Topic: Accounting Environment

Topic
 Accounting
Environment
1
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the meaning, role and importance of accounting;
2. Identify the users and branches of accounting;
3. Describe the main functions of professional accounting bodies in
Malaysia;
4. Assess the qualitative characteristics of financial information,
assumptions, principles and constraints in accounting;
5. Apply the accounting equations; and
6. Analyse transactions based on the accounting equation.
XX INTRODUCTION
Accounting plays an important role in our daily lives without us realising it.
Accounting is a financial information system that helps us make better economic
decisions.
We might assume that accounting is only important to businessmen or

accountants. In fact, we also need accounting in our daily lives. We need financial
information to make economic decisions. For example, when making a decision
on buying a new car, we need to know the total net revenue in a month (gross
revenues minus all expenses) to know whether we can afford to buy the car. We
also need to estimate other costs that might be involved in having a car.
This example is only a decision at an individual level. For a business entity, it

might need to make a decision on whether to buy a new building or just rent it
for operational purposes. Even though it is a higher level decision, the decision-
maker still requires the necessary financial information.
2  TOPIC 1 ACCOUNTING ENVIRONMENT
In this topic, you will be introduced to the basics of accounting. Among them
are the definition and branches of accounting, users of accounting information,
professional accounting bodies in Malaysia as well as the fundamental concepts
in accounting.
1.1 INTRODUCTION TO ACCOUNTING

1.1.1 Definition of Accounting
Accounting is an information system that prepares reports on the economic
activities of an entity for users to help them make better decisions. More
accurately:
Accounting is a process to identify, measure, record and present the

economic information of an entity to the users in order to help them make
evaluations or economic decisions.
Economic information are information related to economic activities; whereas an

entity refers to a business unit.
1.1.2 Users of Accounting Information

Users of accounting information are parties that use the accounting information
for specific purposes. The information required by the users might differ between
one group and another. Users of accounting information can be divided into two
groups - internal users and external users.
Internal users are parties that have direct access to the resources of an
entity and usually involved in the management of the entity, for example
the management of the company.
External users would be the parties who do not have direct access to the
resources of the company and do not involved in the management of the
company.
TOPIC 1 ACCOUNTING ENVIRONMENT  3
The other differences between these two groups are summarised in Table 1.1.
Table 1.1: Differences between Internal Users and External Users
Internal Users External Users

Types of information Information that can help Information required are
required them make planning and different depending on the
exercise control over the type of decisions made.
entity.
Example:
Investor:
Require information on
the profitability of the
company before making
decision to invest.
Loan providers:
Require information on
the stability and liquidity
of the company before
making decision on giving
out credit.
How does the information Using the status or Limited to what is made
been obtained position in the company. available by the company.
Example
Annual report published
by the company.
1.1.3 Branches of Accounting

Accounting is divided into several different branches or other specialised fields.
Among them are:
(i) Financial Accounting;
(ii) Management Accounting;
(iii) Taxation; and
(iv) Auditing.
These branches are not static as they evolve in time and requirement. This
financial accounting course will combine two of the most basic and important
accounting branches; that are financial accounting and management accounting.
Therefore, it is important for you to know some of the differences between these
two branches. Let’s look at Figure 1.2.
Table 1.2: Differences between Financial Accounting and Management Accounting
Financial Accounting Management Accounting

Preparation of report Preparation of financial Preparation of financial
reports of an entity for and non-financial
external and internal users information that are
but focus is given to the required by parties in the
external users. company for planning,
evaluating and controlling
purposes of the operations
of an entity.
Standard or Format Financial reports produced Report is produced at any
are periodically and in time based on requirement
accordance to specified and is not subject to any
standard or format. standard or format.
1.1.4 Professional Accounting Bodies in Malaysia

We also need to familiarise ourselves with the organisations that are involved in
the accounting profession in Malaysia. The organisations are:
(a) Malaysian Institute of Accountants (MIA)

MIA was established under the Accountants Act 1967 as the main
accounting body in the country. Overall, it functions as the core body in
regulating the accounting profession. Other major functions of MIA as
discussed in the Accountants Act 1967 are:
(i) to set the required qualification in order to become a member;
(ii) to provide training and education for practitioners or those who are
interested in becoming accounting practitioners;
(iii) to control the accounting practices in Malaysia; and
(iv) to protect the accounting interest in Malaysia.
(b) The Malaysian Institute of Certified Public Accountants (MICPA)

MICPA, formally known as “The Malayan Association of Certified Public
Accountants”, was established in 1958 under the Companies Ordinances.
On 6 July 1964, the name was changed to “The Malaysian Association of
Certified Public Accountants” to reflect the change of name from Malaya to
Malaysia. Since February 2002, it is known as “The Malaysian Institute of
Certified Public Accountants”. Among the main objectives and functions of
MICPA are:
(i) to advance the accounting theories and practices in all aspects;
(ii) to train and evaluate the competent members;

(iii) to ensure the independence of professional accountants; and
(iv) to oversee the practices and professional conducts of its members.
(c) Malaysian Accounting Standards Board (MASB)

MASB was established under the Financial Reporting Act 1997. Among the
main functions of MASB are:
(i) to set and approve new accounting standards;
(ii) to revise or accept the usage of existing standards as approved
accounting standards; and
(iii) to develop the conceptual accounting framework.
(d) Financial Reporting Foundation (FRF)

FRF was established under the Financial Reporting Act 1997 together with
MASB. Among the main functions of FRF are:
(i) to provide opinion to MASB on matters to be implemented;
(ii) to evaluate the performance of MASB; and
(iii) to be responsible for the overall funding of the operation of MASB,
including to approve its budget.
EXERCISE1.1
EXERCISE 1.1
1. Provide examples of common decisions made by both internal and
external users.
2. How does Financial Accounting and Management Accounting assist
users in making decision?
WEBSITE
Further information regarding the professional accounting bodies in
Malaysia can be obtained from the following websites:
• Malaysian Institute of Accountants (MIA) www.mia.org.my
• The Malaysian Institute of Certified Public Accountants (MICPA)
www.micpa.com.my
• Malaysian Accounting Standards Board (MASB) www.masb.org.my
• Financial Reporting Foundation (FRF) www.masb.org.my
1.2 FUNDAMENTAL ACCOUNTING CONCEPTS

1.2.1 Qualitative Characteristics of Accounting
Information
In this section, you will be exposed to the qualitative characteristics of accounting
information.
Qualitative characteristics of accounting information refer to the

characteristics that must be present in the accounting information to make
it useful.
These characteristics are divided into two categories; primary and secondary
qualities. The primary qualities of accounting information are relevant and
reliability, while the secondary qualities are comparability and consistency.
In summary, accounting information is only useful if it has relevant, reliability,
comparability and consistency qualities.
Figure 1.1 shows the summary for qualitative characteristics of accounting

information.
Figure 1.1: Qualitative characteristics of accounting information
(a) Relevant
In everyday terms, we might describe relevant as important or being related.
In accounting, relevant is described as something that makes a difference
in arriving at a decision. In other words, something is said to be relevant if
it influences or affects the decision being made.
The extent to which information is considered relevant depends on its

importance in decision making and may differ between one decision maker
to another. Information that is relevant to you might not be relevant to
another person and vice versa.
For example, suppose you are an investor and you intend to buy shares
of a public listed company. What kind of information might be relevant to
your needs? You might want to know the profitability and performance of
the said company for the past five years, including new projects or products
for the company that will be profitable in the future. This information is
relevant as it will influence your decision. Suppose the information that you
obtained showed that the company is experiencing continuous losses for the
past five years and it does not have any new projects. Will you still proceed
with the proposal to invest in the company? Probably not.
Figure 1.2 shows an example of performance information of a company in

order to assist investors in decision making.
Figure 1.2: Performance information of a company to assist investor in decision making.
After knowing the meaning of relevant, you must also know how certain
information are said to be relevant. To become relevant, the information
must have three characteristics, namely feedback value, forecast value and
timeliness.
(i) Feedback Value
Relevant information must be able to assist users in substantiating or
correcting early expectations matters at hand.
(ii) Forecast Value

Relevant information must be able to assist users in forecasting.
(iii) Timeliness
Relevant information must be obtained before it becomes obsolete or
unusable.
(b) Reliability
Reliability means that users can rely or depend on the said information to
make good decisions. This characteristic is important because users might
not have the time or expertise to evaluate some information. Generally,
users simply depend on the information presented by the related entity and
assume it to be true. This information is then used in decision making.
Reliability does not mean that the said information must be precise. This is
because in accounting there are a lot of information that involves estimation
and approximation that might not be precise. What is important is that the
estimation and approximation made must be reliable.
Reliable information must have the following characteristics:

(i) Verifiable
This means that the accounting information could be verified
objectively by another person using the same method.
(ii) Objective
Objective in this case means that the information is not biased.
Information contained in the financial statements must be able to fulfil
the requirements of various users and not concentrating on certain
groups only.
(iii) Trustworthy
Information presented is based on the actual result of economic
activities using specified methods.
(c) Comparability
Comparability means that the information can be compared whether among
companies, industries or different periods. This will enable users to identify
the similarities or differences that might exist in the said information. This
characteristic is important because information that can be compared is
more useful.
Let’s look at an example. Assume that you were told that the net profit of a
business in the year 2009 was RM5 million. Is this information useful? This
information would only be meaningful if you can compare it with the net
profit of the business in the year 2008 or the net profit of other businesses
in the same industry as shown in Figure 1.3. Thus, financial statements
contained in the Annual Report also include information on the previous
year in addition to the current year for comparison purposes.
Figure 1.3: Profitability comparison
(d) Consistency
Consistency means that an entity must use the same accounting procedures
in every period. It is for the purpose of enabling comparison to be made
more effectively. In other words, a company cannot change their accounting
procedure every year. This does not mean that the company cannot change
the accounting procedure at all. Changes can still be made, but the company
must make complete disclosure in the financial statement to explain to
the users why they are making the changes and the effect of the changes
towards the financial statements.
SELF-CHECK 1.1
What are the important qualitative characteristics of accounting

information?
ACTIVITY 1.1
In your opinion, what will happen to a business entity if it only

presents the qualitative characteristics of main accounting information
in its annual report?
EXERCISE 1.2
1. State the qualitative characteristics of accounting information.

2. Explain the meaning of comparability provide an example to
show its role in making accounting information useful.
1.2.2 Accounting Assumptions

In this section you will be exposed to accounting assumptions. There are four
accounting assumptions, created to aid the reporting entity and the users, which
are generally accepted. They are:
(a) Assumption of Separate Entity

For the purpose of accounting, an entity is assumed to be separate from its
owner and also other entities. An accounting entity is an economic entity
in its own right which controls resources involving economic activities.
All activities relating to the accounting entity must be separated from the
owner’s activities or other accounting entities’ activities. The examples
below should explain this concept clearly.
Example 1:
Assume that you own a business, your personal economic activities must
be kept separate from the business’ economic activities. If you wish to
buy products for personal use, you cannot take the business’ money and
assume that as part of the business activities. Instead, you must record it as
drawings. The Drawings Account shows the money or products from the
business taken by the owner for personal use.
Example 2:
Supposing you have just set up a business which offers computer repair
services. As it is a small business and you are the sole proprietor, the
business’ cash is deposited into your private account. Assume that on 31
December 2008, the bank balance of your account is RM5,000. Based on
your record, RM1,000 is the money from your business and the balance of
RM4,000 is funds for your studies.
If you did not comply with the assumption of separate entity and assume
RM5,000 is the money from your business, you might make an inaccurate
business decision. You might feel that your business has adequate funds
while in fact only RM1,000 is the business’ cash. Although all the money
belongs to you, from the accounting perspective, RM1,000 is for the
business funds and the balance of RM4,000 is the money for your education
purposes.
Segregation would enable you to evaluate the financial status of the business
much better and to make accurate decisions to enhance the performance
of the business. If an owner has more than one business entity, each entity
must be assumed as separate entity from the others.
Let’s look at an example

Assuming that Mr. Ali owns three different businesses, all three are
considered to be separated from accounting perspective. Accounting records
must be maintained separately; assets and liabilities for each business
cannot be mixed together. Segregation would enable the owner to know the
performance for each business.
As a simple example, suppose that Mr. Ali’s businesses show the following
result on 31 December 2008:
Table 1.3: Mr Ali’s Business
Business Transaction (RM)

Business 1 Profit 6,000
Business 2 Loss 8,000
Business 3 Profit 12,000
If the assumption of separate entity is not complied with and all the entities
are assumed as one, Mr. Ali will have an overall business profit of RM10,000
[RM6,000 + (-8,000) + RM12,000]. Based on this result, Mr. Ali might be
satisfied and might not take any measures for improvement.
However, by preparing separate accounts, Mr. Ali will know that Business
2 is facing problems as it is suffering a loss of RM8,000, while Business 3 is
performing very well with a profit of RM12,000.

(b) Assumption of Going Concern
According to this assumption, an entity is assumed to continue to exist and
in operation in the future. This assumption is important because it enables
the principle of historical cost to be applied. According to the historical cost
principle, all assets and liabilities must be recorded at the purchase price
(original cost). For most assets, this cost would be depreciated throughout
the life span of the assets to depict its usage. However, asset of property
would not be depreciated as its value would always appreciate.
As an example, a machine with a life span of 25 years will be depreciated for

25 years based on the assumption of going concern. With this assumption,
the entity would continue to exist for a period of more than 25 years. If we
assume that the entity would exist only for another 10 years in absence
of this assumption, we obviously cannot use 25 years as the basis for
calculating the depreciation.
The assumption also enables users to make decisions without any doubt
or worries. Suppose you are interested to invest in a company that has
consistently achieved high profits in the past few years. However, you were
informed that the company would exist only for another five years. Would
you still continue with your plan to invest in the said company? Generally,
we will only invest when we believe the company will continue to exist in
the future.
(c) Assumption of Monetary Unit

According to this assumption, all economic activities are measured and
valued in currency unit. In Malaysia, the currency unit used is Malaysian
Ringgit (RM). Only transactions that can be stated in currency unit will be
recorded for accounting purposes. Currency unit enables the transactions
to be summarised, reported and compared. Before the existence of currency,
transactions were conducted by way of exchanging goods (barter system).
The non-existence of currency unit had created difficulties in ascertaining
the value of transactions. With a country’s standard currency unit, we
would be able to value every product.
However, this assumption has two weaknesses, that are:

(i) It restricts the scope of accounting. Only transactions that can be
measured in monetary terms will be taken into account, neglecting
other factors that have impact on the business.
(ii) It assumes that the value of currency is constantly stable, whereas we
know that the currency value is always changing.
(d) Assumption of Accounting Period

In the assumption of going concern, we assumed that the entity will
continue to operate for an unlimited period. However, users (whether
manager, shareholders, loan providers or other parties) require periodical
measurements to help them making decisions. With this assumption, the
lifetime of the entity is divided into a certain period for the purpose of
reporting its economic activities. Normally the period selected is one year.
Financial reports must be produced every accounting year.
The selected accounting period can start from 1 January and ends on 31
December, or starts from 1 July and ends on 30 June the following year,
and so on depending on the operation of the company. For example, if an
entity is established on 1 March, it might choose an accounting period that
starts from 1 March and ends on 28 February of the following year. This
accounting period can be changed if the entity feels that there is a need to do
so.
Figure 1.4 shows examples of accounting period.
Starting Date Ending Date

1 January 2008 31 December 2008
1 July 2008 30 June 2009
1 March 2008 28 February 2009
Figure 1.4: Examples of accounting period
There are also companies which produce reports within a period of less than a
year, for example monthly, quarterly or half yearly. These reports are known as
interim reports. Interim report is normally produced to fulfil the requirement of
users that might need a more up-to-date report.
ACTIVITY 1.2
There is a company that has obtained high profits consistently for the
past 5 years and would exist for a period of another 10 years. Would
you invest in the company? Explain your decision.
1.2.3 Basic Principles of Accounting

After understanding the qualitative characteristics of information and accounting
assumptions, you will be exposed to the basic principles of accounting, which
are the principles used in the process to identify, measure, evaluate and report
financial information. There are four basic principles that you must know:
(a) Principle of Historical Cost

According to this principle, all business resources will be recorded based
on historical cost, which is the original cost at time of purchase. Although
the value of the resources might change in the future, no adjustment will be
made to recognise the changes in the value.
For example, you want to buy a piece of land for your business site. The
seller set the price at RM80,000. You do not agree with the price and ask
the seller to sell it RM70,000. After negotiation, the seller agreed with the
price of RM72,000. In this case, the land would be recorded at the value
of RM72,000 in your financial statement. Five years later, you wish to

revalue the land. The assessor informed you that the value of the land had
appreciated to RM120,000. Although there is a high appreciation in value,
you must still record it at the value of RM72,000, which is the original cost of
the land during the purchase.
The principle of historical cost is justified by its high reliability. The value
recorded in the financial statement is based on the original cost at the time
of purchase supported by documentation. This advantage is also a weakness
for certain parties. These parties criticised the failure of the principle to
recognise any possible changes in asset value. Regardless, this principle is
still adopted.
(b) Principle of Income Recognition

Principle of income recognition provides guidance regarding when and how
to recognise income. The three conditions that must be complied with before
income is recognised are:
• The seller had performed the necessary actions to obtain the income (for
example, providing the goods for trade or rendering services);
• The amount of income can be measured objectively; and
• The income can be collected.
Normally, income is recognised at the point of sale. The point of sale refers
to a situation whereby ownership has been transferred from the seller to
the buyer, notwithstanding whether the cash has been received or not. For
an entity that offers services, the point of sale is when the service has been
provided to the customer.
However, in certain cases, the point of sale method is inappropriate. There

are several different methods that can be used, for instance the percentage of
completion and cash basis methods.
(i) Percentage of Completion Method is normally used by companies

involved in the construction industry which takes a long time to
complete. For example, a housing project might take three years to
complete. It would be inappropriate to recognise the revenue only after
the project is completed. This is because revenue and expenses accrued
throughout the duration of the project that could be determined
periodically based on the degree of completion. This method is more
appropriate because it complies with the accounting period principle
and provides a true picture of the project development.
(ii) Cash Basis Method complies with the basis of cash accounting.
According to this method, revenue is only recognised when cash is
received. This method is applied in credit transactions when cash
receipts are not assured.
(c) Principle of Matching

This principle matches the expense (effort) with the revenue (benefit
obtained from the effort). The matching of the revenue with the expense will
be done when the transaction has completed. To comply with this principle,
two steps will be involved, which are:
(i) First Step
Recognition of the revenue for a specific period.
(ii) Second Step
Recognition of all the expenses involved in ascertaining the revenue.
For example, when we provide services to customers, we will recognise

the revenue according to the principle of income recognition. Then, we will
recognise all the expenses involved in generating the revenue and match
them with the revenue. The difference between the revenue and the expense
will be either profit or loss. If revenue is more than expense, the difference
will be net profit. However, if the revenue is less than expenses, the
difference will be recognised as net loss. Figure 1.5 summarises the concept
of profit and loss.
Income – Expenses = Profit or Loss
Income > Expenses = Net Profit

Income < Expenses = Net Loss
Figure 1.5: The relationship between revenue and expense
(d) Principle of Full Disclosure

The principle stresses for the full disclosure of all relevant information and
material in the financial statement whether in the statement itself or in
the notes to the accounts. This is to ensure that the users can make proper
decisions. The disclosure of financial statements will be explained in detail
in Topic 4.
ACTIVITY 1.3
1. Explain the weaknesses exist in the assumption of monetary unit.

2. Describe three conditions that must be fulfilled before revenue
can be recognised.
1.2.4 Accounting Constraints

We have seen the principles that must be complied with in accounting. However,
there are constraints or obstructions that might result in these principles not being
complied with. The main constraints in accounting are:
(a) Cost-Benefit Relationship

Before deciding on obtaining specific information, a company would
normally analyse the cost involved and the benefit that may be gained
from the information. If the cost of obtaining the information is very high
but the benefit generated is not so much, the company might not reveal the
information even though all information must be completely disclosed in
accordance with the principle of full disclosure.
(b) Materiality
Materiality refers to the effect of an item towards the overall operation of
the entity. An item is considered immaterial if it does not affect the decision
that will be made. Materiality is often measured based on size. A transaction
that involves a huge amount is normally treated as material. A material
transaction must be disclosed in detail, while immaterial transactions are
sometimes combined or not disclosed in detail.
For example, a small amount of expense like a purchase of stamps and

fares are combined into one account known as sundry expenses. Another
example will be the practice of approximation. You can see examples in the
annual report published by companies. Generally, companies would not
record the cents value, but instead will round the figures up to the nearest
ringgit (example: RM471.20 is recorded as RM471). For larger companies,
it might make the approximation to the nearest hundred ringgit (example:
RM525,795 is recorded as 525,800).
1.3 ACCOUNTING EQUATION

Accounting equation is the basis of accounting that will always be used each time
we record a transaction. It consists of three components or basic elements, which
are asset, liability and owner’s equity.
What is asset? Asset is the resources that can bring economic benefit, owned by
the entity. For example, cash, building and fittings.
For each resource, there must be a claim or rights on it. A simple example, if you
own some money, the money belongs to you. If you buy a vehicle with bank loan,
the ownership of the vehicle is claimed by the bank until you have settled your
loan. In other words, the vehicle is not owned by you (but is owned by the bank)
until you have settled your entire loan.
It is the same in business. Every asset owned by the business can be claimed
either by the owner itself, or loan providers. Rights or claims made by the loan
providers are known as liabilities, whereas the rights or claims made by the
owner itself are known as equities.
Loan providers have priority over the rights to the business assets. If the entity is
facing problems, it must first settle its loans. The owner can only claim his rights
if there are assets left. Therefore, liability is put ahead of owner’s equity in the
accounting equation as shown below:
ASSET = LIABILITY + OWNER’S EQUITY
SELF-CHECK 1.3
A business has assets of RM120,000. RM50,000 is the owner’s capital

and the balance is bank loan. What is the accounting equation?
1.3.1 Analysis of Transaction

You must always remember that the accounting equation is always equal
regardless of the transaction that has transpired. All transactions can be stated by
changes in the three components of the accounting equation. Now we will look at
a few common transactions and analyse the results on the accounting equation.
We will use the example of a sole proprietor business owned by Reen. Reen, who
is skilled in the computer field, has established her own company on 1 November
2008. For a start, the business (Reen Cyber Service) offers services in computer
consultancy. If successful, Reen intends to expand her business to selling
computers. The following is a list of transactions incurred by Reen Cyber Service
throughout the month of November 2008:
Table 1.3: List of Transactions for Reen Cyber Service, November 2008
No. Date (Nov) Transactions

1 1 Reen invested cash of RM30,000 into Reen Cyber Service.
2 2 Purchased a piece of land valued at RM20,000. The business
paid cash RM5,000 and the balance is financed by bank loan.
3 4 Purchased office supplies valued at RM2,700 on credit.
4 15 Received revenue from consultancy services provided to
customer. The customer paid RM15,000 cash.
5 30 Paid staff salary expense RM4,250; rental expense RM1,600;
utility expense RM900 and other expenses RM550.
6 30 Made payment for account payable of RM1,900.
7 30 Unused office supplies valued at RM1,100.
8 30 Reen withdrew money from the business amounting to
RM4,000 for her personal use.
All the transactions above are pertaining to Reen Cyber Service. The personal
transactions of the owner (Reen) will not be taken into account if it does not
involve the business. Now we have to analyse each transaction to see their effects
on the accounting equation.
Transaction 1:
Reen invested cash of RM30,000 into Reen Cyber Service. Again, it needs to be
emphasised that we are only interested in transactions involving Reen Cyber
Service, and not Reen’s personal transactions. Therefore, even though the cash
owned by Reen was reduced by RM30,000, the cash owned by Reen Cyber
Service has increased by RM30,000. This capital was contributed by Reen.
Therefore, owner’s equity will increase by RM30,000.
Transaction ASSET = LIABILITY + OWNER’S EQUITY

Cash Capital, Reen
1 30,000 = 30,000
Transaction 2:
The business entity purchased a piece of land valued at RM20,000, paying
RM5,000 by cash and the balance of RM15,000 being financed by bank loan.
From this transaction, the business will have a new asset (land) valued at
RM20,000. The business’ cash is reduced by RM5,000 while a new liability of
RM15,000 is created. Bank loan is always represented by the account Notes
Payable (NP). Note that the equation still holds true. The asset section increased
by RM15,000 and the liability section also increased by RM15,000.
“Balance” shows the final balance for each item after every transaction.
OWNER’S
Transaction ASSET = LIABILITY +
EQUITY
Cash + Land NP Capital, Reen
Balance 30,000 = 30,000
2 (-5,000) + 20,000 = 15,000
Balance 25,000 20,000 = 15,000 30,000
Transaction 3:
Purchased office supplies valued at RM2,700 on credit. The asset will increase
by RM2,700. The purchase by credit will create a new liability, which is Account
Payable (AP).
OWNER’S
EQUITY
Cash + Land + Supplies NP + AP Capital,
Reen
Balance 25,000 + 20,000 = 15,000 + 30,000
3 2,700 = 2,700
Balance 25,000 20,000 2,700 = 15,000 2,700 30,000
Normally, office supplies bought are not only used in the current accounting
period. The purchase of office supplies are prepaid expenses. The usage of
office supplies for the specific period is recorded by using the account Supplies
Expenses.
Transaction 4:
Received revenue from consultancy services provided to customer. The customer
paid RM15,000 cash.
OWNER’S
EQUITY
Reen
Balance 25,000 + 20,000 + 2,700 = 15,000 + 2,700 + 30,000
4 15,000 = 15,000
service
revenue
Balance 40,000 20,000 2,700 = 15,000 2,700 45,000
Service revenue is one of the components in owner’s equity. The other

components are expenses and drawings. Revenue will increase the owner’s
equity while expenses and drawings will reduce it.
Figure 1.6 shows the effect of revenue, capital, expenses and drawings on owner’s
equity.
Revenue ↑ = Owner’s equity ↑

Capital ↑ = Owner’s equity ↑
Expenses ↑ = Owner’s equity ↓
Drawings ↑ = Owner’s equity ↓
Figure 1.6: Analysis of transaction
Transaction 5:
Paid salary expense RM4,250; rental expense RM1,600; utility expense RM900
and other expenses RM550.
OWNER’S
EQUITY
Reen
Balance 40,000 + 20,000 + 2,700 = 15,000 + 2,700 + 45,000
5 (-4,250) = (-4,250)
paid salary
(-1,600) (–1,600)
paid rental
-900 (-900)
paid utility
-550 (-550)
paid
sundry
Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700
In this transaction, all the expenses were paid by cash. Therefore, cash will
decrease according to the amount involved. Each expense item has to be recorded
separately and cannot be combined. As explained in transaction 4, expenses will
reduce owner’s equity.
Transaction 6:
Made payment for account payable of RM1,900. When the business paid
RM1,900, cash will decrease by RM1,900 and liability will also decrease by
RM1,900.
OWNER’S
EQUITY
Reen
Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700
6 (-1,900) = -1,900
Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700
Transaction 7:
At the end of the month, the unused office supplies were valued at RM1,100. The
office supplies was originally bought for RM2,700. The value of office supplies
used up during the period is RM1,600 (RM2,700 – RM1,100)
OWNER’S
EQUITY
Reen
Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700
7 -1,600 = -1,600
Supplies
expenses
Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100
Transaction 8:
Reen withdrew money from the business amounting to RM4,000 for her personal
use.
OWNER’S
EQUITY

Reen
Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100
8 (-4,000) = (-4,000)
cash
drawings
Balance 26,800 + 20,000 + 1,100 = 15,000 + 800 + 32,100
Drawings is the reverse of capital investment. Capital investment will increase

the capital (example in the form of cash) of the business. Drawings will reduce the
capital. At the end of the accounting period, the drawings account will be closed
and the balance will be transferred to the capital account. Therefore, drawings
will be recorded as a reduction in capital account. Although both drawings and
expenses reduced capital, there is a clear difference between these two types of
accounts. Drawings are not for the purpose of generating revenue, but for the
owner’s personal use.
1.3.2 Summary of Analysis

Some important items that we must be aware of during the analysis of
transaction:
(a) Each transaction will affect, either as an increase or decrease, one or more
components in the accounting equation. However, each transaction will
definitely involve more than one item in the financial statements;
(b) The accounting equation explained at the earlier stage will always be equal.
You can examine this yourself by looking into the “Balance” section after
every transaction analysis; and
(c) Owner’s equity will increase with investment from the owner and revenue,
while drawings by the owner and expenses will reduce owner’s equity.
Table 1.4 is a summary of analysis for all the transactions of Reen Cyber Service.
After all the transactions have been recorded, we will discover that the accounting
equation will still be equal.
Table 1.4: Analysis of Transaction for Reen Cyber Service, November 2008
OWNER
EQUITY
Reen
1 30,000 = 30,000
investment
by Reen
Balance 30,000 = 30,000
2 -5,000 20,000 = 15,000
Balance 25,000 20,000 = 15,000 + 30,000
3 + 2,700 = 2,700
Balance 25,000 + 20,000 + 2,700 = 15,000 + 2,700 + 30,000
4 15,000 = 15,000
service
revenue
Balance 40,000 + 20,000 + 2,700 = 15,000 + 2,700 + 45,000
5 (-4,250) = (-4,250)
paid salary
(-1,600) (-1,600)
paid rental
(-900) (-900)
paid utility
(-550) (-550)
paid sundry
Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700
6 (-1,900) = -1,900
Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700
7 -1,600 = (-1,600 )
expenses
supplies
Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100
8 (-4,000) = (-4,000) cash
drawings
Balance 26,800 + 20,000 + 1,100 = 15,000 + 800 + 32,100

47,900 = 15,800 + 32,100
47,900 = 47,900
1.4 TYPES AND OBJECTIVES OF FINANCIAL

STATEMENT
After the transactions have been identified, analysed and recorded, we need to
prepare a report for the users. This report is the final product of the accounting
process and is known as financial statement. There are four types of financial
statement that you need to know:
(a) Income Statement;
(b) Statement of Changes in Owner’s Equity;
(c) Balance Sheet; and
(d) Cash Flow Statement.
These statements are interconnected with one another. The title for each statement
must contain the reporting entity’s name, type of statement and the reporting
period covered. In this section, we will see in summary, the format for each of the
four statements based on the transactions for Reen Cyber Service. We will learn
about the preparation of each statement in detail in Topic 3.
Figure 1.7: Types of business
Let us take a look at Figure 1.7. Generally, businesses are divided into three types,
which are sole proprietorship, partnership and company. Sole proprietorship is
owned by a single owner while partnership is owned by 2 to 20 owners. Financial
statements for these two types of business are not subject to the standards
released by MASB. Therefore, there might be several formats used by these two
types of business.
Companies are divided into private limited and public listed companies. Private
limited companies can be owned by 2 to 50 owners. However, there are unlimited
number of owners for public listed companies. The preparation of financial
statements for companies is subject to the standards released by MASB, whether
in the form of accounting method, disclosure and reporting format.
1.4.1 Income Statement

This statement is also known as Profit and Loss statement which lists all
the revenues and expenses incurred by the entity for a specific period. The
difference between the revenue and expense will result in either net profit or
net loss. Excess of revenue over expense will give us net profit, while expense in
excess of revenue will give us net loss. Figure 1.8 shows the income statement for
Reen Cyber Service for the month ended 30 November 2008.
Reen Cyber Service

Income Statement
for the month ended 30 November 2008
RM RM
Service revenue 15,000
Expenses:
Salary expenses 4,250
Rental expenses 1,600
Utility expenses 900
Supplies expenses 1,600
Sundry expenses 550 (8,900)
Net profit 6,100
Figure 1.8: Income statement
1.4.2 Statement of Changes in Owner’s Equity

This statement shows the changes in owner’s equity for a specific accounting
period. Owner’s equity will increase when the owner makes a capital investment
or when the entity gains net profit. Owner’s equity will decrease when the
owner makes drawings or when the entity incurs net loss. Figure 1.9 shows the
statement of changes in owner’s equity for Reen Cyber Services.
Reen Cyber Service

Statement of Changes in Owner’s Equity
RM
Opening Capital – 1 November 30,000
(+) Net profit 6,100
36,100
(-) Drawings (4,000)
Closing Capital – 30 November 32,100
Figure 1.9: Statement of changes in owner’s equity
1.4.3 Balance Sheet

This statement is also known as the financial position statement, listing all the
assets, liabilities and owner’s equity of the entity on a specific date. The purpose
of this statement is to show the financial status of the entity on a specific date.
There are two formats normally used, which are the statement format and
accounts format. The accounts format places the asset on the left side with
liability and owner’s equity on the right side (refer to Figure 1.10 and Figure 1.11)
Reen Cyber Service

Balance Sheet as at 30 November 2008
ASSETS RM LIABILITIES AND OWNER’S EQUITY RM
Current Assets: Liabilities:
Cash 26,800 Current Liability:
Supplies 1,100 Account payable 800
27,900 Non-current liability:
Non-current Notes payable 15,000
Assets:
Land 20,000 Total liabilities 15,800
Owner Equity:
Capital 32,100
TOTAL LIABILITIES AND
TOTAL ASSETS 47,900 OWNER’S EQUITY 47,900
Figure 1.10: Balance Sheet in accounts format

In the statement format, the asset, liability and owner’s equity are listed
vertically.
Reen Cyber Service

Balance Sheet
as at 30 November 2008
RM RM
Non-current Assets:
Land 20,000
Current Assets:
Cash 26,800
Supplies 1,100
27,900
Less: Current liability:
Account payable (800)
Net current assets 27,100

47,100
Financed by:
Owner’s equity: 32,100
Capital, Reen

Non-current liability:
Notes payable 15,000
47,100
Figure 1.11: Balance Sheet in statement format
1.4.4 Cash Flow Statement

This statement reports all the cash receipts and payments of the entity in a specific
period. Through this statement, the users will know the sources of cash received
and why cash is paid. The difference between cash inflows and outflows will
provide the final cash account balance of the entity. This balance will be the same
as the cash amount shown in the Balance Sheet. In the cash flow statement, cash
transactions are divided according to the type of activities, which are operating,
investing and financing activities. Figure 1.12 shows the cash flow statement for
Reen Cyber Services.
Reen Cyber Services

Cash Flow Statement
RM RM RM
Cash from operating activities:
Cash received from customers 15,000
(–) Expenditure paid 7,300
Payment to supplier 1,900 (9,200)
Net cash flow from operating activities 5,800
Cash from investing activities:

Payment for purchase of land (5,000)
Net cash flow from investing activities (5,000)
Cash flow from financing activities:

Investment by owner 30,000
(–) Drawings by owner (4,000)
Net cash flow from financing activities 26,000
Net cash flow for entity and cash account balance as at 26,800
30 November
Figure 1.12: Cash flow statement
ACTIVITY 1.3
Discuss the issues that might arise if a business entity did not disclose
the relevant information in its financial statement. Present in your
tutorial.
EXERCISE 1.4
Fill the blanks with the most accurate answer:
(a) Financial statement prepared on a yearly basis complies with the

assumption of ______________.
(b) The principle that requires the economic resources of the entity to be
recorded at the original cost at time of purchase is the principle of
___________.
(c) _____________ information must have feedback value, forecast value

and is presented on a timely basis.
(d) The professional body responsible for setting the accounting

standards in Malaysia is ______________.
(e) The qualitative characteristic that enables users to depend or rely on

the information presented is _____________.
(f) The principle that matches the revenue with the expenses in the
specific accounting period is ___________________.
(g) Not all accounting information can be disclosed in detail due to

constraints of ___________________ and __________________.
(h) The branch of accounting that prepares specialised information

for internal users and not subject to specified standard or format is
______________.
(i) According to the assumption of _____________, the entity is

assumed to continue to exist and in operation in the future.
(j) Revenue is normally recognised when ________________.
(k) The statement that shows the cash flow of an entity for a specific
period is _______________.
(l) ____________________ lists all the assets, liabilities and owner’s

equity of an entity in a specific period.
EXERCISE 1.5
1. If revenue = RM12,000; expense = RM8,400 and drawings by owner

= RM2,000; how much is the net profit or net loss for that period?
A. Net profit RM5,600
B. Net loss RM3,600
C. Net profit RM1,600
D. Net profit RM3,600
2. Which of these is NOT a qualitative characteristic of accounting

information?
A. Materiality
B. Reliability
C. Relevant
D. Comparability
3. One example of internal user is:

A. Inland Revenue Board
B. Investor
C. Creditors
D. Management
4. If the total assets increased by RM15,000 and the total liabilities

decreased by RM10,000; owner’s equity had:
A. increased by RM5,000
B. decreased by RM5,000
C. increased by RM25,000
D. decreased by RM25,000
5. For the purpose of simplifying accounting, the business owner and

business entity are assumed as the same.
True False
6. The accounting period for all businesses must start from 1 January
and ends at 31 December each year.
True False
7. Income statement shows the net profit or loss of a business entity at

a specific date.
True False
EXERCISE 1.6
Answers the questions below.
1. Determine the appropriate amount in the spaces marked “?”

(a) 84,000 = ? + 38,000
(b) ? = 72,000 + 28,000
(c) 125,000 = 50,000 + ?
2. State the effects of the following transactions on the asset, liability

and owner’s equity. An example is shown in transaction (a):
Transaction Effect
(a) Paid debts to supplier. Asset decreased, Liability
decreased.
(b) Purchased office equipment
by cash.
(c) Owner took cash from the
business for personal use.
(d) Paid staff salary for the
current period.
(e) Received cash from customer
to settle his account
receivable.
(f) Owner contributed office
equipment for business use.
3. Mr. Ashwin established a tour agency on 1 June 2007. The

transactions for the month are as follows:
(a) Deposited cash into the business account totalling RM20,000.
(b) Purchased supplies on credit for RM800.
(c) Made payment to supplier for RM620.
(d) Received cash on the services provided for RM4,200.
(e) Paid staff salary of RM1,000.
(f) Paid transportation of RM700 and sundry expenses of RM150.
(g) Paid office rental of RM1,200.
(h) Charged customer RM2,500 for services provided.
(i) Supplies unused at the end of the period is valued at RM250.

(j) Mr. Ashwin took cash from the business totalling RM750 for his
personal use.
Required:
(a) State the effect of each transaction and the balance after each
transaction using the accounting equation format that you have
learned.
(b) Create the accounting equation for Mr. Ashwin business after
the last transaction for that month.
4. Below are the assets and liabilities accounts balances for Seri
Consultation Services as at 31 December 2008 including the revenue
and expense incurred throughout the year 2008. On 1 January 2008,
the capital of Miss Seri Devi (the owner) is RM22,200. Throughout
the year, she made a cash drawings of RM6,000 but no records of it
has been made.
Account Amount (RM)

Accounts payable 1,200
Accounts receivable 18,755
Supplies 8,480
Supplies expenses 6,300
Tax expenses 4,200
Salary expenses 18,000
Sundry expenses 1,265
Rental expenses 14,400
Utility expenses 7,350
Service income 78,750
Cash 23,300
Required:
Based on the information given, prepare:
(a) Income statement for the year ended 31 December 2008.
(b) Statement of Changes in Owner’s Equity for the year ended 31
December 2008.
(c) Balance Sheet as at 31 December 2008.
SUMMARY
In this topic, you have learned and discovered:

• The users of accounting information consist of internal users and external
users.
• The difference between financial accounting and management accounting
are:
– Financial accounting prepares the financial report for external users
while management accounting prepares the monetary and non-financial
information for internal users.
– The financial reports in financial accounting is produced periodically and
subject to specified format while the report for management accounting
is produced according to specific needs and not subject to specified
standards.
• The professional bodies involved in the accounting profession are Malaysian
Institute of Accountants (MIA), The Malaysian Institute of Certified Public
Accountants (MICPA), Malaysian Accounting Standards Board (MASB) and
Financial Reporting Foundation (FRF).
• The assumptions and fundamental principles of accounting consist of:
– assumption of separate entity;
– assumption of going concern;
– assumption of monetary unit;
– assumption of accounting period;
– principle of historical cost;
– principle of income recognition;
– principle of matching; and
– principle of full disclosure.
• The accounting equation is fundamental in accounting and it consists of
three components, namely asset, liability and owner’s equity.
• Financial statement is the final product of the accounting process and it
consists of Income Statement, Statement of Changes in Owner’s Equity,
Balance Sheet and Cash Flow Statement.
Accounting Management Accounting

Auditing Monetary Unit
External Users Qualitative Characteristics
Financial Accounting Taxation
Internal Users

Topic: Accounting Environment

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We might assume that accounting is only important to businessmen or

This example is only a decision at an individual level. For a business entity, it

1.1 INTRODUCTION TO ACCOUNTING

Accounting is a process to identify, measure, record and present the

Economic information are information related to economic activities; whereas an

1.1.2 Users of Accounting Information

Table 1.1: Differences between Internal Users and External Users

Internal Users External Users

1.1.3 Branches of Accounting

Table 1.2: Differences between Financial Accounting and Management Accounting

Financial Accounting Management Accounting

1.1.4 Professional Accounting Bodies in Malaysia

(a) Malaysian Institute of Accountants (MIA)

(b) The Malaysian Institute of Certified Public Accountants (MICPA)

(ii) to train and evaluate the competent members;

(c) Malaysian Accounting Standards Board (MASB)

(d) Financial Reporting Foundation (FRF)

1.2 FUNDAMENTAL ACCOUNTING CONCEPTS

Qualitative characteristics of accounting information refer to the

Figure 1.1 shows the summary for qualitative characteristics of accounting

Figure 1.1: Qualitative characteristics of accounting information

The extent to which information is considered relevant depends on its

Figure 1.2 shows an example of performance information of a company in

Figure 1.2: Performance information of a company to assist investor in decision making.

(ii) Forecast Value

Reliable information must have the following characteristics:

Figure 1.3: Profitability comparison

What are the important qualitative characteristics of accounting

In your opinion, what will happen to a business entity if it only

1. State the qualitative characteristics of accounting information.

1.2.2 Accounting Assumptions

(a) Assumption of Separate Entity

Let’s look at an example

Table 1.3: Mr Ali’s Business

Business Transaction (RM)

As an example, a machine with a life span of 25 years will be depreciated for

(c) Assumption of Monetary Unit

However, this assumption has two weaknesses, that are:

(d) Assumption of Accounting Period

Figure 1.4 shows examples of accounting period.

Starting Date Ending Date

Figure 1.4: Examples of accounting period

1.2.3 Basic Principles of Accounting

(a) Principle of Historical Cost

of RM72,000 in your financial statement. Five years later, you wish to

(b) Principle of Income Recognition

However, in certain cases, the point of sale method is inappropriate. There

(i) Percentage of Completion Method is normally used by companies

(c) Principle of Matching

For example, when we provide services to customers, we will recognise

Income – Expenses = Profit or Loss

Income > Expenses = Net Profit

Figure 1.5: The relationship between revenue and expense

(d) Principle of Full Disclosure

1. Explain the weaknesses exist in the assumption of monetary unit.

1.2.4 Accounting Constraints

(a) Cost-Benefit Relationship

For example, a small amount of expense like a purchase of stamps and

1.3 ACCOUNTING EQUATION

ASSET = LIABILITY + OWNER’S EQUITY

A business has assets of RM120,000. RM50,000 is the owner’s capital

1.3.1 Analysis of Transaction