Unit 5: The Accounting Equation

Lesson 5.2
Application of the Accounting Equation
Contents
Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 4

Simple Cases Illustrating the Accounting Equation 5
Cash Inflow from Investment or Sales 5
Item Purchase on Cash Basis 6
Purchase of an Item on Account/Credit 6
Paid Debts 7
Paid Obligations 7
Sample Problems Applying the Accounting Equation 8

Keep in Mind 9

Try This 10

Practice Your Skills 12

Challenge Yourself 14

Photo Credit 14

Bibliography 15
Unit 5: The Accounting Equation

Lesson 5.2

Application of the Accounting

Equation

Introduction

Every day, businesses deal with different transactions: from purchasing materials and
inventory to paying bills or debts. In accounting, a transaction is an economic activity that
changes the assets, liabilities, and equity of an entity. A transaction also affects at least two
accounts. Every transaction and its effects are analyzed and recorded in the accounting
books.

In analyzing a valid business transaction, you can imagine a balance scale wherein any
weight or value placed on the left side should have a corresponding equal value on the right
side to keep the scale balanced. Similarly, if you remove an item on the left side, you should
also remove an item on the right side with the same weight so that both sides will balance.

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Unit 5: The Accounting Equation

Learning Objectives DepEd Competency

Perform operations involving simple cases with

At the end of this lesson, you should be able to
the use of accounting equations
do the following:
(ABM_FABM11-IIIb-c-18).
● Analyze simple cases using the
accounting equation.
● Solve business problems using the
accounting equation.

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Unit 5: The Accounting Equation

Quick Look

Maria Sari-Sari Store

Maria opened a sari-sari store in their barangay. Maria took this opportunity since the
nearest store is located in another barangay two streets away from her store. Maria uses
the concept of an accounting equation to always make sure that the transaction she records
in her business's books is accurate, as well as to monitor the inflow and outflow of the
business's cash account. This way, Maria can track if some items are missing from her
inventory or if her profit is not matching her current stock.

Questions to Ponder
1. How important is the accounting equation for Maria’s sari-sari store?
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2. Is Maria's strategy applicable to any type of business in terms of financial aspect?

Why or why not?
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3. What will be the possible outcome of the sari-sari store after adopting the concept of
accounting equation as a financial strategy in tracking business transactions?
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Unit 5: The Accounting Equation

Learn the Basics

Every business should be familiarized with analyzing business transactions by connecting

them to the different accounting concepts and principles. Companies should also learn to
examine if the transactions affect accounts and are balanced using the accounting equation.
This way, a business can provide an accurate financial report that will determine the entity's
profitability.

In the previous lesson, you learned that the accounting equation is considered the
foundation of the double-entry accounting system. It expresses the relationship between
the assets, liabilities, and equity. It states that assets should equal the sum of liabilities and
equity. In equation form, it is expressed as:

You also learned that, aside from being the foundation of double-entry bookkeeping,
the accounting equation is a fundamental element of the balance sheet. The balance
sheet reports the business’s assets, liabilities, and equity in detail. In double-entry
accounting, every transaction is recorded in at least two accounts affected in opposite ways.

As defined in the past lesson, assets are any objects or entities that are owned and
controlled by the business. Liabilities are financial obligations of a business to an individual
or another business entity. Owner’s equity or equity is the contribution of the owner to the
business.

Essential Question

Why is the accounting equation concept and its application so important in

every business?

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Unit 5: The Accounting Equation
Simple Cases Illustrating the Accounting Equation
Now that you have learned the concepts and principles related to the accounting equation,
you can start analyzing simple cases where it could be applied.

Cash Inflow from Investment or Sales

Cash inflow, either due to the owner's investment or sales from a service rendered, increases
the assets and the equity of a business.

Closer Look

John invested cash to start his printing services business.

Assets = Increase
Liabilities = No Effect
Equity = Increase

In this transaction, the cash inflow represents an increase in cash. Thus, assets increase.
The cash invested is considered the capital of the business and that is why there is also
an increase in equity.

Closer Look

Wes performed legal counseling to a client and received cash.

Assets = Increase
Liabilities = No Effect
Equity = Increase

In this transaction, cash received from a client increases assets. The equity side also
increases since revenues present a return on the capital of the business.

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Unit 5: The Accounting Equation
Item Purchase on Cash Basis
In some cases, a transaction can cause an increase and a decrease within the same major
account. An example is when a business purchases an item paid in cash. It decreases the
amount of cash, which is part of a business’s assets, and at the same time increases other
types of assets or resources owned by the business.

Closer Look

Lily purchased tables and chairs for her office space.

Assets = Increase, Decrease
Liabilities = No Effect
Equity = No Effect

In this transaction, tables and chairs are considered as business properties and their
addition presents an increase in assets. However, since the purchase is paid by cash, the
cash account decreases, so assets also decrease.

Purchase of an Item on Account/Credit

You now understand that any property or resource with monetary value that is acquired by a
company increases the entity’s assets. However, not all assets acquired by the company were
paid in cash. In some instances, the business may opt to purchase them on account. These
kinds of purchases affect the accounting equation differently.

Closer Look

Benjie bought supplies on account.

Assets = Increase
Liabilities = Increase
Equity = No Effect

In this transaction, the purchase of supplies increases assets. However, Benjie did not pay
for the supplies right away, which increased the liability.

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Unit 5: The Accounting Equation
Paid Debts
Paying off debts can decrease a company’s resources and at the same time decrease its
liabilities.

Closer Look

Amanda paid her debt to the supplier for the cabinets purchased
last week.
Assets = Decrease
Liabilities = Decrease
Equity = No Effect

In this transaction, the payment of cash by Amanda to the supplier decreases the asset. On
the other hand, the liability, which is the debt, decreases since the obligation is finally
settled.

Paid Obligations
Paying off obligations, on the other hand, also decreases the asset but at the same time the
owner’s equity.

Closer Look

Rolly paid his business’s electric and water bills.

Assets = Decrease
Liabilities = No Effect
Equity = Decrease

In this transaction, Rolly paid cash for his business’s utilities, which decreased the asset. On
the other hand, the equity also decreases since it is an expense from the business.

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Unit 5: The Accounting Equation

Check Your Progress

How does the accounting equation affect the financial report of a business?
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Sample Problems Applying the Accounting Equation

Now that you have understood the effects of simple transactions in the accounting
equation, you can apply this knowledge in specific cases and situations. In the following
examples, note that in accounting, an amount placed inside parentheses indicates a
negative value (i.e., a decrease in the amount).

Problem 1: RJ Computer Repair paid salaries of employees for ₱20,000.00.

Assets = Liabilities + Owner’s Equity

(20,000.00) = 0 + (20,000.00)

The cash used to pay the salaries decreases cash, which is an asset. Payment of salaries is
an expense and that is why there is also a decrease in equity.

Problem 2: Sunny landscapes rendered services on credit terms for ₱5,000.00.

Assets = Liabilities + Owner’s Equity

5,000.00 = 0 + 5,000.00

Sunny Landscapes has a receivable from a customer amounting to ₱5,000. Since cash
receivables are considered assets, the transaction resulted in an increase in assets. The
transaction resulted in an increase in assets since cash receivables are considered assets. At
the same time, a service rendered is considered revenue, which results in an increase of the
same amount in equity.

Problem 3: West Marketing paid its loan to the bank, ₱2,500.00.

Assets = Liabilities + Owner’s Equity

(2,500.00) = (2,500.00) + 0

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Unit 5: The Accounting Equation

West Marketing paid cash to the bank, so assets decreased by ₱2,500.00. The liability
also decreased by the same amount since the loan has already been settled.

Problem 4: Harrison Insurance purchased additional tables and chairs for P10,000.00.

Assets = Liabilities + Owner’s Equity

10,000.00 = 0 + 0

(10,000.00) = 0 + 0

Harrison Insurance purchased tables and chairs, which caused assets to increase. On the
other hand, another asset, which is cash, decreased because of the cash payment.

Check Your Progress

What will be the challenge for every business in learning the concept of an
accounting equation?
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Keep in Mind

● The accounting equation expresses the relationship between assets, liabilities, and
equity. It states that assets should equal the sum of liabilities and equity.
● Using the accounting equation, an accountant analyzes the effect of every
transaction on the assets (properties and resources owned by a business), liabilities
(debts and obligations owed by the business), and owner’s equity (amount of assets
that owners have full rights to).
● Examples of simple transactions and its effect on the accounting equation are as follows.

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Unit 5: The Accounting Equation

Effects
Simple Transactions
Assets LIabilities Equity

Owner invested cash increase no effect increase

Received cash from sales increase no effect increase

Purchased an item in cash increase, no effect no effect

decrease

Purchased an item on account increase increase no effect

Paying off debts decrease decrease no effect

Paying short term obligations decrease no effect decrease

● A business can come up with an accurate report if it adopts the concept of an

accounting equation in analyzing business transactions and tracking the movements of
assets, liabilities, and equity.

Try This

A. Identification. Given the business transactions below, identify whether these caused an
increase, decrease, or no effect on the assets, liabilities, and owner’s equity. Write your
answers in the blanks provided.

1. The owner invested cash to start its car repair shop.

● Assets = _____________________________________
● Liabilities = _____________________________________
● Equity = _____________________________________

2. The business purchased tools for the shop.

● Assets = _____________________________________
● Liabilities = _____________________________________
● Equity = _____________________________________

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Unit 5: The Accounting Equation
3. The business collected cash from a client.

● Assets = _____________________________________
● Liabilities = _____________________________________
● Equity = _____________________________________

4. The business purchased equipment on credit.

● Assets = _____________________________________
● Liabilities = _____________________________________
● Equity = _____________________________________

5. The business withdraws cash.

● Assets = _____________________________________
● Liabilities = _____________________________________
● Equity = _____________________________________

B. Identification. Given the transactions below, identify whether the assets, liabilities, and
equity increase or decrease by what amount. Write your answers in the spaces provided.

1. The business collected P5,000.00 from a client.

Assets Liabilities Equity

2. The owner invested additional P20,000.00 to the business.

Assets Liabilities Equity

3. The business paid utilities amounting to P2,200.00.

Assets Liabilities Equity

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Unit 5: The Accounting Equation

4. The business borrowed P10,000.00 from the bank.

Assets Liabilities Equity

5. The business purchased supplies on account worth P6,000.00.

Assets Liabilities Equity

Practice Your Skills

What happened in July?

Rocky established his human resource consulting business in July. He invested ₱275,000 to
start the business. The business purchased insurance to cover the month of July,
amounting to ₱75,000. During the last week of the month, the business paid salaries of
employees and incurred utility expenses for a total of ₱102,000.

Given the July activities above, identify three transactions, apply the accounting equation
and explain how the transactions become valid using the accounting equation. You may use
the following format to present your answers:

1. (write transaction here)

Assets Liabilities Equity

(effect, amount) (effect, amount) (effect, amount)

(explanation)

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Unit 5: The Accounting Equation
Write your answers inside the boxes:

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Unit 5: The Accounting Equation

Challenge Yourself

Answer the following questions:

1. How important is the accounting equation in your day-to-day activities and in every
business transaction?

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2. How does the accounting equation measure the financial position of the company?
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3. What is the role of accounting equations in determining the profitability of a

business?
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Photo Credit
realtor-6835635_960_720.jpg by mohamed_hassan is licensed under Pixabay License via
Pixabay.

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Unit 5: The Accounting Equation

Bibliography

Gilbertson, Claudia and Mark Lehman. Century 21 Accounting. Ohio: South-Western

Cengage Learning, 2008.

IFPRS Foundation. “Conceptual Framework for Financial Reporting.” IFRS. Accessed

November 28, 2021.
https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/.

Stanford University Fingate. “Statement of Financial Position.” Accessed February 9, 2022.

https://fingate.stanford.edu/managing-funds/statement-financial-position#anchor-
1421.

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