P5,000 and your total
liabilities decreased from P1,200 to P400.
Your expanded accounting equation is as follows:
Assets = Liabilities + Equity + Income - Expenses
5,500 = 400 + 800* + 10,000 – 6,200

*This represents your equity from ‘Illustration 1’ above.

We can also derive the following variation from the equation above:
Assets + Expenses = Liabilities + Equity + Income
5,500 + 6,200 = 400 + 800 + 10,000
The Accounting Equation 5

Your profit for the period is P3,800 (P10,000 income minus P6,200 expenses). There is profit
because income is greater than expenses.

A variation of the expanded accounting equation is shown below:

Assets = Liabilities + Equity + Profit
5,000 = 400 + 800 + 3,800

Income and expenses (or profit or loss) are closed to equity at the end of each accounting
period. Thus, the adjusted ending balance of equity is computed as follows:

Equity, beginning 800

Add: Income 10,000
Less: Expenses (6,200)
Equity, ending 4,600

OR

Equity, beginning 800

Add: Profit 3,800
Equity, ending 4,600

Your basic accounting equation as of the end of the accounting period is as follows:
Assets = Liabilities + Equity
5,000 = 400 + 4,600

Notice that regardless of its form or variation, the accounting equation (basic or expanded)
remains balanced.

Applications of the accounting equation

Before we move on, let us master first how the accounting equation works. I encourage you to
diligently study the following drill:

Case #1: Total assets

If you have total liabilities of P1,200 and equity of P800, how much is your total assets?

Solution:
Assets = Liabilities + Equity
5,000 = 1,200 + 800

Answer: Total assets = (1,200 + 800) = 2,000

Case #2: Total liabilities
If you have total assets of P2,000 and equity of P800, how much is your total liabilities?

Solution:
Assets = Liabilities + Equity
2,000 = ? + 800

Variation #1 of the basic equation:

Liabilities = Assets - Equity
The Accounting Equation 6

? = 2,000 - 800

Answer: Total liabilities = (2,000 – 800) = 1,200

Case #3: Total equity

If you have total assets of P2,000 and total liabilities of P1,200, how much is your total equity?

Solution:
Assets = Liabilities + Equity
2,000 = 1,200 + ?

Variation #2 of the basic equation:

Equity = Assets - Liabilities
? = 2,000 - 1,200

Answer: Total equity = (2,000 – 1,200) = 800

Case #4.1: Profit or loss

If you have total income of P5,000 and total expenses of P2,000, how much is your profit (or
loss)?

Solution:
Total income 5,000
Less: Total expenses (2,000)
Profit 3,000

Case #4.2: Profit or loss

If you have total income of P6,000 and total expenses of P11,000, how much is your profit (or
loss)?

Solution:
Total income 6,000
Less: Total expenses (11,000)
Profit (5,000)

In accounting, amounts in parentheses are negative amounts.

Case #5: Income

If you have total expenses of P2,000 and a profit of P3,000, how much is your total income?
The Accounting Equation 7

Solution:
Total income ? (squeeze)
Less: Total expenses (2,000)
Profit 3,000 (start)

The unknown (‘?’) is simply “squeezed.” In accounting, to “squeeze” means to come up with
an unknown amount in a given formula by performing basic arithmetic functions like adding,
subtracting, multiplying or dividing. When squeezing “upwards” (just like in the illustration
above), the arithmetic function is simply reversed. Thus, the amount P2,000 which is deducted
when solving downwards is added when “squeezing” upwards.

Answer: Total income = (3,000 + 2,000) = 5,000

When “squeezing” upwards, it is always advisable to recheck your answer by squeezing

downwards. This is done as follows:

Rechecking:
Total income 5,000 (start)
Less: Total expenses (2,000)
Profit 3,000 (squeeze)

“Squeezing” simplifies the computation process because it eliminates the need to make
variations of a formula. If we did not squeeze the amount above, we would have made the
following variation to the formula:
➢ Original formula: Income – Expenses = Profit
➢ Variation: Profit + Expenses = Income

Case #6: Expenses

If you have total income of P5,000 and a profit of P3,000, how much is your total expenses for
the period?

Solution:
Total income 5,000
Total expenses ? (squeeze)
Profit 3,000

Answer: Total expenses = (5,000 – 3,000) = 2,000

Rechecking:
Total income 5,000
Less: Total expenses (2,000) (squeeze)
Profit 3,000

Case #7: Income

You have ending* total assets of P4,800, ending total liabilities of P1,000 and beginning*
equity is P800. If your total expenses for the period amount to P2,000, how much is your total
income?

*(In accounting parlance, the term ‘beginning’ means ‘at the start’ of an accounting period
while ‘ending’ means ‘at the end’ of an accounting period.)
The Accounting Equation 8

Solution:
Assets = Liabilities + Equity + Income - Expenses
4,800 = 1,000 + 800 + ? - 2,000

Answer: Total income = (4,800 – 1,000 – 800 + 2,000) = 5,000

Rechecking: (Check out the equality of the accounting equation)

Assets = Liabilities + Equity + Income - Expenses
4,800 = 1,000 + 800 + 5,000 - 2,000

Case #8: Expenses for the period

You have ending total assets of P4,800, ending total liabilities of P1,000 and beginning equity
of P800. If your total income for the period amounts to P5,000, how much is your total
expenses?

Solution:
Assets = Liabilities + Equity + Income - Expenses
4,800 = 1,000 + 800 + 5,000 - ?

Total expenses = (4,800 – 1,000 – 800 – 5,000) = 2,000

Rechecking: (Checking out the equality of the accounting equation)

Assets = Liabilities + Equity + Income - Expenses
4,800 = 1,000 + 800 + 5,000 - 2,000

Case #9.1: Ending equity

Your beginning equity is P5,000. If your total income for the period is P8,000 while your total
expenses are P6,000, how much is the ending balance of your equity?

Solution:
Equity, beginning 5,000
Add: Income 8,000
Less: Expenses (6,000)
Equity, ending 7,000

OR

Equity, beginning 5,000

Add/Less: Profit or Loss (8,000 – 2,000) 2,000
Equity, ending 7,000

Case #9.2: Ending equity

Your beginning equity is P12,000. If your total income for the period is P5,000 while your
total expenses are P8,000, how much is the ending balance of your equity?

Solution:
Equity, beginning 12,000
Add: Income 5,000
Less: Expenses (8,000)
Equity, ending 9,000
The Accounting Equation 9

OR

Equity, beginning 5,000

Add/Less: Profit or Loss (5,000 – 8,000) (3,000)
Equity, ending 9,000

Notice that profit is an addition to equity while loss is a deduction.

Case #10.1: Profit for the period

If your beginning equity is P5,000 while your ending equity is P7,000, how much is your
profit or loss for the period?

Solution:
Equity, beginning 5,000
Add: Profit (or Less: Loss) ? (squeeze)
Equity, ending 7,000

Profit = (7,000 – 5,000) = 2,000

Rechecking:
Equity, beginning 5,000
Add: Profit (or Less: Loss) 2,000
Equity, ending 7,000

Case #10.2: Loss for the period

If your beginning equity is P6,000 while your ending equity is P2,000, how much is your
profit or loss for the period?

Solution:
Equity, beginning 6,000
Add: Profit (or Less: Loss) ? (squeeze)
Equity, ending 2,000

Loss = (2,000 – 6,000) = (4,000)

Rechecking:
Equity, beginning 6,000
Add: Profit (or Less: Loss) (4,000)
Equity, ending 2,000

Case #11: Ending total assets

You have total assets, liabilities, and equity of P10,000, P7,000 and P3,000, respectively, at the
beginning of the period. During the period, your total liabilities decreased by P4,000 while
your profit is P5,000. How much is your ending total assets?

Solution:
Assets = Liabilities + Equity
Beg. 10,000 = 7,000 + 3,000
Decrease in liabilities/Profit _______ (4,000) 5,000
End. ? = 3,000 + 8,000
The Accounting Equation 10

Answer: Ending total assets = (3,000 liabilities, end. + 8,000 equity, end.) = 11,000

Rechecking: (Ending balances)

Assets = Liabilities + Equity
End. 11,000 = 3,000 + 8,000

Case #12: Ending total assets

You have total assets, liabilities, and equity of P10,000, P7,000 and P3,000, respectively, at the
beginning of the period. During the period, your total liabilities decreased to P4,000 while your
profit is P5,000. How much is your ending total assets?

Solution:
Assets = Liabilities + Equity
Beg. Irrelevant(a) = Irrelevant + 3,000
Profit _______ Irrelevant 5,000
End. ? = 4,000(b) + 8,000
(a)
(Irrelevant: These amounts are not needed in computing for the requirement in the problem.)

The phrase “decreased to P4,000” means that P4,000 is the ending balance of liabilities.
(b)

Notice the difference between the phrases “decreased by” (Case #11) and decreased to” (Case
#12).

Answer: Ending total assets = (4,000 liabilities, end. + 8,000 equity, end.) = 12,000

Rechecking: (Ending balances)

Assets = Liabilities + Equity
End. 12,000 = 4,000 + 8,000