ABFA1173 Principles of Accounting 1

Lecture 1: The Accounting Equation

Learning objectives:
Important Textbook Reading: After you have studied this chapter, you should be able to:
 Chapters 1, 2 & 4: Frank Wood & Alan Sangster “Business Accounting 1”  Explain the meaning of assets, liabilities and equity
 Additional reference per approved unit plan  Understand the accounting equation
Recommended Practice Questions:  Explain the meaning of profit, revenue and expenses
 Chapter 1: Question no. 1.11, 1.12A  Understand the profit determination equation

THE ACCOUNTING EQUATION

Assets

equals to

Liabilities

plus
Equity

Profit

equals to

Expenses

minus

Revenue
ABFA1173 Principles of Accounting 2
 Owner
ABFA1173 Principles of Accounting 3

Business
$$ Cash $$ increases
Other resources increase
Assets

equals to

plus Capital increases $$ Cash $$

Equity Other resources

Capital

equals to

minus

Assets = Equity
ABFA1173 Principles of Accounting 4

1. Equity

Equity represents the resources that are provided by the owner into the
business, for use in the business.
Drawings represents withdrawals made by the owner for personal use
(equity will reduce).
Equity will increase when the business makes a profit. Equity will
reduce when the business makes a loss.
There are 2 categories of assets:
i) Non-current assets – assets acquired for continuing use over a long
period of time (more than 1 year), e.g. building, machinery, fixture
and fittings, furniture, office equipment, motor vehicles, etc.
ii) Current assets – assets owned by the business and likely to change
in the short term (within a year), e.g. inventories (oil, spare parts,
etc), receivables (trade and others), deposits, bank and cash
balances.

Example: Example:
Mr. Lee decided to start a business in repairing and servicing vehicles, The following are examples of the assets that Lee Workshop needs in
trading under the name of “Lee Workshop”. His father gave him order to run the business:
RM300,000 cash as injection of capital into the business. Mr. Lee Types of assets What are assets used for?
brought a computer (valued at RM3,000) and some furniture (valued at Cash  To purchase tools and equipment for
RM1,000) from his home to be used in his business. Due to urgent <current assets> repairing vehicles
needs, Mr. Lee withdrew RM2,000 cash for personal use.  To purchase spare parts for repairing
customers’ vehicles
Business Owner  To pay rental for the workshop
Lee Workshop Mr. Lee  To pay salaries for the workers
Receive cash RM300,000 Injects capital RM300,000 Computer  To keep record of all customers’
Receive computer RM3,000 Injects capital RM3,000 <non-current assets> information
Receive furniture RM1,000 Injects capital RM1,000  To issue invoices to customers
Less: Pay cash RM2,000 Less: Withdraw cash RM2,000  To keep record of all business transactions
Furniture  To be used in the office

Total assets = RM302,000 Total capital = RM302,000 <non-current assets>  To be used for entertaining customers in the
workshop
Tools and equipment  To be used for repairing vehicles
2. Assets <non-current assets>
Inventories  Spare parts, oils etc for repairing or
Assets are the resources that are inside the business, to be used for <current assets> servicing customers’ vehicles
running the business activities. The more assets a business has, the Receivables  Customers who have not yet paid (due to
bigger and stronger is the business, compared to competitors who have <current assets> credit term e.g. 15 days or 30 days)
fewer assets.
 Bank / Suppliers
ABFA1173 Principles of Accounting 5

Business
$$ Cash $$ increases
Other resources increase
Assets

equals to
Amount owing increases
Liabilities
plus $$ Cash $$
Other resources
Amount owing

equals to

minus

Assets = Liabilities
ABFA1173 Principles of Accounting 6

3. Liabilities

Liabilities represent the supply of resources by outsiders: Liabilities will be reduced when the business repays the loan or settles
i) Bank loan – the bank gives loan (cash) to the business. This is an the amount owing to suppliers (payables).
amount owing to the Bank.
ii) Suppliers – supply other resources for use in the business, such as, Example:
the purchases of inventories, non-current assets, etc. This is an Lee Workshop settles the following amounts owing to suppliers:
amount owing to the suppliers, also called as payables.
Business Outsiders
There are 2 categories of liabilities: Lee Workshop Payables
i) Non-current liabilities - amount payable for more than 1 year, e.g.
mortgage loan, bank loan, etc. Pay RM500 for tools Receive cash RM500
ii) Current liabilities – amount payable within one year, e.g. short-term Pay RM90,000 for equipment Receive cash RM90,000
loan, bank overdraft, payables (trade or others), etc. Pay RM5,000 for spare parts Receive cash RM5,000

Example:
The following are examples of the resources that Lee Workshop needs Assets reduce by RM95,500 Liabilities reduce by RM95,500
to obtain from outsiders in order to run the business:
It is a disadvantage if the business has a lot of liabilities because it will
Business Outsiders be burdened with the pressure to find the assets (resources) to settle
Lee Workshop Bank / Suppliers them, together with interest (cost of capital), if any.
Receive cash RM50,000 Loan RM50,000
4. The accounting equation
Receive tools RM500 Supply tools RM500
Receive equipment RM90,000 Supply equipment RM90,000
ASSETS = EQUITY + LIABILITIES .
Receive spare parts RM5,000 Supply spare parts RM5,000
All the assets (resources) available in the business are either provided by
Total assets = RM145,500 Total liabilities = RM145,500 the owner (equity) and/or supplied by outsiders (liabilities).
ABFA1173 Principles of Accounting 7

Illustration 1:

Elaine Tan started business on 1 May, operating a shop “Sweet Bun” selling Prepare a listing based on the Accounting Equation as at 31 May.
various types of buns, with her own cash of RM30,000 and a 2-year loan Types Amount (RM)
from RHB Bank of RM20,000. She opened a current account with RHB Assets Cash 10,000
Bank and deposited RM40,000 into it. During the month, she paid the Bank 17,000
following by cheques: Fixture and fittings 8,000
Furniture 7,000
 Fixture and fittings RM8,000 Office equipment 5,000
 Furniture RM7,000 Inventories 3,000
 Office equipment RM5,000 50,000
 Inventories RM3,000
Liabilities Loan 20,000
Calculate the cash and bank balances at the end of May.
Equity Capital 30,000
Increase Decrease Balance
(RM) (RM) (RM) 50,000
Cash:
 Capital injection by Elaine Tan 30,000
 Loan from RHB Bank 20,000
 Deposited into the bank account (40,000) 10,000
Bank account:
 Deposited into the bank account 40,000
 Paid for fixture & fittings (8,000)
 Paid for furniture (7,000)
 Paid for office equipment (5,000)
 Paid for inventories (3,000) 17,000
 Customers
ABFA1173 Principles of Accounting 8

Business
$$ Cash $$ increases
minus
Assets Inventories decrease

equals to

Profit increases equity

plus
Equity $$ Cash $$
Payment

Revenue
Revenue minus cost of inventories sold Profit Sale of inventories
equals to

Cost of inventories sold Expenses

minus

$$ Cash $$ received Revenue

Assets (increase) = Equity (increase)

Profit = Revenue - Expenses

ABFA1173 Principles of Accounting 9

5. Profit 6. Revenue

Business makes a profit when the selling price charged to the customer Revenue is the income received/earned by the business from
is higher than the cost of the inventories. undertaking business activities, which results in an increase of assets,
e.g. cash/receivables. Types of revenue are:
All profits made by the business belong to the owner. Therefore, all i) Sales – income earned from selling goods and services, e.g. selling
profits made will increase equity. Conversely, when the business spare parts to customers, repairing vehicles.
makes a loss, it will reduce equity. ii) Other income – other sources of income earned that are not directly
related to the main business activities, e.g. rent received, discount
Example: received, interest received, commission received, etc.
Lee Workshop sells 10 boxes of spare parts to a walk-in customer at a
total selling price of RM500. Lee Workshop had purchased these spare 7. Expenses
parts from the supplier at a price of RM20 per box (total = RM200):
Expenses are all the resources that have been consumed in running the
Business Outsiders business. Types of expenses are:
Lee Workshop Customers i) Cost of goods sold – cost of inventories sold to customers.
Sell inventories costing RM200 Inventories selling price RM500
ii) Expenses – other forms of resources, e.g. salaries to workers, rental,
electricity, telephone, water, insurance, etc.
Receive cash RM500 Pay RM500
8. The Profit Determination Equation
Assets increase by RM300 Amount owing = Nil
PROFIT = REVENUE - EXPENSES .

Cost of inventories RM200 Profit is the net amount after adding up all the revenue and deducting all
Selling price RM500 the expenses. If expenses exceed revenue, then the business makes a
loss.
Profit increase by RM300
ABFA1173 Principles of Accounting 10

Illustration 2:

Continuing from Illustration 1 above, Elaine Tan’s “Sweet Bun” business Prepare a listing based on the Profit Determination Equation for the month
transactions during the month of June are as follows: ended 30 June.
Types Amount (RM)
 Purchases of inventories by cheque totalling RM5,000 Revenue Sales 20,000
 Sales totalling RM20,000, all deposited into the bank account Discount received 200
(inventories sold were costing RM7,000) 20,200
 Received a cheque RM200 being discount received from supplier
 Paid staff salaries by cash RM2,000 Expenses Cost of inventories sold 7,000
 Paid shop rental by cheque RM3,000
Staff salaries 2,000
 Paid electricity by cash RM500
Shop rental 3,000
 Withdrew RM2,000 cash for personal use (drawings)
Electricity 500
12,500
Calculate the cash, bank and inventories balances as at 30 June.
Increase Decrease Balance
(RM) (RM) (RM) Profit Revenue - Expenses 7,700
Cash:
 Balance from last month 10,000 Prepare a listing based on the Accounting Equation as at 30 June.
 Paid staff salaries (2,000) Types Amount (RM)
 Paid electricity (500) Assets Cash 5,500
 Drawings (2,000) 5,500 Bank 29,200
Bank: Fixture and fittings 8,000
 Balance from last month 17,000 Furniture 7,000
 Purchase of inventories (5,000) Office equipment 5,000
 Sales 20,000 Inventories 1,000
 Discount received 200 55,700
 Paid shop rental (3,000) 29,200
Inventories: Liabilities Loan 20,000
 Balance from last month 3,000 Equity Capital 30,000
 Purchases 5,000 Drawings (2,000)
 Sales (7,000) 1,000 Profit 7,700
55,700
ABFA1173 Principles of Accounting 11

Double Entry Bookkeeping Learning objectives:

After you have studied this chapter, you should be able to:
Important Textbook Reading:  Distinguish between debit and credit items
 Chapters 1, 2 & 4: Frank Wood & Alan Sangster “Business Accounting 1”  Understand the meaning of ‘double entry’
Recommended Practice Questions:  Explain the relationship between accounting and bookeeping
 Chapter 2: Question no. 2.2A  Explain the Accounting Cycle
 Chapter 4: Question no. 4.1, 4.2  Prepare ledger accounts and journal entries
 List the main users of accounting information
 List the types of business activities and modes of business ownership

THE ‘DOUBLE ENTRY’ SYSTEM

Debit Credit

Liabilities

Assets Revenue

Expenses Equity

Assets = Liabilities + Equity

Profit = Revenue - Expenses
ABFA1173 Principles of Accounting 12

Debit items Illustration 1:

Debit items, denoted as “Dr”, represent the resources that are needed Identify whether “Dr” or “Cr” for the following items:
in undertaking the business activities:
i) Assets Office equipment Dr
ii) Expenses Motor vehicles Dr
iii) Losses (i.e. expenses exceeding revenue) Discount received Cr
Interest received Cr
9. Credit items Loan Cr
Amount owing to suppliers Cr
Credit items, denoted as “Cr”, represent the sources that provide or Capital Cr
supply for the resources that are needed in undertaking the business Office rental Dr
activities: Telephone Dr
i) Liabilities Salaries Dr
ii) Equity Sales Cr
iii) Revenue Purchases Dr
iv) Profit (i.e. revenue exceeding expenses) Amount owing by customers Dr
Profit Cr
Loss Dr
Cash Dr
Bank Dr
ABFA1173 Principles of Accounting 13

10. Double entry

We have seen that every business transaction has two effects in the
accounting equation (dual effect). ‘Double entry’ is the accounting
system of systematically recording both effects in every business Assets = Liabilities + Equity
transaction. Increase  Dr Increase  Cr Increase  Cr
Decrease  Cr Decrease  Dr Decrease  Dr
The two effects cause a debit entry and a credit entry, arising from a
combination of the following changes:

Changes to debit items will be either:

i) an increase – recorded as a debit entry
ii) a decrease – recorded as a credit entry
Profit = Revenue - Expenses
Increase  Cr Increase  Cr Increase  Dr
Changes to credit items will be either: Decrease  Dr Decrease  Dr Decrease  Cr
i) an increase – recorded as a credit entry
ii) a decrease – recorded as a debit entry

For every change on the debit side, there is an exactly equal and
opposite change on the credit side. The debit side must be equal to the
credit side.
ABFA1173 Principles of Accounting 14

Illustration 2:
Double entry effect of transaction:
Identify the effect of the following transactions on the elements of the Assets/ Liabilities/ Amt Amt
Increase / Title of ledger
Accounting Equation or Profit Determination Equation. Equity/ Revenue/ (RM) (RM)
Decrease account
Expenses DR CR
1. Encik Othman starts business with RM30,000 cash. 1 Dr Assets Increase 30,000 Cash
2. Loan from Public Bank Bhd. RM20,000 entered into bank account. Cr Equity Increase 30,000 Capital
3. Deposit cash of RM20,000 into the bank account. 2 Dr Assets Increase 20,000 Bank
4. Paid a cheque amounting RM8,000 for fixtures and fittings. Cr Liabilities Increase 20,000 Loan
5. Bought furniture from Fanzy Furniture RM7,000 on credit 30 days. 3 Dr Assets Increase 20,000 Bank
6. Purchased inventories from North Pole RM10,000 on credit 30 days. Cr Assets Decrease 20,000 Cash
7. Sales on cash term RM8,000 4 Dr Assets Increase 8,000 Fixture & fittings
8. Othman’s father gave him a gift of RM9,000 cash as additional capital Cr Assets Decrease 8,000 Bank
for the business. 5 Dr Assets Increase 7,000 Furniture
9. Paid cash RM2,000 to settle an amount owing to payables. Cr Liabilities Increase 7,000 Payables
10. Sales RM9,000 on credit term. 6 Dr Expenses Increase 10,000 Purchases
11. Encik Othman brought a computer (valued at RM4,000) from his home Cr Liabilities Increase 10,000 Payables
for use in the business. 7 Dr Assets Increase 8,000 Cash
12. Received a cheque RM9,000 as settlement of amount owing by Cr Revenue Increase 8,000 Sales
receivables. 8 Dr Assets Increase 9,000 Cash
13. Encik Othman issued a cheque amount RM1,000 to pay for his son’s Cr Equity Increase 9,000 Capital
tuition fee at TAR University College. 9 Dr Liabilities Decrease 2,000 Payables
14. Paid a cheque RM9,000 to settle part of the loan from Public Bank Bhd. Cr Assets Decrease 2,000 Cash
10 Dr Assets Increase 9,000 Receivables
Cr Revenue Increase 9,000 Sales
11 Dr Assets Increase 4,000 Office Equipment
Cr Equity Increase 4,000 Capital
12 Dr Assets Increase 9,000 Bank
Cr Assets Decrease 9,000 Receivables
13 Dr Equity Decrease 1,000 Drawings
Cr Assets Decrease 1,000 Bank
14 Dr Liabilities Decrease 9,000 Loan
Cr Assets Decrease 9,000 Bank
ABFA1173 Principles of Accounting 15

11. Accounting vs. Bookkeeping

Accounting is a process of:
i) Collecting source documents as evidence of transactions and as the
source for recording business transactions.
ii) Recording relevant details from source documents in the respective
books of prime entry.
iii) Summarising from the books of prime entry and transferring
(posting) these summaries to the respective ledgers.
iv) Communicating the accounting information to users, by preparing
the financial statements.
Source documents are written documents that contain details of the
business transactions. They provide evidence that the transactions have
taken place. They are used as the source information for recording in the
appropriate books of prime entry.
Source Documents Explanation
Invoice To inform customer the amount to be paid,
amount of discount given, whether cash term or
credit term and interest charges for late
payment.

Credit Note To deduct an amount overcharged in the

Bookkeeping is an initial part of the accounting process that emphasise
Invoice and returns of goods from customers.
on – collecting and recording business transactions from the source
documents to the respective books of prime entry, using the double Debit Note To add to the amount of Invoice for any
entry system. additional charges, e.g. transport fee, interest
charges and any amount undercharged.
12. The Accounting Cycle
Cash bill This is the same as Invoice, but is used only
when transaction is on cash terms (by cash or
Source by cheque) customer only.
Documents The 7 Books of
Prime Entry
Payment voucher To record the payment by cash or cheque.
Closing
entries Official receipt To acknowledge money has been collected.
The 3 Ledgers
The Cheque counterfoil To record the amount paid on a particular
Accounting numbered cheque (the counterfoil is the portion
Adjusted Trial Cycle left after tearing out the particular cheque).
Balance &
Financial Memo A written message/note from the
Draft Trial
Statements Balance & management/boss to inform about decision on
Financial certain transactions.
Adjustments
Statements

Source Documents
ABFA1173 Principles of Accounting 16

The 7 Books of Prime Entry The 3 Ledgers

i) Record the daily business transactions in chronological order based The 3 Ledgers are the final sets of accounts containing the summarised
on the source documents. accounting information that have been transferred/posted from the
ii) The purpose is to record similar transactions into one book and books of prime entry, using double entry system.
reduce the detail in the ledgers, as only the total amounts are posted
to ledgers. The 3 Ledgers Explanation
General Ledger This is the main ledger that contains all the
The 7 Books of Explanation accounts (the complete double entries) that
Prime Entry summarise all the business transactions that
Cash Book Cash / cheque transactions occurred. Therefore, the Trial Balance and
Financial Statements are prepared using the
Petty Cash Book Small amounts of daily payments, such as General Ledger.
postage and stamps, stationery, wages for
cleaning and minor repairs, Subsidiary ledgers:
general/miscellaneous expenses, etc. Sales Ledger Contains all the individual trade receivables
accounts (customers on credit terms). It forms
Specialised journals: only half of the double entry bookkeeping. An
Sales Journal Sales of goods on credit terms account inside the General Ledger controls this
entire ledger.
Purchases Journal Purchases of goods on credit terms
Purchases Ledger Contains all the individual trade payables
Sales Returns / Returns of goods that were sold on credit terms accounts (suppliers on credit terms). It forms
Returns Inwards (defective/damaged goods) only half of the double entry bookkeeping. An
account inside the General Ledger controls this
Purchase Returns / Returns of goods that were purchased on credit entire ledger.
Returns Outwards terms (defective/damaged goods)

General Journal All other business transactions (that are not

involving cash/ cheque payments, sales and
purchases of goods)
ABFA1173 Principles of Accounting 17

All the accounts in the 3 Ledgers are in the ‘T’ account format: When posting the total amounts from the books of prime entry to the
ledger accounts using double entry system, it is necessary to:
Title of account i) Identify the two effects of the transaction (debit and credit).
RM RM ii) Decide which accounts to be posted to.
iii) Enter the opposite account as particulars
iv) Enter the amount of change being effected by the transaction

The rules of the double entry system are illustrated below: Illustration of double entry system of posting to the ledger accounts:

Debit <Assets> Credit Title of account <A>

Year RM RM
RM RM
Date Title of account <B> Amount
Increase in assets Decrease in assets
of change

Title of account <B>

Debit <Liabilities> Credit
RM Year RM
RM RM
Date Title of account <A> Amount
Decrease in liabilities Increase in liabilities of change

Example:
Debit <Equity> Credit On 1 May Year X, Mr. Ong brought in his personal car (valued
RM RM
RM80,000) for use in the business.
Decrease in equity Increase in equity
i) Identify the two effects of the transaction:
Increase in asset (Dr) RM80,000; Increase in equity (Cr) RM80,000
Debit <Revenue> Credit ii) Decide which accounts to be posted to:
RM RM Asset – Motor vehicles account; Equity – Capital account
Decrease in revenue Increase in revenue
Motor Vehicles account
Year X RM RM
Debit <Expenses> Credit May 1 Capital 80,000
RM RM
Increase in expenses Decrease in expenses
Capital account
RM Year X RM
May 1 Motor Vehicles 80,000
ABFA1173 Principles of Accounting 18

Trial Balance 13. Journal entry

The Trial Balance is the summary of balances of all the accounts The journal entry is written to illustrate understanding of double-
contained in the General Ledger. It shows that the total of all debit items entry system.
are equal to the total of all credit items in the General Ledger.
Therefore, it is used to check the accuracy and completeness of double The purposes of journal entry are:
entry system. i) For discussion on what is the correct double entry in the books of
prime entry and ledgers
Financial Statements ii) For the Accountant to give the correct instruction to the bookkeeper
iii) For the Accountant to explain to the external auditors on how
There are two main financial statements, the Statement of Profit or Loss certain business transactions had been entered in the books of prime
and the Statement of Financial Position. The Accounting Equation can entry and ledgers
be used to demonstrate the link of the individual business transactions iv) For the examiner to test students’ understanding of the double entry
to the financial statements. system
Adjustments
Format of the journal entry:
Dr (RM) Cr (RM)
In order to prepare financial statements that are ‘true and fair’ (i.e. to
Dr <title of account> <amount>
be useful to the users of such accounting information), adjustments are
Cr <title of account> <amount>
required to be included in the General Ledger. <Narrative>

These adjustments require the Accountant to exercise professional

Example:
judgement; therefore, the bookkeeper will receive the Memo from the
Mr. Ong brought in his personal car (valued RM80,000) for use in the
Accountant regarding the required adjustments.
business.
Closing Entries
Dr (RM) Cr (RM)
Dr Motor Vehicles 80,000
Finally, the General Ledger has to be properly closed off in order to be
Cr Capital 80,000
ready to start the Accounting Cycle again in the next accounting period. Mr. Ong brought in his personal car for use in the
business
ABFA1173 Principles of Accounting
14. Users of accounting information
Below is the list of the main users of accounting information (i.e.
financial statements) and the reasons for their interest and usage:
i) Management – decision making, planning, control and co-
ordination of business activities
ii) Shareholders/investors – company’s future plans and dividends
iii) Customers – long-term supply of goods to ensure supply is secured
iv) Suppliers – ability of the company to pay its debts within the credit
period given
v) Finance providers (i.e. banks and financial institutions who lend
money to a business) – ensure its financial stability and ability to
repay the amount borrowed (principal sum) and pay interests
vi) Employees – payment of salary, other benefits, career growth,
secured employment
vii) Government (government agencies) – assess tax payable, compile
statistical data for economic analysis
viii) Public (the local community) – protection of the environment, fair
trade, responsible business, community service, provision of job
opportunities, researchers, etc.
19
15. Types of business activities
i) Retail/trading – buy goods and re-sell at a higher price to customers,
e.g. supermarkets and grocery shops.
ii) Wholesale - buy goods in bulk (large quantities) from
manufacturers/importers and re-sell to retailers in smaller quantities,
e.g. distributors.
iii) Manufacturing – production process that converts raw materials/
components into finished goods.
iv) Service industry – provide services to clients (not selling goods),
e.g. accounting firms and law firms.
16. Modes of business ownership
i) Sole proprietorship – the business is owned by only one individual
and the business is run (managed) by the sole proprietor (assisted by
family members and/or staff). If the business fails, the sole
proprietor is required to personally settle all the debts/loans on
behalf of the business.
ii) Partnership – the business is owned by at least 2 individuals but not
more than 20 individuals and the business is jointly run (managed)
by the partners (assisted by staff). The partners are required to
jointly settle all the debts/loans, if the partnership business fails.
iii) Company – the business is owned by at least 2 persons, up to any
number and it can be either a private limited company (Sdn. Bhd.)
or public limited company (Berhad). The business is professionally
run (managed) by directors. Shareholders are not required to settle
the business debts/loans, if the business fails.