Chapter 2: Basic Accounting Concepts

CHAPTER 2

BASIC ACCOUNTING CONCEPTS

OBJECTIVES

After learning this chapter, student should be able to:

 Describe the meaning and the importance of Generally Accepted

Accounting Principle (GAAP).

 Describe the accounting concepts: historical cost, monetary

measurement, economic entities, going concern, consistency,
accounting-period, materiality, revenue recognition, expense
recognition (matching concept), full disclosure, objectivity and fair value
measurement.

 Describe the accounting equation for services businesses.

 Define assets, liabilities and owner’s equity.

 Analyse the effects of business transactions on accounting equation.

 Explain the double entry system.

 Describe the rules of debit and credit on asset, liabilitiy, owner’s equity,
revenue, expense and drawings.

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 Chapter 2: Basic Accounting Concepts

2.1 GENERALLY ACCEPTED ACCOUNTING PRINCIPLE @ GAAP

- is a common set of accounting principles/concepts, regulation, standard and

procedures issued by the Malaysian Accounting Standard Board (MASB) .
- Must be adopted by accounting profession to prepare accounting information
for the purpose of making external economic decision.
- This principle sets out ways on how to measure and record economic activities
of a business and how to disclose the information to the public.

2.2 THE ACCOUNTING CONCEPTS

Concepts Main issues Explanation

1 Historical cost Record of A principle that requires all non-current assets to be

non-current valued at purchase cost or the cost of assets when it is
assets acquired.

Example: Laila Enterprise has bought a building with a

cost of RM 50,000 on 8th August 2001. The market price
of the building rose to RM 65,000 on the next day.
However, the company has to record the building as its
purchase price of RM 50,000.

2 Monetary Monetary Every transaction and accounting events should be

measurement value for measured in terms of money, using the currency of a
each particular country.
transactions
Example: A transaction has occurred in a business but its
value cannot be determined in monetary form. The
accountant decided not to record the transaction until its
monetary value is identified. Is the decision correct?
Why?

Solution:
The accountant’s decision is correct as the value of
business transactions should be properly determined and
disclosed in monetary form.

3 Economic Distinction of Busines and its owner are treated as two separate
entities transactions entities.
between the
owners and Example: Mr. Hassan bought a vehicle for his wife’s
the business personal use. He recorded the purchase of the vehicle in
itself. his business’s accounting book. Moreover, its petrol
expenses are also treated as his business’s expenses.

Solution:
Mr. Hassan did not comply with the business entity
concept. The purchase of an asset for personal use and
its related expenses should not be recorded in his
business accounting book.

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4 Going concern Lifetime of Financial statement is prepared with the assumption that
business the company will continue its operation for an
unforeseeable future.

Example: Abu Enterprise bought a machine at a cost of

RM 40,000 with its lifetime of 10 years. It is advised that
the machine should be depreciated for 5 years as the
company is assumed to liquidate in that period of time.

Solution:
The company does not comply with the concept of going
concern. Cost of the machine should be recorded at RM
40,000 and be depreciated for 10 years as the company
is assumed to continue its operation for an
unforeseeable future.

5 Consistency Consistent in A company uses the same accounting principles and

practicing methods from year to year
methods of • Depreciation- straight line method, reducing balance
accounting method
• Inventories – FIFO, LIFO, Weighted Average.

Example: Abadi Corporation Berhad uses straight line

method in valuing its depreciation of non-current assets.
The company then decides to change its depreciation
method to reducing balance for all its non-current assets.

Solution:
The company does not comply with the consistency
concept as the same method of recording financial
transactions should be used for the financial years ahead.

6 Accounting Accounting The life of a business can be divided into artificial time
period period periods
That useful reports covering those periods can be
prepared for the business

Financial statement of a company is prepared for a

certain period of time – 12 months (1 year) / 6 months
(1/2 year) / 3 months (1/4 year).

Example: Dian Enterprise is incorporated on 1st January

2009. Its financial statement is prepared for every 12
months, with its financial year ends on 31st December
every year.

Solution:
This is a normal action done by a company that follows
the accounting period concept. The financial statement is
prepared for certain period of time.

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7 Materiality Materiality Refers to the impact of an item’s size on a company’s

financial operation
Companies must use good judgment in deciding between
a revenue expenditure and capital expenditure

Example: Untung Selalu Corporation bought two

equipment, A and B where the costs are RM 10 and RM
10,000 respectively. The expected life of both equipment
are 10 years. The company decides to depreciate them
for the period of 10 years.

Solution:
According to materiality concept, it is not material to
consider RM 10 equipment for depreciation. Thus, it
should be treated as an expense for the year while RM
10,000 equipment is material to be depreciated for the
period of 10 years.

8 Revenue Recognised Revenue should only be recognised when it is already

recognition revenue occurred and received.
Special rule: Goods/ services has already been sold.
(change of ownership)

Example: Mr. Shamu is a fruit distributor. He received an

order from a customer for 100 watermelons. He then
recorded and recognised the order as a revenue on the
date of order made.

Solution:
Mr. Shamu cannot immediately recognise the order of
watermelons as revenue because sales transaction had
not occurred yet. His action did not comply with the
revenue recognition concept.

9 Expense Record of Expenses are recorded in its related accounting period

Recognition expenses for which it is incurred to gain revenue.

Example: An owner of a business found that the business

will experience loss and he suggested the accountant not
to record depreciation expense and reduce the amount of
electrical expense for that year.

Solution:
The accountant should not follow the order as it is not in
line with expense recognition concept. All expenses for
the year should be reported to show the financial
performance as the expenses are related to the revenue
gained in the current year.

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10 Full Disclosure Presentation Financial statement of a company should represent all

in financial transactions and other events that occurred in the
statement company at the reporting date

Example: Shiba Corporation made a significant change in

its inventories valuation method. However, this is not
presented in the financial statement for the particular
period.

Solution:
This is a wrongful action being done by the company. Any
changes of methods used in valuing inventories should
be presented so that all financial statements users will
notice the changes made by the company.

11 Objectivity Accounting All accounting transactions should be legitimate and

evidence proven by evidence to ensure the transactions do exist.

Example: Awal Maju Corporation only issues invoices for

all of its credit sales transactions and no document is
issued for any cash sales transactions.

Solution:
Concept of objectivity is not abide by the company as all
business transactions should be accompanied with
relevant documents as evidences.

12 Fair value The practice of measuring assets and liabilities at their

measurement current market value. The fair value is the amount the
assets could be sold, or the liabilities settled for a value
that is fair to both the buyer or the seller.

Example: Company sold a machine worth RM500,000 at

market price but the actual cost is RM600,000.

Solution:
According to the fair value measurement concept, that
company can use the market price RM500,000.

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2.3 THE ACCOUNTING EQUATION

ASSETS LIABILITIES OWNER’S EQUITY

Current assets = Current liabilities + Capital + profit (revenues -
Non- current Non-current expenses) – drawings
assets liabilities

ITEMS EXPLANATION EXAMPLE NORMAL

BALANCE

ASSETS Any resource owned by a Debit balance

business or economic entity (Dr)
that is used to operate the
business and to generate
economic benefit.

Non-current  Assets that have a life

assets more than one year.
 Devided into three :
- Tangible/fixed assets - Land, vehicles,
can be seen physically. buildings

- Intangible assets - can’t Trademarks,

be seen physically. patens,
copyright

- Long-term investments The purchase

– fixed deposits for of bonds
more than a year,

Current  Exist on one accounting Cash in hand,

assets period and can be Cash in bank,
converted into cash within accounts
a year. receivables,
 Constantly of changing Inventories etc.
form and value.

LIABILITIES Obligation (debt) of a Credit balance

company that should be paid (Cr)
to anotherl parties.

Non-current Debt to be settled within a Long term loan,

liabilities period exceeding one year. mortgage

Current Debt that should settled Accounts

liabilities within one year. payable,
overdraft, notes
payable,
expenses
payable

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OWNER’S The ownership claim on total Capital, Credit balance

EQUITY assets of the company. additional (Cr)
capital, net
profit,
Debit balance
Drawing (Dr)

EQUITY = CAPITAL + PROFIT/LOSS (REVENUES-

EXPENSES) – DRAWING

CAPITAL The assets that are - Credit balance

brought into the business (Cr)
by the owner.
DRAWING The owner withdraw cash - Debit balance
or other assets for (Dr)
personal use

REVENUE The income generated Credit balance

from normal business (Cr)
operations.

2 types :
- Revenue of business Services revenue,
Sales

- Revenue of non- Interest income,

business rental income,
gains on sales of
fixed assets

EXPENSES Is the money spent or Debit balance

costs incurred in effort to (Dr)
generate revenue.

2 types :
- Operating expenses Wages and
salaries, rent,
utilities,
depreciation

- Non operating expenses Property taxes

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2.3.1 Transaction Analysis

Step 1 Read and analyse transactions

Step 2 Decide the accounts involved, determine the
classification of accounts and the effects of
transactions.
Step 3 Balance-off the accounting equation. If it is not
balanced, there might be mistakes in step 1 or 2.

Schedule of transaction analysis:

Date Assets = Liabilities + Owner’s

equity
Cash Account Equipment Account Loan Capital
receivable payable

2.4 DOUBLE ENTRY SYSTEM

Double entry system is a system that involves debit and credit in a business’
accounting record.
Debit - record in the left hand side of a T-account
Credit - record in the right hand side of a T-account

2.4.1 T-account

Debit Name of account Credit

Date Particular Amount Date Particular Amount

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2.4.2 Rule of debit and credit

Tips

Remember: AED = CLIC

AED - Assets, Expenses, Drawings

LCR – Liabilities, , Capital , Revenue

Group Normal Effect of Record

balance transaction
Debit
AED Debit
Credit

Credit
LCR Credit
Debit

Nature of Debit account Nature of Credit account

(AED) (LCR)

Debit
Credit

Debit Credit

Example of transaction analysis using schedule of transaction analysis

Below are the accounting transactions for Adam that occurred in the period of October 2018:

1. Adam invested cash of RM 15,000 to start his personal tuition class called Tutor Elit Enterprise.
2. Purchased computer equipment on credit amounted to RM 7,000.
3. Purchased printing paper and other office supplies by cash amounted to RM 1,600.
4. Adam received cash of RM 1,200 from customers for the services he has provided.
5. Adam paid a sum of RM 500 cash to an advertisement company after the company has prepared
brochures for Tutor Elit Ent.
6. Adam issued a bill to a customer for the service he has provided amounted to RM 1,500.
7. Paid RM 400 for office rent for the month of October.
8. Paid clerks’ october salary for RM 800.
9. Adam made a drawing of RM 1,200 for his personal use.

Required: -

1. Prepare a schedule of transaction analysis for the transactions above and prove that the rule of
accounting equation is applied after the final transaction.

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TUTOR ELIT ENT.

TRANSACTION ANALYSIS SCHEDULE
For the month ended 31st October 2018
No Assets = Liabilities + Owner’s equity
RM RM RM

Cash Equipment Office Accounts Accounts Capital Notes

supplies receivable payable

1 15,000 15,000 Investment/

capital
2 7,000 7,000
3 (1,600) 1,600
4 1,200 1,200 Services revenue

5 (500) (500) Advertisement

expense
6 1,500 1,500 Services revenue

7 (400) (400) Rent expense

8 (800) (800) Salary expense
9 (1,200) (1,200) Withdrawal
Final
balance 11,700 7,000 1,600 1,500 7,000 14,800

RM 21,800 = RM 21,800

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