THE BASIC ACCOUNTING EQUATION

The equation has two elements which equally divide the entity into two parts. The left side of the equation represents what
the entity owns. On the other hand, the right side represents those that the company owes.

Assets = Liabilities + Equity

The left side of the equation represents what the company owns. These are resources that the entity controls in order to
attain future benefits. On the other hand, the right side represents the claims of the different parties to the company’s
assets. Liabilities represent the claims of the entity’s creditors while the equity represents the residual interest of the
owners of the entity.

Also, remember that just like in any equation, the two sides of the equation should always be balanced. Hence, what the
company owns should always equal what it owes to its owners.

Elements of the Accounting Equation

ASSETS
As we have learned earlier, assets are resources that an entity owns in order to derive some future benefit. These assets are
used by the company in its normal operations such as the manufacture of goods or delivery of services. The main feature
of these assets is their capability to give benefits to the entity. These benefits are usually in the form of their ability to
directly or indirectly increase the inflow of cash to the entity or a reduction of its outflows.

Some examples of these assets are the following:

1. Cash
We all know what cash is. Generally, it is the money that we use comprising of the bills and coins we use in our everyday
lives in order to buy the goods that we want and also avail the services that we need. However, when accounting for cash,
we also consider cash as the money that is deposited in the banks and even undeposited checks from customers.

2. Accounts Receivable
This represents amounts that are collectible from customers. They arise when a business sell its goods or services on
account or on credit.

3. Inventories
If you go to a sari-sari store, you will notice piles of assorted products being offered for sale.Chances are, you may easily
find various items that you need or want such as food and household items. Such products are normally owned by the sari-
sari store. These products are inventory which are normally held for sale by the store in its normal operations.

4.Equipment
Pandesal shops would need ovens and furnaces in order to properly and actually create their goods. The product of these
ovens are the pandesals which would be sold later on and eventually increase the cash of the shop.

5.Land and Building

In most businesses, a physical store is necessary for them to operate. For example, how can a local carenderia function
without an actual store? Where will a barber shop operate without its building? Such buildings are also assets of the
businesses. These buildings are owned by the company so that they can use them for their business to operate normally.

6.Intangible Assets
When we think of the things we can own, we normally think of tangible things or those that can be seen and touched.
However, assets also encompass intangible things that can neither be seen nor touched. For example, the software used by
computer shops are actually assets that they own. Even though one cannot actually touch the software, it is still an asset of
the computer shop that will earn the shop future benefits.

LIABILITIES

Liabilities are one of the claims of external parties from the entity. Basically, they are the debts of the entity to external
creditors. These debts do not always have to be paid in money. Some of these liabilities are in the form of obligations to
do some service or even give something.

These liabilities can take the form of the following:

1. Accounts Payable
When a local supermarket or convenience store like 7-Elevenbuys its goods, it is unusual for it to immediately pay cash
for such goods. Normally, it would only incur an obligation to pay its supplier after a certain number of days. For
example, when it gets a delivery of milk, it might have an agreement to pay its supplier only after 30 days. Thus, in the
meantime that the product has not been paid yet, it would only carry a “payable” in its books.

2. Unearned Revenue
Telecommunication companies such as Globe and Smart normally offer prepaid load to customers. These load credits can
be later on used by customers for text messages or to call other people. On the other hand, when Globe or Smart receive
payments from customers, it creates an obligation for them to actually deliver their services. Such obligations to give their
service are recorded as liabilities.

EQUITY
The equity reflects the residual claims or net assets of the owners of the entity. This is similar to the “net worth” part of
the SALN of our public servants. Take note that these are only residual claims of the owner since the creditors get their
share of the entity first before the owners are given their share. This is also why the “net worth” of individuals is
computed by subtracting their liabilities from their assets.
Generally, equity comes from two sources. The first one comes directly from the owners in the form of investments of
capital. The other comes from the income of the business from its normal operations. The net income or net loss of the
business from its operations can be determined by using the following equation:

Revenues – Expenses = Net Income / (Net loss)

A business will have net income if its revenues exceed expenses and will have a net loss if its revenues are less than its
expenses.

1. Revenues
A business earns revenue when it sells its products or its services. When you go to a store and buy a phone, the store earns
revenue. When you get a haircut from a barbershop, the shop also earns revenue. Generally, we can say that it is that a
business earns revenue when it expects to earn an economic benefit in the form of an increase in assets such as cash or a
decrease in liabilities. Other terms used for revenue are sales, rent, fees, etc.

2. Expenses
Matching principle states that no revenue can be earned without incurring corresponding expenditures. As such, when a
store sells a phone, aside from getting cash for the phone, it also incurs costs for the goods it has sold. On the other hand,
such is also true when services are also rendered. In the barber shop, when someone gets a haircut, the barber shop incurs
costs in the form of salary for its employees.

3. Capital
The capital account of the equity represents the net investments of the business. This means that any contribution of the
owner which increases the assets of the business or decreases its liabilities will increase the capital account.
For example, when creating a business, an owner normally contributes a significant amount of cash to kick-start the
business. Such transaction increases the capital account of the business. Note that it does not only have to be cash to
increase the capital account. An owner may even contribute equipment or land to increase his or her capital. Moreover,
since capital represents the net investments of the investments, withdrawals by the owner are also taken into
consideration. As such, when an owner gets cash from the business to use for its personal use, its capital accounts are
deducted.
Lastly, at the end of each accounting period, the net profit or net loss of a business is also “closed” to this account.
Moreover, the equity portion of the accounting equation is where the revenues and losses incurred by the company are
taken into consideration. Thus, when a company sells its products, the company earns revenues and therefore increases its
equity as well. On the other hand, when it pays its bills or even just loses some assets, the entity incurs expenses and
losses, thereby decreasing its total equity.

TYPES OF MAJOR ACCOUNTS

Current assets are all assets which are expected to be realized within the ordinary course of business, or a span of twelve
months, whichever is longer. Realization here only means that these assets are expected to be converted into cash, sold or
disposed after a certain time, or through the passage of time.

1. Cash
The most basic and familiar of all the assets is generally classified as a current asset. But did you know that cash not only
includes money? Money means everything composed of bills and coins, considered as legal tender (such as the Philippine
Peso in the Philippines), or legal tenders of other nations (such as the U.S. Dollar).
Cash, on the other hand, also includes money in the form of bank deposits in checking accounts and savings accounts. It
can also include checks, such as those provided by customers in payment for goods or services received.
Some companies would also include cash equivalents in the cash classification. Cash equivalents are short term
investments which are considered subject to negligible changes in fair value, and are maturing within three months from
the date of their purchase. Examples of these would include three month BSP Treasury Bills, certificates of deposit, and
money market instruments.
It is important to note that among all assets, cash is considered the most liquid, as reflected by its ready usability through
almost all transactions accompany can enter. As such, the cash account is routinely monitored through the statement of
cash flows.

2. Accounts Receivable
Accounts receivable are oral promises to the entity to receive cash at a later date. They usually arise from the normal
course of business, such as selling goods or delivering services, but can also come from non-trade events, such as you
lending your friend. Those which arise from the normal course of business are called trade receivables, and those which
do not are either called non-trade receivables or simply other receivables.
While they can be just as easily convertible and liquid as cash, definitely, not all receivables can be collected. Hence,
companies also setup a contra-asset account, called allowance for doubtful accounts or bad debts allowance that estimates
how much of their current receivables are uncollectible.

3. Short-term Investments
The short-term investments account contains the company’s investments in low risk, highly liquid assets such as bonds
and stocks, which are expected to be liquidated in less than a year. Most often, short-term investments are entered into by
the company to make the most income out of its otherwise idle cash. This income is earned through interests, dividends,
and price appreciations, usually exceeding income earned from interests on bank savings deposits.
Companies with sound cash management would tend to have this account balance, compared to those which are not doing
as great. However, the primary downside of putting excess cash into short-term investments is their added risk of change
in value and lesser readiness for conversion.

4. Notes Receivable
Similar to the accounts receivable, a notes receivable account represents promises to the entity to receive cash at a later
date, with the main distinction that notes receivable are all written, and hence, more formal than accounts receivable. This
added formality feature ensures that, in the case of a default by the borrower, the company can seek additional legal
remedies to recover what has been lent. And by its written nature, notes receivable tend to have longer maturity dates than
accounts receivable, but still are generally considered as within the operating cycle. Note receivable are also sometimes
called as promissory notes.

5. Inventories
As you look at a sari-sari store across the street, you see a lot of items hanged and displayed on the shelves, such as
candies, chips, canned goods, and toiletries—all ready to be sold. These items are called inventory in accounting parlance.
Aside from these finished goods which are available for sale, inventory also includes raw materials, work-in-process
items, and supplies.
Raw materials are basically inputs for producing other materials Once they are entered into production, but awaiting
completion, they are called work-in-process items. Meanwhile, there are items which do not actually serve as an input for
a product but are nevertheless used during the production these are called supplies. Finally, upon completing production,
the end products are now called as finished goods.

6. Prepayments
A prepayment is an amount simply paid in advance for goods or services anticipated to be received by the entity in the
future. In the previous example, you have paid money in advance to acquire load, from which you expect your network to
send your messages (i.e., to provide a service) as long as you have enough load to carry on.
On a broader perspective, prepayments can be other sorts of things provided that the two requirements in the definition
have been met. Usual examples are rent, salaries, utilities, and insurance paid in advance. Prepayments would only cease
to be as such when they are finally used up, and this is applicable to all the examples mentioned before.

Noncurrent Assets

All other assets which are not current basically fall into the definition of noncurrent assets. Take note that they necessarily
do not need to have at least twelve months remaining before their expected realization; as long asthey do not meet the
current asset classification, they are classified here.

1. Investments
Perhaps the most liquid of the noncurrent assets, the investments account include all the company’s investments which it
does not expect to realize within one year. Different from the short term investments account which usually include only
highly liquid investments such as bonds and stocks, the investments account here can also include other forms of
investments, such as real estate, long-term notes, government treasury bills, and funds set aside for long-term purposes.

2. Fixed Assets
Fixed assets are what can be called as the most tangible, longest serving assets a company can have. They are expected to
not be converted into cash immediately, and are regularly placed as means of production. Examples of fixed assets are
land, land improvements, buildings, machineries, equipment, furniture and fixtures and land improvements. Collectively,
they can be also called as property, plant and equipment (PPE).
Unlike current assets, they are not usually consumable and are only used through utilization. Fixed assets, with the
exception of land, also gradually deteriorate with the passage of time, through usage, normal wear-and-tear, and
obsolescence. Such deterioration is more properly termed as depreciation, a form of an expense
On a personal level, your mobile phones, laptops, and other gadgets can be considered as your fixed assets.

3. Intangible Assets
In contrast to fixed assets, intangible assets lack physical substance, and yet are similarly realizable over long periods of
time. Being intangible, it is harder to measure their value and evaluate them as assets, compared to tangible assets. Prime
examples include patents, copyrights, franchises, goodwill, trademarks, and licenses. Often,they are simply represented by
written documents or certificates stating their description and ownership status.
Overtime, the value of most intangible assets would likewise decrease; hence, similar to fixed assets, intangible assets are
also subject to some form of depreciation, which is more appropriately called as amortization.

4. Other Assets
All remaining items which do not fall into any of the accounts mentioned above are classified together as other assets.
This account serves as a catch all for assets which are usually very much unique or hard to classify. As a practical
consideration, it is favourable to limit the usage of this account to encourage more distinct classifications.

Current Liabilities

These are liabilities which are expected to be settled or paid out by the entity within twelve months. Paying out does not
necessarily mean payment through cash, but can also include conversion and/or refinancing.

1. Accounts Payable
- it is the opposite of Accounts Receivable. While in accounts receivable, the entity is on the receiving side,the entity is
now on the paying side, hence, the borrower.

2. Notes Payable
- are written promises of the entity to pay a sum certain in a future determinable time. While these can usually arise from
larger trade or business transactions which additional formality from accounts payable is necessary, they can also arise
from the regular borrowings of the entity. They are the opposite of notes receivable, in that the entity now, instead of
being the lender, is the borrower.

3. Accrued Liabilities
-are all other accounts which the company should pay, arising from the normal course of business. Throughout the
operating cycle, it is very much possible that the company has already received benefits from certain events, yet has still
been unable to pay for it. In a way, accrued liabilities can also be considered the opposite of prepaid assets. This is very
much true as regards to unearned revenues, a form of an accrued liability related to goods or services that the entity has
yet to deliver, but has already received payment from a customer.

4. Current Portion of Long-term Debts

-these are long-term debts payable within the coming year. Some long-term debts, due to their large principals, usually
have features that allow the borrower to pay on an instalment basis, so as to ease them the burden of a heavy cash outflow
from a single maturity date.

5. Other Payables
Other payables include those which are due from the entity outside the normal course of its business. These include
common items such as dividends payable and interest payable and unusual items such as payables arising from lawsuits.
As long as they are payable within the year but do not enter into the other previous current classifications, they can be
included in this catch-all classification.
Noncurrent liabilities form the residual portion of liabilities. By strict definition, these are liabilities which the entity
expects to settle after more than a year, or have the legal or contractual capacity to defer payment accordingly.

Bonds Payable
-are even a degree more formal than notes payable. Bonds payable are a form of long-term debt, often in huge sums,
contained in an agreement called as the bond indenture.
Unlike notes payable, bonds payable have stated interest rates, which may differ from prevailing market interest rates,
causing their fair values to change from time to time. They are usually issued by the government, banks, and huge
corporations seeking huge financing sources. Bonds which have principal that mature in a single date are called term
bonds; those that mature in multiple dates are called serial bonds.

Equity / Owner’s Equity / Stockholders’ Equity

Equity is the residual interest of the owners in the assets of the business after considering all liabilities. It is equal to total
assets minus total liabilities.
To illustrate the concept of equity, consider sole proprietor who wants to start a business. In order to fund the assets of the
business, the sole proprietor obtains a loan from banking addition to investing his other own money. In this case, the
business technically has two owners: the creditor bank and the sole proprietor.
These two entities have claims in the assets of the business. But because the sole proprietor has the obligation to
eventually pay for the loan, the creditor bank has the greater claim on the business assets. To determine how much really
of the business the sole proprietor owns, he or she has to deduct the loan he or she has to pay for from the total assets of
the business.
In the case of sole proprietorships and partnerships, equity is also called owner’s capital. Balance sheets of these entities
have simple titles for the owner’s equity components (usually the name of the sole proprietor or the partners followed by a
comma and the word Capital, i.e., Juan Dela Cruz, Capital). A sole proprietorship has only one equity component while a
partnership has as many components as there are partners.
In the case of corporations, it is more appropriate to use the term shareholders’ equity or stockholders’ equity.
Shareholders’ equity is more complex than owner’s capital because it has many components which vary according to the
complexity of the corporation’s capital structure. The shareholders’ equity section of the balance sheet usually has a
common stock account, a preferred stock account, an additional paid-in capital account, and a retained earnings account.

Common Stock
-is a security which represents ownership in a corporation. Those who own common stock of a corporation are called
common stockholders. A common stockholder has many rights among which are the following:
1. Right to vote in the stockholders’ meetings
2. Right to receive dividends
3. Pre-emptive right which is the right to be offered first to buy additional shares in the event of a future issuance
All common stock comes with a par value. This is the legal nominal value assigned to it, and it is illegal for it to be issued
for less than this price. In the balance sheet, the common stock account represents the number of common shares issued
and outstanding multiplied by the stock’s par or stated value.

Preferred Stock
-Similar to the common stock account, the preferred stock account represents the number of preferred shares issued and
outstanding multiplied by the stock’s par value. A preferred stock is also a security which represents ownership in a
corporation, and owners of preferred stock are called preferred stockholders.
The difference between a preferred stock and common stock is the preferred stocks’ preference as to corporate dividends
and/ or liquidation. When a corporation declares a dividend, preferred stockholders are given priority over common
stockholders. Preferred shares almost always come with a par value and a stated interest.
For example, Happy Donuts Corporation has 1000 common shares and 1000 preferred shares outstanding. The par value
of common shares and preferred shares are ₱ 5 and ₱10, respectively. The stated interest rate of the preferred shares is
5%. If the company declared a ₱2000 cash dividend, the common shareholders and the preferred shareholders each get ₱
1500 and ₱ 500 pesos respectively, based on the following computation:

Preferred Shareholders:
1000 Preferred Shares x ₱10 Par Value of Preferred Shares x 5% = ₱500 to Preferred Shareholders

Common Shareholders:
₱2 000 Total Cash Dividend –₱500 to Preferred Shareholders = ₱1 500 to Common Shareholders

Additional Paid-in Capital

Additional paid-in capital, also called share premium, is the excess over par value contributed by the company’s
shareholders in a stock issue. It can either be from the issuance of common shares or preferred shares. For example,
accompany issues 5000 common shares with a par value of ₱ 10 for ₱ 15pershare.The additional paid in capital from this
share issuance is ₱5(₱15 –₱10)per share for a total of ₱25000.Additional paid in capital arises because the selling value of
a stock is almost always greater than its par value. In other words, the par value is the minimum amount a share can be
issued for.

Retained Earnings
Retained earnings represent the accumulated net income from operations over several periods. It is a measure of how
much the company earned since day one of its operations. Sometimes, a company’s investors (or shareholders) will want
to reap the benefits of their investments. When the company gives back to its shareholders because it has been operating
successfully over several periods, it declares dividends which reduce retained earnings. To gain a better understanding of
retained earnings, it would be appropriate to discuss increases and decreases inequity.

Increases in Equity
Equity increases as a result of revenues, gains, or capital contributions. Revenues are the amounts received by a business
earned as a result of selling something or rendering a service. It is the increases in equity as a result of day-to-day
operations.
Note that the amount of revenues for a period does not necessarily equate to the amount of actual cash received in that
period of time. Revenues are only recognized when incurred and when an entity already incurs the related expenses.
For example, if a magazine publishing company is given cash in advance to deliver magazines to its subscribers, the
company should not yet recognize revenues because it has not yet delivered. Only when the company has already incurred
expenses to produce the magazines and delivered them to the subscribers should the company recognize the revenues. But
how should the company classify the cash it initially received if it should not be revenue? In this case, the cash received is
called deferred revenue, and this is considered a liability.

Revenues can be classified as follows:

1. Operating Revenue –revenues that originate from main business operations (e.g., sales, service revenue, etc.)
2. Non-operating Revenues –revenues that do not originate from main business operations and are a result of some side
activity (e.g., interest revenue, rent revenue of a business not engaged in the renting industry).

Examples of revenue accounts are the following:

1. Sales Revenue –main source of revenue for businesses that sells products (e.g., supermarkets, convenience stores, food
manufacturers)
2. Service Revenue –main source of revenue for businesses that render services
(e.g., barber shops, accounting firms)
3. Interest Revenue –revenue earned as a result of investment in debt securities or receivables from other entities
4. Dividend Revenue –revenue earned as a result of dividend declaration of a company where in a business has invested
stocks
5. Contributions Revenue –revenue earned by not-for-profit organizations usually in the form of donations by outside
parties.

Gains -are increases in equity as a result of non-recurring activities or the increase in value of investments. Non-recurring
activities include the sale of company noncurrent assets.

Capital contributions -are increases in equity as a result of transactions with owners. It can be in the form of cash and
non-cash assets given by owners for use in the business. Measuring the amount of capital contributions for sole
proprietorships is often difficult because the contributions are usually personal assets of the proprietor. These assets are
often used for both personal and business reasons. This is usually not the case for partnerships because they keep books of
accounts separate from the owners.

Decreases in Equity -Equity decreases as a result of expenses, losses, and distribution to owners. Expenses are the
amounts consumed by the business to operate. They are the result of attempting to generate revenues. Just like revenues,
they are the result of day-to-day operations and do not always equal the amount of cash used up in a given period.

Examples of Expense accounts are the following:

1. Cost of Goods Sold –when inventory is sold, the cost of goods sold reflects what the company incurred to make the
inventory sell (in manufacturing companies) or to buy them (in merchandising companies)
2. Utility Expense –include water and electricity and reflects the amount paid for to utility companies like MERALCO
and Manila Water Company, Inc.
3. Depreciation Expense – a result of using building and equipment
4. Office Supplies Expense-a result of using up office supplies
5. Insurance Expense – a result of insurance paid for expiring over time
6. Salaries Expense – a result of recognizing salaries of company employees
7. Bad Debt Expense – an estimate of how much accounts receivable the company will not be able to collect
8. Interest Expense –interest incurred as a result of borrowing money

Losses -are the direct opposite of gains. They are decreases inequity as a result of nonrecurring activities or decreases in
value of assets. If the value of an investment in stock decreases overtime, a loss also exists.

Distribution to owners is assets given to owners, usually in cash. For corporations, they are called dividends. Dividends
can be viewed as rewards for the stockholders for investing their money with the corporation. They ideally should come
from the retained earnings of a business because they represent the fruits of the company’s hardwork. If the dividends
originate from some other equity account, they are called liquidating dividends and indicate that the company is closing
down, if not, reducing in size.

Treasury shares –are technically also distribution to owners. However, instead of being viewed as rewards like dividends,
treasury shares are usually bought for an underlying motive. Treasury shares also reduce owner’s equity.

If we add up all the revenues and gains and deduct all the losses and expenses, we get a business’s net income for the
period. Net income can also be called net earnings .All the net incomes throughout years of a company’s operations
accumulate in the retained earnings account. The transactions with owners (capital contribution and distribution to
owners) affect shareholder’s equity but they never form part of net income.