Chapter 3

The Accounting Equation

and Financial Statements
Fundamentals of Financial Accounting All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 1
 Overview

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 2
 Learning Outcomes

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 3
 The Accounting Equation

ASSETS = LIABILITIES + OWNER’S EQUITY

Assets are Liabilities are Owner’s Equity is

resources that outsiders’ the owner’s
possess future (creditors’) claim on residual claim on
economic benefits the assets and total assets
represent the debts
and obligations of
the business

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 4
 The Accounting Equation – cont.

EXAMPLE

Liabilities
RM 4,000

Assets
RM 10,000

Capital
RM 6,000

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 5
 Assets

 Assets are items of values owned by a business.

They are bought and held by the business to
help them generate income and make profit.
 Examples of assets:
– a piece of land, a building,
– motor vehicles,
– furniture,
– office equipments,
– inventories or stock of goods, and
– cash in the bank.
Fundamentals of Financial Accounting All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 6
 Liabilities

 Liabilities are amount owed by a business to

external parties. Liabilities are “outsider claims”
which are economic obligations (debts) of a
business payable to outsiders.
Examples of liabilities:
– Creditors,
– bank overdraft,
– taxes payable and
– salaries payable.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 7
 Owner’s Equity

 Owner’s equity is the amount of the owner’s

interest or investment in the business.
 The owner’s equity can be divided into four
components which are :
– Capital
– Drawings
– Revenues
– Expenses

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 8
 Components of Owner’s Equity

Capital

Owner's
Expenses Revenue
Equity

Drawings

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 9
 CHANGES IN OWNER’S EQUITY

DECREASES Drawings Expenses

OWNER’S EQUITY

INCREASES CAPITAL REVENUE

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 10
 Expanded Accounting Equation

LIABILITIES

ASSETS

CAPITAL – REVENUE –
EXPENSES – DRAWINGS

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 11
 Analysis of Transactions

 Business transactions are the economic events of the

business recorded by accountants.
 Examples of economic events or business transactions
include purchases of goods, sales of goods, salary paid
to an employee etc.
 Before the accountant records the transaction in the
business books, each transaction must be analysed in
terms of its effect on the components of the basic
accounting equation.
 This analysis must identify the specific items affected
and the amount of the change in each item.
Fundamentals of Financial Accounting All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 12
 Analysis of Transactions

 Since the equality of the basic equation must be

maintained, each transaction must have a dual
effect on the equation. For example, if an asset
is increased, any one of the following must also
occur in order for the equation to remain in
balance:
– Decrease in another asset, or
– Increase in a specific liability or owner’s equity, or
– Some combination of these

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 13
 Analysis of Transactions – cont.

Transaction 1: Investment by Owner

Ashraf decides to start a consultancy firm. He opens up
a new company “Forever Excellent”. He invests
RM20,000 cash as capital.
The effect of this transaction on accounting equation:
– Asset (cash) - Increases
– Capital - Increase

Assets = Liabilities + Owner’s equity

Cash = + Capital
+RM20,000 +RM20,000 Investment

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 14
 Analysis of Transactions – cont.

Transaction 2: Purchase of Office Equipment for Cash

Forever Excellent purchases a machine costing RM5,000 and
pay by cash.
The effect of transaction on accounting equation:
– Asset (Equipment) - Increases
– Asset (Cash) - Decreases
  Assets = Liabilities + Owner’s Equity
Cash + Equipment = + Capital
Old Bal RM20,000 = + RM20,000
(2) -RM5,000 +RM5,000 = + RM20,000
New Bal RM15,000 + RM5,000 = + RM20,000
  RM20,000  

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 15
 Analysis of Transactions – cont.

Transaction 3: Purchase Stationery on Credit

Forever Excellent buys office stationery such as papers
and files at RM2,000 on credit from Ah Seng Enterprise.
Stationery is an expense. Ah Seng allows payment to be
made next month.

The effect of transaction on accounting equation:

– Owner’s equity - Decreases (because
of an increase in expense)
– Liability (accounts payable) - Increases

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 16
 Analysis of Transactions – cont.

  Assets = Liabilities + Owner’s Equity

Accounts
Cash + Equipment = + Capital
Payable

Old Bal RM15,000 RM5,000 = + RM20,000

Stationery
(3) = +RM2,000 + -RM2,000
Expense

New Bal RM15,000 + RM5,000 = RM2.000 + RM18,000

RM20,000 RM20,000

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 17
 Financial Statements

 Financial statements are the final product of the

accounting process.
 They are usually prepared at the end of the
business accounting period.
 They are prepared by the management of a
business to show the performance and the
financial position of the business for ecah
accounting period.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 18
 Types of Financial Statements

 Statement of Profit or Loss and Other

Comprehensive Income (previously known as
Income Statement) for a trading business or
Statement of Comprehensive Income for a
service business
 Statement of Financial Position (previously
known as Balance Sheet)
 Cash Flow Statement
 Statement of Changes in Equity

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 19
 Statement of Profit or Loss and
Other Comprehensive Income

 The Statement of Profit or Loss and Other

Comprehensive Income presents the revenues
and expenses and resulting net profit or net loss
of a business for a specific period of time.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 20
 Statement of Profit or Loss and Other
Comprehensive Income – cont.

Example of Statement of Profit or Loss and Other

Comprehensive Income (Service Industry)

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 21
 Statement of Profit or Loss and Other
Comprehensive Income – cont.

Example of Statement of Profit or Loss and Other

Comprehensive Income (Trading Business)

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 22
 Statement of Financial Position

 The Statement of Financial Position is like a

snapshot of the business financial condition at a
specific point in time (usually the month-end or
year-end).
 It reports the assets, liabilities, and owner’s
equity of a business at a specific date.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 23
 Example of Statement of
Financial Position

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 24
 Classification of the Financial
Position

 A classified Statement of Financial Position

generally contains the following standard
classifications;

ASSETS LIABILITIES and OWNER’S

EQUITY
Non-Current Assets Non-Current Liabilities
Current Assets Current Liabilities
Owner’s Equity

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 25
 Non-Current Assets

 Non-current assets (previously called Fixed

Assets) are tangible assets which have a useful
life of more than one year. They are used in the
business and not intended for sale.
Some examples of non-current assets are:
– land and buildings,
– machinery,
– fixtures and fittings,
– office equipment and
– motor vehicles.
Fundamentals of Financial Accounting All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 26
 Current Assets

 Current assets are cash and other resources

that are reasonably expected to be realized in
cash or sold or consumed in the business within
one year.
Examples of current assets include:
– inventory of goods
– accounts receivable (debtors)
– payments in advance (prepaid expenses)
– cash in hand and
– cash at bank.
Fundamentals of Financial Accounting All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 27
 Non-Current Liabilities

 Obligations or debts that are expected to be

paid after one year are classified as non-current
liabilities (previously called long-term liabilities).
 Liabilities in this category include:
– long-term loan
– mortgage loan and
– debentures.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 28
 Current Liabilities

 Current liabilities consist of obligations or debts

that are expected to be repaid within a year.
 Current liabilities include:
– payables
– short-term loan
– expenses incurred but not yet paid (accrued
expenses) and
– bank overdraft.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 29
 Statement of Changes in Equity

 A Statement of Changes in Equity details out

the changes in owners’ equity over an
accounting period.
 Equity increases when capital is added or when
profit is earned. On the other hand, equity
reduces when dividends are paid or when a
business incurs trading losses.
 This statement is prepared in columnar form.

Fundamentals of Financial Accounting All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 1– 30