Chapter 2 Accounting Classification and Equation

CHAPTER 2
Accounting Classification and Equation

LEARNING OBJECTIVES

At the end of this chapter, you should be able to:

• Define assets, owner’s equity, liabilities
• Determine the basic accounting equation
• Define revenues and expenses
• Identify the relationship of profit to the accounting equation
• Show the effect of the transaction on the accounting equation
• Identify the movement of stocks

2.1 INTRODUCTION

Business transactions can be classified into five categories that are assets, owner’s
equity, liabilities, revenues and expenses. Assets, owner’s equity and liabilities are
recorded in the Balance Sheet whereas revenues and expenses are recorded in the
Trading and Profit and Loss Accounts. For non-accounting students, the easier way to
learn accounting is to start with the balance sheet.

2.2 THE BALANCE SHEET PRESENTATION

The balance sheet may be presented either using the horizontal format that is the side-
by side form of presentation or using the vertical format. At present, vertical format is
preferred since most businesses nowadays presented their balance using this format.
The balance sheet presentation of a sole proprietorship, partnership and limited
company using the horizontal format are shown in Figure 2.1, 2.2 and 2.3. Vertical
presentation of the balance sheet will be shown in chapter 6.

9
Accounting 1

Figure 2.1 Sole Proprietorship

Balance Sheet as at 31 December 2004

Fixed Assets 25,000 Owner’s Equity

Opening Capital 15,000
Add Net Profit 4,000
Current Assets 3,500
19,000
Less Drawings (500)

18,500

Long Term Liabilities 8,000

Current Liabilities 2,000

28,500 28,500
============ ==========

Figure 2.2 Partnership

Balance Sheet as at 31 December 2004

Fixed Assets 50,000 Capital Accounts

Ali 20,000
Bob 15,000
35,000
Current Accounts
Current Assets 20,000 Ali 5,000
Bob 3,000
8,000

Long Term Liabilities 20,000

Current Liabilities 7,000

70,000 70,000
=========== =========

10
 Chapter 2 Accounting Classification and Equation

Figure 2.3 Limited Companies

Balance Sheet as at 31 December 2004

Authorised Share Capital

Fixed Assets 350,000 300,000 ordinary shares of
RM1 each 300,000
150,000 preference shares
Current Assets 150,000 of RM1 each 150,000
450,000
Issued and Paid up Capital
150,000 ordinary shares of
RM1 each 150,000
100,000 preference shares
of RM1 each 100,000

Capital Reserves 100,000

Revenue Reserves 50,000

Shareholders Fund 400,000

Long Term Liabilities 70,000

Current Liabilities 30,000

500,000 500,000
============ ==========

2.3 ASSETS

Assets are property own by the business. There are two types of assets:

a. Fixed Assets or Non Current Assets

b. Current Assets

Fixed Assets or Non Current Assets

Fixed assets are assets acquired/bought not for resale and it is to be used in the running
of the business. The useful life of the assets is more than one year. Fixed assets are
divided into three categories:

a. Tangible fixed assets

e.g. Land and Building, Machinery, Office Equipment, Furniture and Fittings,
Motor Vehicles etc.

b. Intangible fixed assets

e.g. Franchise, Goodwill, Pattern, Trademark etc.

11
Accounting 1

c. Investment
e.g. Fixed Deposit (>1 year ),Quoted and Unquoted Investment

Current Assets

Current Assets are assets that are either cash or those that can be converted into cash
within one year. They are constantly changing their form during an accounting period.
e.g. Stock, Debtors or Accounts Receivables, Cash at bank, Cash in hand.

2.4 OWNER’S EQUITY

It represents owner-supplied fund to the business for the acquisition of assets for the
business. It is the financial obligations of the business to the owner.

Profit will increase the capital of the business (therefore increases the owner’s equity)
whereas losses and drawings will reduce the capital of the business (therefore
decreases the owner’s equity). Drawings occur when the owner took whatever assets of
the business for his own use.

Thus, owner’s equity is represented by capital that has been adjusted taking into
account profit or loss of the business and any withdrawals made by the owner. That is,

Owner’s Equity = Capital + /(-) Profit (Losses) - Drawings

2.5 LIABILITIES

It is the financial obligations of the business to external parties. There are two types of
liabilities:

a. Long Term Liabilities

b. Current Liabilities

Long Term Liabilities

It is an amount owing by the business that have a repayment period of more than one
year.
e.g. Long Term Loan, Mortgage on Premises, Debenture

Current Liabilities

It is an amount owing by the business that is to be paid in within one year.

e.g. Short Term Loan, Bank Overdraft, Creditors or Accounts Payable.

12
 Chapter 2 Accounting Classification and Equation

2.6 THE ACCOUNTING EQUATION

A business needs resources to enable it to operate. Resources own by the business are
known as assets. All assets that a business owns have to be supplied by the owner and
the external parties. Therefore, the relationship between the assets and equities (that of
the owner and the external parties) of the business can be expressed in the following
equation:

ASSETS = OWNER’S EQUITY + LIABILITIES

A = OE + L
OE = A - L
L = OE - C

The above equation is known as the basic accounting equation or the balance sheet
equation. It forms the basis of the whole double entry bookkeeping system. The
equality of the accounting equation is always maintained regardless of the number of
transactions recorded in the business. Any change in the amount of the total assets is
always accompanied by an equal change in the amount of the total liabilities and
owner’s equity.

2.7 THE BALANCE SHEET AND THE EFFECTS OF BUSINESS

TRANSACTIONS

The accounting equation A = OE + L is expressed in a financial statement known as

the Balance Sheet. It is the detailed expression of the accounting equation. A balance
sheet is an accounting report that shows all the assets, liabilities and owner’s equity of
an organisation at a particular time.

Example

On 1 January 2000, Ali started business with RM10,000 in the business bank account.
The balance sheet extracted as at 1 January 2000 is as follows :

Balance Sheet as at 1 January 2000

Assets RM Owners Equity RM

Bank 10,000 Capital 10,000

On 2 January 2000, the business bought office equipment from Dot.Com Trading
RM5,500.

13
Accounting 1

Balance Sheet as at 2 January 2000

Assets RM Owners Equity RM

Bank 10,000 Capital 10,000
Office Equipment 5,500
Liabilities
Creditor – Dot.Com Trading 5,500
______ _______
15,500 15,500
===== ======

On 3 January 2000, the business paid Dot.Com Trading RM3,000 by cheque.

Balance Sheet as at 3 January 2000

Assets RM Owners Equity RM

Bank 7,000 Capital 10,000
Office Equipment 5,500
Liabilities
Creditor – Dot.Com Trading 2,500
______ _______
12,500 12,500
===== ======

2.8 EFFECTS OF TRANSACTIONS ON THE BASIC ACCOUNTING

EQUATION

Every transaction will have double effects on the accounting equation. The effects are
there might be an increase or decrease in assets, increase or decrease in liabilities or
increase or decrease in owner’s equity.

Below are the transactions at the beginning of the business for Ahmad Trading for the
month of January 2000:

Date Transactions Assets Owner’s Liabilities

Equity
Jan 1 Ahmad started a business with Cash RM10,000 Capital
RM10,000 cash in hand. RM10,000
Effect : Cash increase and
Capital increase

Jan 2 The business bank in Cash RM1,000 Capital

RM9,000 of the cash into the Bank RM9,000 RM10,000
bank account.
Effect: Cash decrease and
bank increase
Jan 3 Received cheque RM5,000 Cash RM1,000 Capital Loan

14
 Chapter 2 Accounting Classification and Equation

being loan from Bank Rakyat. Bank RM14,000 RM10,000 RM5,000

Effect: Bank increase and
Loan increase

Jan 4 Purchased furniture RM1,500 Cash RM1,000 Capital Loan

by cheque. Bank RM12,500 RM10,000 RM5,000
Effect : Furniture increase Furniture RM1,500
and Bank decrease

Jan 5 The owner took RM400 cash Cash RM600 Capital Loan
from the business for his own Bank RM12,500 RM9,600 RM5,000
use. Furniture RM1,500
Effect : Cash decrease and
Capital decrease

2.9 REVENUES

Revenue is the gross increase in owner’s equity resulting from business activities
entered into for the purpose of earning income. Trading businesses derive their main
form of revenue from the sale of goods. Service businesses derive their main form of
revenue from the performance of services. Examples of revenue are sales of goods or
services, commission received, interest received etc.

2.10 EXPENSES

Expenses are the cost of assets consumed or services used in the process of earning
revenue. A business must incur expense items which are necessary for the continued
operation of the business, but for which no long-term benefit will be obtained. Examples
of expenses are purchased of goods, salary, interest expense, rent expense, discount
allowed, etc.

2.11 PRESENTATION OF TRADING AND PROFIT AND LOSS ACCOUNTS

The Trading and Profit and Loss accounts will show the trading results of a business.
The purpose of preparing Trading account is to determine the gross profit or gross
loss, whereas the Profit and Loss account is to calculate the net profit or net loss.
Similar to the balance sheet, the trading and profit and loss also can be presented using
either the horizontal format or the vertical format. Below is the horizontal form of the
trading and profit and loss accounts:

15
Accounting 1

Trading and Profit and Loss Accounts for the year ended ……
Opening Stock 14,000 Sales 100,000
Purchases 60,000
74,000
Less: Closing Stock 14,000
Cost of goods sold 60,000
Gross Profit c/d 40,000
100,000 100,000
Telephone and Electricity 200 Gross Profit b/d 40,000
Salary 5,000 Rent Received 800
Stationery 100 Commission Received 500
Net profit 36,000
41,300 41,300

2.12 RELATIONSHIP OF PROFIT TO THE ACCOUNTING EQUATION

Profit is the difference between revenues and expenses. Since profit belongs to the
owner of the business, it should be added to the capital of the business. By taking into
account the profit of the business, the basic accounting equation A = OE + L can be
further expanded as follows:

A = OE + P + L

If Profit (P) = Revenues (R) - Expenses (E)

Thus, A = OE + R - E + L

The expanded accounting equation is:

ASSETS + EXPENSES = OWNER’S EQUITY + REVENUES + LIABILITIES

2.13 EFFECTS OF TRANSACTIONS ON THE EXPANDED ACCOUNTING

EQUATION

Every transaction will have a double effect on the expanded accounting equation. There
will be either an increase or decrease in assets, expenses, capital, revenues or
liabilities.

Below is the continuation of transactions for Ahmad Trading:

2000
Jan. 6 Paid insurance by cash RM200.
Effect : Insurance Expense increase and Cash decrease

16
 Chapter 2 Accounting Classification and Equation

Jan. 7 Received commission by cheque RM350.

Effect : Bank increase and Commission Received increase

Jan. 8 Paid electricity bill by cash RM100

Effect : Electricity Expense increase and Bank decrease

Jan 9 Received rent by cash RM400.

Effect : Cash increase and Rent Received increase

Date Assets Expenses Owner’s Revenues Liabilities

Equity
Jan 6 Cash Insurance Capital Loan
RM400 RM200 RM9,600 RM5,000
Bank
RM12,500
Furniture
RM1,500

Jan 7 Cash 400 Insurance 200 Capital Commission Loan 5,000

Bank RM9,600 Received
RM12,850 350
Furniture
RM1,500

Jan 8 Cash Insurance 200 Capital1 Commission Loan 5,000

RM300 Electricity RM9,600 Received 350
Bank 100
RM12,850
Furniture
RM1,500

Jan 9 Cash Insurance 200 Capital Rent Loan 5,000

RM700 Electricity 100 RM9,600 Received
Bank RM400
RM12,850 Commission
Furniture Received
RM1,500 RM350

2.14 ACCOUNTING FOR STOCK

Stocks or inventories are tangible assets:

a) held for sale in the ordinary course of business

b) in the process of production for such sale
c) to be consumed in the production of goods or services for sale.

17
Accounting 1

Stock comprises of raw materials, work in progress and finished goods. However this
chapter will only concentrate on stock of finished goods. The purpose of accounting for
stock is to determine the cost of goods sold and to determine the value of unsold stock
or closing stock at the end of the accounting period.

Goods are normally sold at a price higher than the cost price. If goods were sold at cost
price, it would be possible to have a stock account. However, most sales are not at cost
price. Therefore, the sales figure would include elements of profit or loss and the
difference between goods purchased and goods sold would not represent the stock of
goods. For example, a company purchases 100 books at a cost of RM10 each. All the
books were sold at a selling price of RM12 each. There is a different of RM200, which
represents the profit since all the goods were sold above the cost price.

2.15 MOVEMENTS OF STOCK

Stock can be divided into several transactions that show the movements of stock that
are either an increase or decrease in stock.

1. Increase in Stock Effect of transaction Accounts

Purchase Purchases Expense Purchases Account
Goods bought by the increase
business for the purpose of
resale

Sales Revenue decrease Sales Returns or Returns

Sales Return or Return Inwards Account
Inwards
Goods return by buyer
2. Decrease in Stock Effect of transaction Accounts
Sale of goods Sales Revenue increase Sales Account
Sale of goods which the
business bought with the
prime intention of resale

Purchase Return or Purchases Expense Purchases Returns or

Return Outwards decrease Returns Outwards Account
Goods return to supplier

18
 Chapter 2 Accounting Classification and Equation

PURCHASE AND SALE OF GOODS

Purchase and sale of goods can be divided into two categories:

Transactions Accounts involved

a. Cash Purchase Cash account and Purchases account
b. Credit Purchase Creditors account and Purchases account
c. Cash Sales Cash account and Sales account
d. Credit Sales Debtors account and Sales account
Goods purchased that are not sold at the end of the accounting period are known as
closing stock. Closing stock for one accounting period will become the opening stock for
the next accounting period.

PURCHASES RETURN AND SALES RETURN

There are cases where goods purchased previously may be returned by the
buyer/customer. A document known as credit note will be sent to the buyer. It is
known as credit note because the buyer’s account will be credited to show the reduction
in the amount he owes.

On the other hand, If the business returned goods to the supplier, a document known as
debit note will be sent to the supplier. It is known as debit note since the supplier’s
account will be debited to show the reduction in the amount owing to the supplier.

Example
Refer to example in Ahmad Trading

2001
Jan. 10 Purchased goods on credit RM3,000 from Ujang Enterprise.
Effect : Purchases Expense increase and Creditor (Ujang Enterprise)
increase

Jan. 11 The owner took goods worth RM100 for his own use.
Effect : Purchases Expense decrease and Capital decrease

Jan. 12 Sold goods on credit to Azmi RM1,000.

Effect : Sales Revenue increase and Debtor (Azmi) increase

Jan 13 Return goods to Ujang Enterprise RM200.

Effect : Purchases Expense decrease and Creditor decrease

Jan 14 Goods return by Azmi RM100.

Effect : Sales Revenue decrease and Debtor decrease

19
Accounting 1

Date Assets + Expenses = Capital + Revenues + Liabilities

Jan Cash RM700 Insurance Capital Commission Loan
10 Bank RM200 RM9,600 Received RM5,000
RM12,850 Electricity RM350 Creditor
Furniture RM100 Rent RM3,000
RM1,500 Purchases Received
RM3,000 RM400

Jan Cash RM700 Insurance Capital Commission Loan

11 Bank RM200 RM9,500 Received RM5,000
RM12,850 Electricity RM350 Creditor
Furniture RM100 Rent RM3,000
RM1,500 Purchases Received
RM2,900 RM400

Jan Cash RM700 Insurance Capital Commission Loan RM5,000

12 Bank RM200 RM9,500 Received Creditor
RM12,850 Electricity RM350 RM3,000
Furniture RM100 Rent
RM1,500 Purchases Received
Debtor RM2,900 RM400
RM1,000 Sales
RM1,000

Jan Cash RM700 Insurance Capital Commission Loan RM5,000

13 Bank RM200 RM9,500 Received Creditor
RM12,850 Electricity RM350 RM2,800
Furniture RM100 Rent
RM1,500 Purchases Received
Debtor RM2,700 RM400
RM1,000 Sales
RM1,000

Jan Cash RM700 Insurance Capital Rent Loan

14 Bank RM200 RM9,500 Received RM5,000
RM12,850 Electricity RM400 Creditor
Furniture RM100 Commission RM2,800
RM1,500 Purchases Received
Debtor RM2,700 RM350
RM900 Sales RM900

20
 Chapter 2 Accounting Classification and Equation

DEFINITION OF TERMS

Fixed Assets
Assets bought not for resale but to be used in the running of the business and the
useful life is more than one year

Current Assets
Assets that are either cash or those that are expected to be converted into cash within
one year

Owner’s Equity
It represents owner-supplied fund to the business for the acquisition of assets for the
business

Long Term Liabilities

An amount owing by the business that is not expected to be repaid within one year

Current Liabilities
An amount owing by the business that is expected to be repaid within one year

Revenues
The gross increase in owner’s equity resulting from business activities entered into for
the purpose of earning income.
Expenses
The cost of assets consumed or services used in the process of earning revenue

Drawings
Any assets/property of the business taken by the owner for his personal used

Profit
The excess of revenue over expenses

Losses
The excess of expenses over revenues

Stock
Asset held for sale in the ordinary course of business

Purchases
Goods bought by the business for the purpose of reselling

Sales
Sale of goods which the business bought with the prime intention of resale

Purchases Return
Goods returned by the business organisation to the supplier

Sales Return
Goods returned by the buyer to our business organization.

Debit Note

21
Accounting 1

A document sent to the supplier to show the reduction in the amount owing to the
supplier

Credit Note
A document sent to the buyer to show the reduction in the amount owing by the buyer

SELF TEST QUESTIONS

1. Differentiate between

a) Fixed Assets and Current Assets

b) Long Term Liability and Current Liability

Give three (3) examples for each.

2. Motor Vehicles were recorded as fixed assets by Syarikat Perabot FYN, but at the
same time it was recorded as current asset by ANW Auto Bhd. Explain.

3. Differentiate between capital and liability.

4. Name two (2) items that an owner of a business can contribute as capital.

5. State the two forms of accounting equation.

6. Calculate the value for the missing items below :

Assets Capital Liabilities

RM48,000 ? RM13,400
? RM35,000 RM14,400
RM25,200 RM12,000 ?
RM45,678 ? RM23,456
? RM87,900 RM42,500
RM68,500 RM32,800 ?

7. State whether the following are fixed asset, current asset, owner’s equity, long-term
liability, current liability, revenues or expenses.

a) Premises
b) Long Term Loan
c) Insurance
d) Dividend Received
e) Stock

22
 Chapter 2 Accounting Classification and Equation

f) Bank Overdraft
g) Cash in Hand
h) Motor Vehicles
i) Trade Debtors
j) Trade Creditors
k) Fixtures and Fittings
l) Capital
m) Machinery
n) Franchise

8. Show the effect upon assets, liabilities, capital, revenues and expenses for the
following transactions using the example below as a guide.

Transactions Effect
Bought furniture by cash Asset Furniture Increase
Asset Cash Decrease

a) Started business with cash and motor vehicle.

b) Paid advertising expenses by cash.
c) Purchase building using loan from ACF Finance.
d) The owner paid his son’s school fees using the business cheque.
e) Paid creditor amount due by cheque.
f) Debtor paid amount owing by cash.
g) Owner took cash for his own use.
h) Bought motor van by cheque.
i) Paid stationery by cash.
j) The owner brought in his furniture for office use.
k) Monthly installment payment of loan by cheque.
l) The owner brought in additional cash into the business.
m) Paid shop assistant salary by cash.
n) Paid electricity bill by cash.
o) Deposit cash into the bank.

9. On 1 July 2001, Ahmad decided to open up a sole proprietorship with the following
items:

Cash RM15,000, Stock RM12,000, Delivery Van RM30,000, Shop house

RM100,000, Loan from Maybank RM120,000.

What was the amount of capital?

10. Draw up the Balance Sheet of Majujaya Enterprise as at 31 December 2001 from
the following items :

RM
Capital ?
Cash in hand 16,500
Loan from Bank 30,000
Accounts Receivable 8,000
Accounts Payable 2,000
Stock 8,500

23
Accounting 1

Office Equipment 15,000

11. Differentiate between:

a) Purchases and Sales
b) Return Inwards and Return Outwards
c) Debit Note and Credit Note

12. What do you understand by the term stock?

13. Show the effect upon assets, liabilities, capital, revenues and expenses for each
of the following transaction using the example below as a guide.

Transactions Effect
Cash Sales Asset Cash Increase
Sales Revenue Increase

a. Start a business with RM10,000 in the bank

b. Bought goods on credit from Ariff Sdn Bhd RM1,000
c. Bought goods from Ali paying by cheque RM500
d. Purchase motor van using loan from BMF Finance RM15,000
e. Sold goods on credit to Hasan RM2,000
f. Cash sales to Azmi RM250
g. Azmi returned goods and received cash refund RM20.
h. The owner took goods for his own use RM100
i. The owner took cash for his own use RM200
j. Returned goods to Ariffl Sdn Bhd RM100
k. Paid Ariffl Sdn Bhd amount due by cheque RM900
l. Hasan returned goods due to some damage RM50.
m. Hasan paid amount owing by cheque RM1,950
n. Bought computer by cheque RM2,500
o. The owner brought in his furniture for office use RM1,200.

14. State whether each of the following statements is true or false.

a) Furniture bought by the business for the purpose of resale is considered as

purchase and not as fixed assets.
b) An old van sold by a merchandise business is considered as sales.
c) A computer bought by a company selling computer for the purpose of using it
in the business is considered as purchase.
d) Return inwards means return of goods to the supplier
e) Sale of furniture by Syarikat Perabot Ali Baba will result in the increase of
sales revenue

24
 Chapter 2 Accounting Classification and Equation

REFERENCES

1. Fatimah Abd Rauf, Amla Abu & Radziah Mahmud, Financial Accounting for
Non Accounting Students, McGraw-Hill (Malaysia) Sdn Bhd, 2004.

2. Frank Wood, Business Accounting 1, 7th Edition, Longman Group Limited,

London, 1996.

3. Jerry J. Weygandt, Donald E. Keiso & Walter G. Kell, Accounting Principles,

3rd Edition, John Wiley & Sons, New York, 1993.

4. Betsy Li, Tan Sai Kim & Goh Ling Chin, Principles of Accounts, 3rd Edition,
Oxford University Press, Singapore, 1998.

25
Accounting 1

26