CHAPTER 2

THE ACCOUNTING EQUATION AND BOOK OF ACCOUNTS

REVIEW OF THE DOUBLE-ENTRY SYSTEM
AND ACCOUNTING EQUATION
As discussed in previous accounting courses,
accounting uses a double-entry mechanism in capturing
economic transactions. This means that in every business
transaction, at least two accounts are affected. The effect
of the double-entry mechanism, is generally captured by
the accounting equation. The following is a review of the
basic double-entry system and accounting equation
concepts;
1. Accounting equation depicts economic transactions
through three key elements.
Assets = Liabilities + Owner’s Equity

2. Accounting equation must always be kept balanced.

3. A double-entry system captures the accounting
equation.
Assets = Liabilities + Owner’s Equity

Left Right Left Right Left Right

(dr.) (cr.) (dr.) (cr.) (dr.) (cr.)

Element Side in the Equation Normal Balance Side

Assets Left Debit
Liabilities Right Credit
Owner’s Equity Right Credit
4. The normal balance side of owner’s contributions,
withdrawals, revenues and are determined through their
relationship with owner’s equity.
Component Effect on Owner’s Normal Balance Side
Equity
Contribution Increase Credit, similar to
owner’s equity
Withdrawal Decrease Debit, reverse to
owner’s equity
Revenues Increase Credit, similar to
owner’s equity
Expenses Decrease Debit, reverse to
owner’s equity
5. Thenormal balance side of an element is used to
increase the element. The reverse side is used to decrease
the element.
Element Normal Balance Increase Decrease
Side
Assets Debit Debit Credit
Liabilities Credit Credit Debit
Owner’s Equity Credit Credit Debit
Contribution Credit Credit Debit
Withdrawal Debit Debit Credit
Revenues Credit Credit Debit
Expenses Debit Debit Credit
REVIEW OF THE ACCOUNTING CYCLE

As discussed in previous courses, accounting generally

follows a cycle. The accounting cycle revolves around the
process of identification, measurement, recording and
communication of financial information.
1. Analysis of transaction
-accounting captures business transactions through the
double-entry mechanism. This mechanism maintains the accounting
equation in balance.
2. Journalizing of transaction
-an accountant’s or bookkeeper’s analysis of transaction is
captured through a journal entry.
3. Posting of entries to the general ledger
-a general ledger presents transactions in relation to the
accounts they affect. This is in contrast to the general journal where
transactions are presented chronologically.
4. General of the Unadjusted Trial Balance
-accounts in the general ledger are updated, a bookkeeper now
generates a trial balance. A trial balance is a listing of the general ledger
accounts.
5. Journalizing and Posting of Adjusting Entries
-after generating the unadjusted trial balance, the bookkeeper
now adjusts certain accounts.
a) Adjustment of Prepayments
b) Adjustment of Accrued Expenses
c) Depreciation Expense
6. Preparation of Financial Statements, Closing of Nominal
and Drawing Accounts
-nominal accounts are temporary accounts which are not
carried over to the next year or accounting period.
7. Preparation of the Post-Closing Trial Balance
-accounts are prepared for the succeeding period, a
bookkeeper normally prepares a “Post-Closing Trial Balance”. Post-
closing trial balance contains the balances of the real accounts at the
start of the succeeding year.