ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

Lecture 1: The Accounting Equation

Important Textbook Reading: Chapters 1, 2 & 4: Frank Wood & Alan Sangster Business Accounting 1 Additional reference per approved unit plan

Learning objectives: After you have studied this chapter, you should be able to: Explain the meaning of equity, assets and liabilities Understand the accounting equation Explain the meaning of profit, revenue and expenses Understand the profit determination equation

THE ACCOUNTING EQUATION

Assets minus Liabilities

Equity

Profit

Expenses minus Revenue

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

Assets minus

$$ Cash $$ increases Other resources increase

Capital increases

$$ Cash $$ Other resources

Equity

Capital

minus

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

1. Equity Equity represents the resources that are provided by the owner into the business, for use in the business. The business receives these resources, with the understanding that they actually belong to the owner. However, if the owner makes withdrawals (also called as Drawings), equity will reduce. When the business makes a profit, equity will increase, and vice-versa. Example: Mr. Lee decided to start a business in repairing and servicing vehicles, trading under the name of Lee Workshop. His father gave him RM300,000 cash as injection of capital into the business. Mr. Lee brought a computer (valued at RM3,000) and some furniture (valued at RM1,000) from his home to be used in his business. Due to urgent needs, Mr. Lee withdrew RM2,000 cash for personal use. Business Lee Workshop Receive cash RM300,000 Receive computer RM3,000 Receive furniture RM1,000 Less: Pay cash RM2,000 Total assets = RM302,000 2. Assets Assets are the resources that are inside the business, to be used for running the business activities. It is an advantage if the business has more assets because it will have the ability to run more business activities. Therefore, the more assets a business has, the bigger and stronger is the business, compared to competitors who have fewer assets. Owner Mr. Lee Injects capital RM300,000 Injects capital RM3,000 Injects capital RM1,000 Less: Withdraw cash RM2,000 Total capital = RM302,000 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: The following are some example of the assets that Lee Workshop needs in order to run the business: Types of assets What are assets used for? Cash To purchase tools and equipment for <current assets> repairing vehicles To purchase spare parts for repairing customers vehicles To pay rental for the workshop To pay salaries for the workers Computer To keep record of all customers <non-current assets> information To issue invoices to customers To keep record of all business transactions Furniture To be used in the office <non-current assets> To be used for entertaining customers in the workshop Tools and equipment To be used for repairing vehicles <non-current assets> Inventories Spare parts, oils etc for repairing or <current assets> servicing customers vehicles Receivables Customers who have not yet paid (due to <current assets> credit term of say, 15 days or 30 days)

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

Assets minus Liabilities

$$ Cash $$ increases Other resources increase

Amount owing increases

$$ Cash $$ Other resources

Amount owing

minus

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

3. Liabilities Liabilities represent the supply of resources by outsiders: i) Bank gives loan (cash) to the business, if there is insufficient capital from the owner. The business must repay the loan to the Bank, according to the terms and conditions of the loan agreement. Therefore, this is an amount owing to the Bank. ii) Suppliers supply other resources for use in the business, such as, the tools and equipment, spare parts for repairing customers vehicles, etc. The business must pay these suppliers for the resources supplied, according to the payment terms (e.g. credit term of 30 days or 60 days, etc.). Therefore, this is an amount owing to the suppliers, also called as payables (or trade payables). There are 2 categories of liabilities: i) Non-current liabilities - amount payable for more than 1 year, e.g. mortgage loan, bank loan, etc. ii) Current liabilities amount payable within one year, e.g. short-term loan, bank overdraft, payables (trade or others), etc. Example: The following are some example of the resources that Lee Workshop needs to obtain from outsiders in order to run the business: Business Lee Workshop Receive cash RM50,000 Receive tools RM500 Receive equipment RM90,000 Receive spart parts RM5,000 Total assets = RM145,500 Outsiders Bank / Suppliers Loan RM50,000 Supply tools RM500 Supply equipment RM90,000 Supply spart parts RM5,000 Total liabilities = RM145,500 Liabilities will be reduced when the business repays the loan or settles the amount owing to suppliers (payables). Example: Lee Workshop settles the following amounts owing to suppliers: Business Lee Workshop Pay RM500 for tools Pay RM90,000 for equipment Pay RM5,000 for spart parts Assets reduce by RM95,500 Outsiders Payables Receive cash RM500 Receive cash RM90,000 Receive cash RM5,000 Liabilities reduce by RM95,500

It is a disadvantage if the business has a lot of liabilities because it will be burdened with the pressure to find the assets (resources) to settle them. 4. The accounting equation ASSETS = LIABILITIES + EQUITY . All the assets (resources) available in the business are either provided by the owner (equity) or supplied by outsiders (liabilities).

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

Illustration 1: Elaine Tan started business on 1 May 2010, operating a shop Sweet Bun selling various types of buns, with her own cash of RM30,000 and a 2-year loan from RHB Bank of RM20,000. She opened a current account with RHB Bank and deposited RM40,000 into it. During the month, she paid the following by cheques: Fixture and fittings RM8,000 Furniture RM7,000 Office equipment RM5,000 Inventories RM3,000 Calculate the cash and bank balances at the end of May 2010. Increase Decrease (RM) (RM) Cash: Capital injection by Elaine Tan Loan from RHB Bank Deposited into the bank account Bank account: Deposited into the bank account Paid for fixture & fittings Paid for furniture Paid for office equipment Paid for inventories Prepare a listing based on the Accounting Equation as at 31 May 2010. Types Amount (RM) Cash Assets Bank Fixture and fittings Furniture Office equipment Inventories

Balance (RM)

Liabilities Equity

Loan Capital

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

Assets minus

$$ Cash $$ increases minus Inventories decrease

Profit increases equity

Equity

$$ Cash $$

Payment Revenue
Revenue minus cost of inventories sold

Profit

Sale of inventories

Cost of inventories sold

Expenses minus

$$ Cash $$ received

Revenue

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

5. Profit Business makes a profit when the selling price charged to the customer is higher than the cost of the inventories. As the owner of the business (who injected capital into the business), all profits made by the business belong to the owner. Therefore, all profits made will increase equity. Conversely, when the business makes a loss, it will reduce equity. Example: 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 parts from the supplier at a price of RM20 per box (total = RM200): Business Lee Workshop Sell inventories costing _____ Receive cash ________ Assets increase by ______ Outsiders Customers Inventories selling price _____ Pay _______ Amount owing = _______

6. Revenue Revenue is the income earned by the business from undertaking business activities, which results in an increase of assets, such as cash. Types of revenue are: i) Sales income earned from selling goods and services. Goods refer to inventories that the business purchased for the purpose of selling at a higher price to customers, e.g. selling spare parts to customers. Services refer to the value of work done by the business that customers will pay a price, e.g. repairing vehicles. ii) Other income other sources of income earned that are not directly related to the main business activities, e.g. rent received, discount received, interest received, commission received, etc. 7. Expenses Expenses are all the resources that have been used up to enable the sale of goods and services to customers. Types of expenses are: i) Cost of goods sold cost of inventories sold to customers. These inventories had earlier been purchased from suppliers. ii) Expenses other forms of resources that had to be spent in order to run the business, e.g. salaries to workers, rental, electricity, telephone, water, insurance, etc. 8. The Profit Determination Equation PROFIT = REVENUE - EXPENSES .

Cost of inventories _______ Selling price _________ Profit increase by _______

Profit is the net amount after adding up all the revenue and deducting all the expenses. If expenses exceed revenue, then the business makes a loss.

ABFA1013 INTRODUCTION TO ACCOUNTING

SKH2009 revised May 2011

Illustration 2: Continuing from Illustration 1 above, Elaine Tans Sweet Bun business transactions during the month of June 2010 are as follows: Sales totalling RM20,000, all deposited into the bank account (inventories sold were costing RM7,000) Received a cheque RM200 being discount received from supplier Purchases of inventories by cheque totalling RM5,000 Paid staff salaries by cash RM2,000 Paid shop rental by cheque RM3,000 Paid electricity by cash RM500 Withdrew RM2,000 cash for personal use (drawings) Calculate the cash, bank and inventories balances at the end of June 2010. Increase Decrease Balance (RM) (RM) (RM) Cash: Balance from last month Paid staff salaries Paid electricity Drawings Bank: Balance from last month Sales Discount received Paid for inventories Paid shop rental Inventories: Balance from last month Sales Purchases Prepare a listing based on the Profit Determination Equation for the month of June 2010. Types Amount (RM) Sales Revenue Discount received

Expenses

Cost of inventories sold Staff salaries Shop rental Electricity

Profit

Revenue - Expenses

Prepare a listing based on the Accounting Equation as at 30 June 2010. Types Amount (RM) Cash Assets Bank Fixture and fittings Furniture Office equipment Inventories

Liabilities Equity

Loan Capital Drawings Profit