Defining the Parts
of the Equation
The equation has three elements, collectively they are
called the accounting elements; Assets, Liabilities, and Equity.
What are Assets?
A Resource
Resources are the scarce means
available in carrying out business activities; it includes cash, properties,
human, technology, natural resources, etc. In simple terms, a resource is
anything that we can use to achieve our objectives. We use cash to buy goods
and services, we use human resources to carry out tasks, we use technology to
make work more efficient, etc.
An asset should be
controlled
It is to be emphasized that not
all resources are assets, but all assets are considered as resources. Another
characteristic of an asset is it should be controlled, or the risk and reward
of using the item are significantly transferred to the entity. When we say
control, we are talking about the capability to decide over it. We determine
what will be the outcome of such resource. To illustrate, natural resources
like the mountains and rivers cannot be considered as assets although they are considered
as resources since the control or the risk and reward of using it cannot be
transferred to the entity. An entity cannot decide on the fate of the mountains
and rivers. What if a company is renting a building being used as its office,
is the building considered to be the asset of the company? The answer is no.
Although the building is being used by the company to achieve its objectives,
that is selling, producing, purchasing, etc. the company does not have over-all
control with the building since any decisions concerning it like modifications
and improvements, shall be approved by the owner of the building. What if a
company bought a delivery van which it has acquired through a loan, can the
company record the van as part of its assets even if it has not fully paid loan
and the company do not ownership over it? The answer is yes. Since the company
is already enjoying the risk and rewards of using the van in its operation, it
can already be considered as the asset of the company.
An asset is a result of past
event
An asset can be acquired through
events like purchasing, producing, donations, grants from governments, etc. One
of these events should occur before an asset can be recognized.
An asset provide future economic
benefit
This characteristic is main
gauge if an item can be considered as an asset. It is the capability of an item
to contribute, directly or indirectly, to the cash inflow of the entity. For
example, we use cash to buy goods and supplies that is in turn used to provide
services or goods that will be sold to customers that will in turn be paying
for cash. Production equipment is considered to be an asset because it is used
to convert different ingredients to salable goods that can be sold to paying customers.
Examples of assets are, but not limited to, the
following:
ü
Cash – includes coins and currencies and
financial instruments that are considered to be money substitutes that are
acceptable by a bank for deposit.
ü
Receivable – represents the amount that is
collectible from customers or other parties owing the company.
ü
Inventories – represents the goods that are for
re-sale to customers.
ü
Office supplies – represent the pens, papers,
business forms, folders, envelope, etc. that is being used in the office.
ü
Office Equipment – represents the electrical
machines like computes, air conditioner, fax machines and printers that is
being used in the office.
ü
Building – a structure, regardless of the number
of floors that is being used by the entity as an office, a factory, a
warehouse, a store, etc.
ü
Land – a lot that is either being used by the
company as a site for its building or being held for speculation (it will be
sold when the market value – selling price is already higher than its
acquisition cost)
What are Liabilitie?
s
It is a present obligation
An obligation is defined by the
civil code of the Philippines as the juridical necessity to give, to do, or not
to do. When we say there is juridical necessity, in simple terms, it means that
it arises from a contract between two parties (contract of sales, employment
contract) or from a requirement prescribed by law (paying of taxes) or from
maintaining good relationship with other party (granting of warranties and
additional services for products sold to customers). The important
characteristic of a liability that separates it from other types of obligation
is that it is already a present obligation, meaning all the conditions and
requirements has been met hence the condition is already certain and
enforceable. Example if a father promises his son a brand new car after his
graduation from college is not a liability since the obligation is not yet
present, there is still a condition to be met – graduation from college. If the
son has already graduated from college, then the obligation of the father
becomes a liability.
A Liability arises from past events
A liability normally arises when
an asset is delivered, or the entity entered into an irrevocable contract to
acquire an asset. Examples of Liabilities includes liabilities for supplies
purchased, promissory note issued, loan granted by the bank, and warranty to be
provided from goods sold. But liabilities also arises when there are new laws
that are enacted that will require an entity to have an outflow of resources,
for example, when a new tax law is enacted, an entity should comply with such
and pay the tax being prescribed. The events like assets being delivered or
laws being enacted are called obligating events or events that create present
obligation to an entity.
A
Liability will be settled requiring an outflow of an entity’s resources
A liability can be settled by
paying cash, or delivering a property, or by rendering services. A liability
can also be settled by issuing another liability or an equity security. For
example, instead of paying a lender cash, an entity offer such lender to be an
owner of the company in exchange for the amount owed.
Examples of liabilities are, but not limited to, the
following:
ü
Accounts Payable – the amount owed to suppliers
for the goods acquired like inventories and office supplies.
ü
Notes Payable – the amount owed being evidenced
by a promissory note.
ü
Loans Payable – the amount owed to a financial
institution that is covered by a loan agreement.
ü
Salaries Payable – the amount owed to employees
representing their compensation and other benefits for the tasks already
accomplished.
ü
Utilities Payable – the amount owed to companies
like Meralco, Maynilad, and PLDT for the electricity, water or communication
fee that was incurred.
Capital
This represents the residual interest of the owners in
the assets of the entity after deducting all of the entity’s liabilities. Another
term for capital is equity which is used by the accounting standards in describing
the owner’s right to the assets of the company. The claims of the owner to the
business’ assets after deducting any liabilities can be classified into two:
the invested capital and the earned capital.
Invested
Capital
This represents the amount that
were invested into and withdrawn from the business by the owner. This can be compared to a depositor in a
bank. When we deposit (invest) cash to our bank account are rights which is
equivalent to the balance in our bank account increases and when we withdraw
from the bank account, our rights decreases since the bank account balance also
decreases.
Earned Capital
The main purpose why an investor
put money into a business is, so that money will increase in value from the net
income that the business will earn. Net income or loss is determined by
deducting total expenses from total revenues. Revenues are earnings that arise
from the ordinary activities of an entity like rendering services and selling
goods. Generally, we recognize (in accounting, the term recognize is synonymous
with the term Recorded in the books of accounts) revenues when we have the
right to collect for the services rendered or for the goods delivered. Expenses
are items that were used, incurred, consumed, or have expired in the process of
earning revenues. Examples of expenses include salaries, utilities (electricity
& water), communication, permits and licenses, repairs and maintenance,
etc. Net Income exist if total revenues
is greater than total expenses while there will be a net loss if total revenues
is less than total expenses. If a net loss has occurred, this will decrease the
owner’s capital.
Constructing the
Equation
At the beginning of a business, the owner would invest
assets like cash and other properties to establish the business hence the
equation would be expressed as follows:
A = C
The asset (A) represents the resources invested by the owner
and the capital (C) represents the right of the owner for the resources that he has
invested. For example, Mr. Rey Cruz
invested ₱100,000 in cash to establish a security agency; the
accounting equation of the agency upon investment of Mr. Cruz would be as
follow:
Assets (Cash)
|
=
|
Capital (R.
Cruz, Capital)
|
₱100,000.00
|
=
|
₱100,000.00
|
However,
after the business is established, it incurs liabilities for the resources
purchased, services used, or utilities and other expenses incurred that will
not be paid for by the owner but rather will be paid by the business from its
own resources. Hence, the equation will now be expressed as follows:
A = L + C
For example, after the cash investment of Mr. Cruz, the
business purchased office supplies on account amounting to ₱30,000
payable within 30 days after the date of purchase. The accounting equation will
now be as follows:
Assets
(Cash+ Office
Supplies)
|
=
|
Liabilities +
Capital
(Accounts
Payable + R. Cruz, Capital)
|
₱130,000.00
|
=
|
₱30,000
+ ₱100,000.00
|
The equation now shows that all Assets were provided by
either the Lenders (Liabilities or L) or the Owners (Capital) and that all funds
provided by the Lenders and Owners are accounted for as Assets as either cash
or non-cash resources. This is the main essence of accountability, everything
is accounted for. Hence, as a rule, the accounting equation should always
balance to assume that all were accounted for.
As a point of emphasis, the table below shows three
different accounting equations, with each equation missing an element. As the
rule on equilibrium, the missing item should be an amount that will hold the
equation valid or an amount that will balance both sides.
Assets
|
=
|
Liabilities
|
+
|
Capital
|
?
|
=
|
₱30,000.00
|
+
|
₱40,000.00
|
₱
100,000.00
|
=
|
?
|
+
|
₱60,000.00
|
₱80,000.00
|
=
|
₱20,000.00
|
+
|
?
|
On the first equation, assets are equal to ₱70,000.00 or ₱30,000 + ₱ 40,000. While on the second row, the liabilities
can be computed by re-constructing the equation wherein, it will be liabilities
is equal to assets less capital or ₱100,000 - ₱60,000 is equal
to ₱40,000. Lastly, the same as how liabilities is computed in the previous
row, the equation should be re-constructed so that capital is the result of the
process, hence, the equation will not be Assets less Capital or ₱80,000 - ₱20,000
is equal to ₱60,000.
Effect of Business
Transactions in the Accounting Equation
As discussed in the previous chapter, business
transactions are events that affect the resources and/or obligations of the
entity or as previously defined, the accounting equation. In other words, the
accounting equation represents the different resources and obligations that an
entity have. A business transaction will always have a two-fold effect or for
every value received and there a value given up. Table 2.1 shows the possible
effect of business transactions to the accounting elements.
A business transaction can:
|
With a corresponding:
|
Increase an Asset
|
Decrease in another
asset
|
Increase in Liability
|
Increase in Capital
|
Decrease an Asset
|
Increase in another asset
|
Decrease in Liability
|
Decrease in Capital
|
Increase in a Liability
|
Increase in an asset
|
Decrease in another
Liability
|
Decrease in Capital
|
Decrease in a Liability
|
Decrease in an asset
|
Increase in another
Liability
|
Increase in Capital
|
Increase in Capital
|
Increase in an asset
|
Decrease in Liability
|
Decrease in another
Capital
|
Decrease in Capital
|
Decrease in an asset
|
Increase in Liability
|
Increase in another
Capital
|
Table 2.2 Effect of Business Transactions to
the Accounting Element
In the table, the first column shows the primary effect
of a business transaction while the next three columns show the corresponding possible
effect to any of the other elements. For example, in the first row, a business
transaction like a purchase of equipment will increase asset since the purchase
will increase the entity’s equipment which is an asset. Consequently, the
purchase might decrease another asset if it was purchase for cash or might
increase a liability if the equipment is acquired by issuing a promissory note
or increase capital if the owner purchases the equipment using his own money.
Increase in Asset
and Decrease in another Asset
Cash purchases and selling goods are examples of business
transactions that increase assets while decreasing another asset. Purchasing
office supplies amounting to ₱30,000 cash will mean an
increase in office supplies while the cash of the entity will be decreased
since it was used to pay for the office supplies. Using the existing equation
of Mr. Cruz’s security agency discussed earlier, the effect of purchasing the
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Purchase Transaction :
|
+₱30,000;
(₱30,000)
|
=
|
0
|
+
|
0
|
Balance
after transaction
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
An amount
being enclosed in an open-close parenthesis will mean a decrease or deduction.
Increase in Asset
and Increase in Liability
Purchasing on credit or on account is an example of
business transactions that increase assets while increasing liabilities. As
already discussed above, purchasing office supplies ₱30,000 will
increase the assets of the company but since the supplies was yet to be paid
for; this will require an increase in the liabilities of the company.
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Purchase Transaction:
|
+₱30,000
|
=
|
₱30,000
|
+
|
0
|
Balance
after transaction
|
₱160,000
|
=
|
₱60,000
|
+
|
₱100,000
|
Increase in Asset
and Increase in Capital
When an owner invest assets in the company, such
transaction will increase asset equal to the value of the assets invested and
will also increase the owner’s capital by the same amount. For example, Mr.
Cruz invested an additional ₱50,000 in cash to the security
agency.
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Investment Transaction:
|
₱50,000
|
=
|
0
|
+
|
₱50,000
|
Balance
after transaction
|
₱180,000
|
=
|
₱30,000
|
+
|
₱150,000
|
Decrease in Asset
and Decrease in Liability
A business transaction that decrease assets and
correspondingly decreases liability includes making cash payment for the amount
owed to creditors. For example, in the original equation, the security agency
of Mr. Cruz purchased supplies amounting to ₱30,000 on account,
if the security agency will be paying the amount owed for such purchases, it
will decrease its liabilities while also decreasing its assets (cash).
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Payment Transaction:
|
(₱30,000)
|
=
|
(₱30,000)
|
+
|
0
|
Balance
after transaction
|
₱100,000
|
=
|
0
|
+
|
₱100,000
|
Decrease in Asset
and Decrease in Capital
When an owner takes assets from the business for personal
use, it is said to be withdrawing from the business. This transaction will
decrease assets equivalent to the value of the assets taken and an equal
decrease in owner’s capital. To illustrate, assume that Mr. Cruz took ₱5,000 cash from the security agency for personal use.
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Withdrawal Transaction:
|
(₱5,000)
|
=
|
0
|
+
|
(₱5,000)
|
Balance
after transaction
|
₱125,000
|
=
|
₱30,000
|
+
|
₱95,000
|
Increase in Liability and Decrease in another Liability
When a business settles its liabilities by issuing
another liability, it will decrease its liabilities but at the same time
increasing the same. For example, instead of paying the ₱30,000
due to the suppliers for the office supplies purchased on account, the company
issued a promissory note stating a promise to pay the amount due plus 10%
interest payable in one year. This transaction will decrease accounts payable
which is a liability but will increase another liability which is notes
payable.
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Liability Transaction:
|
0
|
=
|
+₱30,000;
(₱30,000)
|
+
|
0
|
Balance
after transaction
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Increase in Liability and Decrease in Capital
A business transaction like the business assuming the
personal liabilities of the owner will be considered as a withdrawal by the
owner which will result to a decrease in capital while the assumption of the personal
liabilities will increase the company’s liabilities. Assuming Mr. Cruz’s
personal credit card bill amounting to ₱10,000 will be assumed
and paid for by the business will have an effect in the accounting equation as
follows:
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Assuming Liability:
|
0
|
=
|
+₱10,000
|
+
|
(₱10,000)
|
Balance
after transaction
|
₱130,000
|
=
|
₱40,000
|
+
|
₱90,000
|
Decrease in Liability and Increase in Capital
If an owner paid for the liabilities of the business from
his personal funds, this is considered to be an investment which will increase
the owner’s capital while decreasing the liabilities of the entity. If Mr. Cruz
paid for the ₱30,000 due from the purchase of office supplies
using his own funds, the effect of such transaction to the accounting equation
follows:
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
Balance:
|
₱130,000
|
=
|
₱30,000
|
+
|
₱100,000
|
Paying for the Liability:
|
0
|
=
|
(₱30,000)
|
+
|
₱30,000
|
Balance
after transaction
|
₱130,000
|
=
|
0
|
+
|
₱130,000
|
