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3
Accounting Equation and Financial
Statements
Learning Outcomes
Learning Outcomes (cont.)
After studying this chapter, you should be able to:
 Define the accounting equation
 Explain the terms asset, liability and owner’s equity
 List the components of an owner’s equity and
explain the effects of these components on the
owner’s equity
 Use the accounting equation to analyse business
transactions
Fundamentals of Financial Accounting (SECOND EDITION)
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3.0 Introduction
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Explain the meaning and purpose of preparing the
Statement of Profit or Loss and Other
Comprehensive Income and the Statement of
Financial Position
Briefly explain the purpose of preparing both the
Statement of Changes in Equity and the Statement
of Cash Flows
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3.1 Accounting Equation
The value of a business can be determined by
working out how much it owns and how much it
owes others. This basic idea can be explained by
the accounting equation.
The dual aspect concept states that there are two
aspects of accounting that are always equal to
each other.
 One represented by the assets
 The other represented by the claims against the
assets
This concept is also known as the accounting
equation.
Fundamentals of Financial Accounting (SECOND EDITION)
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3.1 Accounting Equation (cont.)
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3.1 Accounting Equation (cont.)
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The two sides of the equation must be equal.
Assets
– Bought and held by the business to generate
income and make profit
– Economic resources that are expected to be of
benefit in the future
– e.g. land, building, machinery, cash

– Assets – e.g. land, building, machineries, cash
– Liabilities – accounts payable, creditors, loans
– Owners equity
Fundamentals of Financial Accounting (SECOND EDITION)
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– Economic obligations (debts) payable to outsiders
– e.g. accounts payable, creditors, loans
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Fundamentals of Financial Accounting (SECOND EDITION)
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3.1 Accounting Equation (cont.)

Owner’s equity
3–8
3.1 Accounting Equation (cont.)
– Assets = Liabilities + Owner’s Equity

Capital – increase owner’s equity
Drawings – decrease owner’s equity
Revenues (income) – increase owner’s equity
Expenses – decrease owner’s equity
Fundamentals of Financial Accounting (SECOND EDITION)
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The accounting equation can now be expanded:
 Basic Accounting Equation
– Value of owner’s interest or investment in the
business by deducting the total liabilities from
the total assets of the business
– The owner’s equity can be divided into four
components:
•
•
•
•
Liabilities
Expanded Accounting Equation
– Assets = Liabilities + Capital + Revenue –
Expenses – Drawings
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Fundamentals of Financial Accounting (SECOND EDITION)
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3.2 Components in FR
Effects of Transaction
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Exercise 1
Identify the category & report of accounts listed as follows (i.e.
revenue, expenses, asset, liability & equity AND the report
where the account should be included):
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Fundamentals of Financial Accounting (SECOND EDITION)
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Service revenue
Salary
Depreciation
Cash
Prepaid expenses
Account Receivable
Account Payable
Equipment
Prepaid Rent
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Bad debt expense
Building
Accrued Salary
Sales
Maintenance & Repairs
Inventory
Electricity & Utilities
Accumulated depreciation
Preferred Share
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Steps to REMEMBER
1.
2.
3.
4.
5.
Exercise 2
Identify economic transaction.
Identify accounts involve.
Classify the identified accounts into types of
the account (i.e. asset, liability, owner’s equity,
revenue, expense).
Identify the effects (i.e. increase/decrease) of
the accounts.
Identify the debit or credit on the identified
accounts.
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Fundamentals of Financial Accounting (SECOND EDITION)
© Oxford Fajar Sdn. Bhd. (008974-T), 2018
3–13
Illustration: Encik Osman opens his own law office, Osman Associates, on 1 January
20x6. During the first month of operations, the following transactions occurred:
Items
Invested RM40,000 in cash in
the business.
2
Opened a current account with
a bank and deposited
RM30,000 of the cash in hand
into the bank account
3
Borrowed RM20,000 from a
bank. The loan was received in
the form of a cheque and this
was deposited in the bank
account.
4
Purchased office equipment
worth RM10,000 on credit.
Transactions
5
Rendered legal services to
clients for cash, RM2,000.
6
Received a cheque,
RM3,000, for services
rendered.
7
Paid monthly expenses by
cheque: salaries, RM2,000;
utilities, RM300; telephone,
RM100; rent, RM1,000.
8
Owner withdrew RM200 cash
from the business for his own
use.
9
Rendered legal services to
client on credit, RM1,000.
Effect on Assets
Effect on Assets
Effect on Liabilities and
Owner’s Equity
Fundamentals of Financial Accounting (SECOND EDITION)
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Exercise 2 (cont.)
Items
Transactions
1
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3.3 Financial Statements
Effect on Liabilities and
Owner’s Equity
Fundamentals of Financial Accounting (SECOND EDITION)
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3.3.1 Statement of Profit or Loss
and Other Comprehensive
Income

Presents the revenues and expenses and
resulting net profit or loss of a business for a
specific period of time.

The statement should include a heading with:
Statement of Comprehensive Income / Income
Statement / Statement of Profit or Loss
Statement of Financial Position (previously
known as balance sheet)
Cash flow statement
Statement of Changes in Equity
Notes to Financial Statements
Fundamentals of Financial Accounting (SECOND EDITION)
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3.3.1 Statement of Profit or Loss
and Other Comprehensive
Income (cont.)
Sample of Statement of Profit or Loss and Other
Comprehensive Income
– Name of the business,
– Title of the statement, and
– Time period covered by the statement.
Fundamentals of Financial Accounting (SECOND EDITION)
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3.3.2 Statement of Financial
Position (cont.)
3.3.2 Statement of Financial
Position
Sample of Statement of Financial Position
It is a snapshot of the business’ financial
condition at a specific point in time.
 It reports the assets, liabilities and owner’s
equity of a business at a specific date.
 The statement should include a heading with:

– Name of the business,
– Name of the financial statement, and
– Date of the financial statement.
Fundamentals of Financial Accounting (SECOND EDITION)
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Fundamentals of Financial Accounting (SECOND EDITION)
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3.3.2 Statement of Financial
Position (cont.)
Classification of Statement of Financial Position (cont.)
 Non-current liabilities
– Tangible assets with useful life of more than one
year; used in the business, not intended for sale
– e.g. land & buildings, machinery, motor vehicles
– Obligations/debts that are expected to be paid after
one year
– e.g. long-term loans, debentures

Current assets
– Resources that are expected to be realised in cash,
sold or consumed within one year
– e.g. cash in hand, cash at bank, inventory of goods
Fundamentals of Financial Accounting (SECOND EDITION)
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Reflects changes in owner’s equity between the
beginning and the end of the reporting period,
arising from:
– transactions between the business entity and the
owner
– transfer of profit or loss
to indicate the increase or decrease in the value
of the owner’s investment in the business.
Fundamentals of Financial Accounting (SECOND EDITION)
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Current liabilities
– Obligations/debts that are to be paid within a year
– e.g. bank overdraft, prepaid revenue

Owner’s equity
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3.3.3 Statement of Changes in
Equity
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3–20
3.3.2 Statement of Financial
Position (cont.)
Classification of Statement of Financial Position
 Non-current assets
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3.3.4 Statement of Cash Flows
Reports the business’s cash transactions
through a particular accounting period.
 Reflects a business’s liquidity from its operating,
investment and financing activities.
 Helpful in determining the business’s ability to
pay bills, payroll and other immediate expenses.
 Useful to investors/lenders to assess the
company’s financial stability and ability to repay
debts in the near future.

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