05 Bbfa1103 T1

Topic  Accounting
Environment
1
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define accounting and its four components;
2. Explain the importance of accounting;
3. Identify users and disciplines of accounting;
4. Discuss the qualitative characteristics of accounting information;
5. Describe the purpose of financial statements; and
6. Describe the four components of financial statements.
 INTRODUCTION
Did you know that the movie Forrest Gump starring Tom Hanks made over
US$329.7m in gross domestic revenue in the United States, and yet it was
reported as having a net loss? Tom Hanks made millions from his fees, which
include certain shares of the gross revenue, and yet the original author, Winston
Groom, who sold the screenplay rights of his novel for a price plus a share of the
movie profit, received none.
Had Mr Groom known the accounting language, he would have understood the
difference between revenue and profit, and this situation could have been
avoided. The movie might have made millions but the expenses which included
production cost, marketing and distribution costs and even the fees (based on
revenue sharing) paid to Tom Hanks, directors and others, reduced the millions
of revenue to a net loss.
Copyright © Open University Malaysia (OUM)

2  TOPIC 1 ACCOUNTING ENVIRONMENT
This case is a good example of how accounting plays an important role in making
the right decision. It enables us to make informed and better economic decisions.
But how or where can you obtain this accounting information from?
This information is provided through the financial statements of a business. It is

common for public listed companies to publish their financial statements in the
newspapers. After you have completed this module, the financial statements will not
look so strange after all as you have understood the language of accounting.
This topic introduces accounting, its importance and definition. We will then look
at who are the users of accounting information as well as the qualitative
characteristics that must exist so that the information will be valuable to the users.
You will also learn the purpose of preparing financial statements and the
components of financial statements.
1.1 THE IMPORTANCE OF ACCOUNTING

Accounting plays an important role in our daily life, directly or indirectly. The
views that accounting is only important for businesses and accountants are not
true. Accounting provides valuable financial information that enables us to make
informed and better decisions.
An example of making this economic decision in our daily life is the handling of
our monthly income. You need to know your financial position before you can
spend wisely. You need some accounting knowledge to plan or to budget your
spending. You need to determine your net income, which is gross income minus
all expenses.
In deciding whether to purchase your dream car, you need to know whether you
can afford it. This is where accounting knowledge play an important role,
providing you with the necessary financial information to make decisions.
In The Life of Mahatma Gandhi, the author quoted Gandhi when he wrote a letter
to his son saying, „You should keep an account of every penny you spend.‰ Gandhi
used to keep a daily record of whatever he spent! According to him, you will be
able to manage your money by keeping track of it.
Similarly for businesses, companies need accounting information to help them run
their business effectively and efficiently. They need to know whether the business
is profitable or not, whether they have enough cash to pay their workers salary and
more. If they know that their business is not profitable, they could do something

TOPIC 1 ACCOUNTING ENVIRONMENT  3
about it such as selling it or trying to improve the situation by changing their

operations. Only with proper financial information will businesses make the right
decisions.
So what is accounting? Before we go on to discuss the definition of accounting, let

us look at the history of accounting.
Luca Pacioli who is regarded as the „Father of Accounting‰ did not invent the
accounting systems. However, in 1494 he described the methods used by Italian
merchants to record their business transactions in his book Summa de Arithmetica,
Geometria, Proportioni et Proportionalita (Everything about Arithmetic, Geometry
and Proportion). Most importantly, he described the double entry accounting
systems, emphasising that debit must equal credit.
The system described by Pacioli has changed little over the next four centuries and
you will soon learn about the systems throughout this module.
Figure 1.1: Luca Pacioli

Source: http://22accounting22.tripod.com/id2.html
ACTIVITY 1.1
In your own words, justify the need for us to study accounting.

Share your justification in the myINSPIRE online forum.

1.2 DEFINITION OF ACCOUNTING
Accounting is described as a system or process that provides reports on an

entityÊs economic transactions to users.
Accounting can be defined as a process of collecting, identifying, measuring,

recording, summarising and communicating the results of business or economic
transactions to users in order for them to make informed or better decisions.
Figure 1.2: The information flow in an accountancy system
There are four components in accounting:

(a) Recording – written records of journalising and posting business
transactions;
(b) Summarising – preparing the financial statements;

(c) Analysing – examining the results to determine the financial position and
performance; and
(d) Interpreting – using the financial statements to make judgments and
decisions.
Accounting systems process inputs, namely business transactions (such as making

sales, paying expenses, buying assets and borrowing money) into outputs of
financial statements (income statement and balance sheet).
This module will teach you the recording process and summarising process in
detail. The final topic of the module will introduce basic techniques that are used
to analyse and interpret financial statements.
From these outputs, information such as how much resources the business owns,
how much is owed as well as its business performance are known. The accounting
process is shown in Figure 1.3.
Figure 1.3: The accounting process
ACTIVITY 1.2
„Imagine running a business with no knowledge of accounting. It is
really necessary to have at least some basic knowledge in preparing
accounts.‰
What is your opinion? Can you think of ways in which accounting helps
a business? Share your thoughts on this in myINSPIRE.

1.3 USERS OF ACCOUNTING INFORMATION

Accounting information is useful for anyone who makes decisions that have an
economic impact. Take a look at this scenario: As users, we have scarce resources
(capital, cash) and we would like to allocate these resources so that they can give
maximum returns to us. For this, you need information to enable you to make the
right decisions.
Different users may need different types of information to aid their decision-
making. There are two types of accounting information users, namely internal and
external users.
1.3.1 Internal Users

Internal users are part of the business entity and they make decisions for the
company. Examples of internal users are as follows:
(a) Directors of companies – in deciding the amount of dividend to pay to
shareholders or bonus to employees, they need to know the companyÊs profit;
and
(b) Managers who want to know if a new product will be profitable.
Management accounting is the area of accounting that provides information

for internal usage. It includes areas of costing, budgeting and payroll, among
others,
On the other hand, financial accounting provides financial statements to be

used mainly by external users and to some extent by internal users.

1.3.2 External Users

External users are those outside of the company and they make decisions about the
company. Examples are:
(a) Investors
Before buying a companyÊs shares, investors will want to know the
companyÊs profitability and the amount of dividends paid out to
shareholders. Shareholders holding shares in a company may want to decide
whether to buy more shares or to dispose the shares that they owned.
(b) Creditors
Suppliers and bankers want to know if they should extend credit to the
business, how much to extend and for how long. They will assess the ability
of the business to repay the loan.
(c) Government Agencies

Agencies such as Lembaga Hasil Dalam Negeri (LHDN) need to know the
income of a business entity in order to determine the amount of tax to be
collected from the business.
1.4 BRANCHES OF ACCOUNTING

In the earlier section, you have learned that internal users require information from
management accounting and financial accounting while external users require
information solely from financial accounting. Accounting has expanded and
changed in response to global changes and needs. Accounting has developed into
several disciplines, as shown in Figure 1.4:
Figure 1.4: Accounting disciplines

This introductory accounting course will only cover financial accounting.

However, it is important for you to understand the differences between financial
accounting and management accounting. A summary of the differences is shown
in Table 1.1.
Table 1.1: Comparison between Financial Accounting and Management Accounting
Financial Accounting Management Accounting
Users External users and internal users. Internal users only.
Reports Provides the financial statements Provides financial and non-financial

of an entity. information required by an entity in
order to plan, evaluate and control
its operations.
Format of Financial reports are produced Reports are produced at any time
reports periodically according to a according to needs and are not
specific format or standards. subjected to a specific format or
standard.
1.5 QUALITATIVE CHARACTERISTICS OF

ACCOUNTING INFORMATION
We will now discuss the characteristics that must exist in accounting information.
In order for accounting information to be useful to decision makers, it must be
relevant, faithful representation, comparable and consistent. Useful information
should also be understandable, material and timely.

Figure 1.5: Six characteristics of accounting information
1.5.1 Relevance
Relevance means that the financial information is capable of making a difference
in the decision. The relevance principle stipulates that all relevant information
should be included in the financial statements. Information is considered relevant
if it can assist users in making decisions.

Let us assume that you have some extra money and would like to buy shares in
one of the companies listed in Bursa Malaysia. What type of information might be
useful for your decision-making? You might want to know:
(a) The companyÊs performance for the past five years;
(b) What future projects or new products of the company are; and
(c) Who manages the company?
All the information ă quantitative and/or qualitative ă is relevant as it will assist

you in deciding whether to buy the companyÊs shares or otherwise. For example,
let us say that the company has made a good profit of RM2,000,000 for the current
year. You should not solely rely on this information. You must also look at the past
trend. Assume that you found out the company has been incurring big losses for
the past three years. Will you still invest your money in the company? Knowing
how the company performed in the past years is relevant to your decision. Big
losses for three consecutive years might indicate that it is risky to invest in the
company even though it has been profitable in the current year.
1.5.2 Faithful Representation

Faithful representation replaced the reliability characteristic in the revised
conceptual framework for financial reporting. Faithful representation means that
the information accurately depicts what really happened; the numbers and
descriptions match what really exist.
To provide a faithful representation, information must be complete (nothing

important has been omitted), neutral (is not biased towards one position or
another) and free from error. Information is complete if a user can understand the
event being shown. Information is considered neutral if it is without any bias in its
selection or presentation of financial information. Free from error means there are
no errors or omissions in the descriptions and no errors in the process used to
produce the reported information. Free from error does not mean perfectly
accurate in all aspects.

Figure 1.6: How faithfully represented is the accounting practice?
1.5.3 Comparability
Comparability refers to the quality of the information that enables users to make
comparisons in evaluating similarities or differences between companies,
industries or over time. This characteristic is important because comparable
information is more useful.
Consider this example.

You are only provided with this information about Syarikat Along – Syarikat
Along made RM10 million profit last year.
Is this information sufficient for you to decide if you will invest in the company?
Will your decision change if you had known that the company made RM20 million
in the previous year? Comparing the companyÊs performance over two periods can
lead to a better decision as you can see that there has been a 50 per cent drop in
profit.
It is a requirement that a company must provide the previous yearÊs information

to enable users to make comparisons.

1.5.4 Consistency
For information to be comparable across industries or over time, the information
needs to be consistent from one company to another as well as over time.
Consistency refers to the requirement that companies are to maintain consistency
in the treatment of various items for all accounting periods. In other words,
companies should not change the accounting procedures or methods used each
year.
An example is the method for depreciating non-current assets. There are several
acceptable methods to recognise depreciation expense. Among them are the
straight line method and the reducing balance method. If a company had used the
straight line method in one period, they ought to use the same method in the next
accounting period.
For your information, a company may change the accounting method that they use.
However, a full disclosure is required in the notes to financial statements to explain
why the changes are made and the effects of the changes to the financial statements.
1.5.5 Materiality
Materiality is another important concept, which states that an entity must account
for items that are significant to the entityÊs financial statements. In other words, an
amount can be ignored if the effect on the financial statements is unimportant to
usersÊ business decisions.
The materiality of an item depends on the size or value of the items according to
the main activities of the business and the nature of the items involved.
For example, a separate account for postage expenses for a grocery store is not
required to be kept, as the amount is small and not significant for the grocery store.
It is sufficient to lump this expense with other expenses under a miscellaneous
expense account. However, for a courier company, postage expenses are material
and must be disclosed separately.
1.5.6 Understandability
The understandability principle requires information to be presented in a format
that can be easily understood. The information reported should be understood by
users whom are generally assumed to have reasonable knowledge of business and
economic activities.

1.5.7 Timeliness
Relevant and reliable information will be useless if you do not obtain the information
on time. Hence, it is extremely important to prepare the financial statements on time.
ACTIVITY 1.3
You have just read the six qualitative characteristics of accounting.
Based on your experience, which one quality is the most difficult to
comply? Justify your claim.
1.6 FINANCIAL STATEMENTS

The final output of an accounting system is the financial statements. The main
function of financial statements is to provide information of the business financial
position and financial performance to users.
This information is normally obtained from the income statement, balance sheet,
statement of changes in ownerÊs equity and cash flow statement. The information
provided will give a picture of how the resources are used by the business entity.
This module covers the steps required in the preparation of the income statement,
statement of changes in ownerÊs equity and balance sheet. You will learn how to
prepare the cash flow statement in another module.
The Malaysian accounting standard, MFRS 101, provides the guidelines on the
presentation of financial statements.

1.6.1 Purpose of Financial Statements

MFRS 101 (para 9) states the purpose of financial statements as follows:
Figure 1.7: MFRS 101 (para 9)

Source: MASB – MFRS 101 – Presentation of Financial Statements
In other words, the objective of preparing the financial statements is to provide

useful information with regard to the financial position, performance and cash
flow of a business to all types of users in order for them to make economic
decisions. The result of the financial statements shows how the manager of a
business entity manages resources contributed by owners.
The information provided in the financial statements together with other

information in the explanatory notes will be used by users to understand and make
decisions.
SELF-CHECK 1.1
Users depend not only on financial information provided in the financial
statements but also on non-financial information to make investment
decisions. Can you identify the qualitative information that users need to
make such decisions?

1.6.2 Components of Financial Statements

Financial statements of public listed companies can be easily obtained by the
public. Bursa Malaysia provides access to the annual reports of public listed
companies on its website.
You may visit Bursa MalaysiaÊs website for further information:

http://www.bursamalaysia.com/market/listed-companies/company-
announcements/#/?category=all
Please take note that the following illustrations of financial statements are for sole
proprietorship (single ownership). There are slight differences in reporting
requirements and format for partnership and corporation.
(a) Income Statement

Income statement reports the financial performance of an entity. It contains
information on revenues and expenses including the profit and loss of the
business entity. It is also known as revenue statements or profit and loss
statement.
There are several formats in reporting the revenues and expenses depending
on the nature of the business of the entity. Figure 1.8 is an example of income
statement of a service provider. Service providers such as travel agents,
hotels and colleges earn their revenues by performing or providing services
to customers.

Figure 1.8: Income statement of a service provider
Figure 1.9 is an example of a trade merchandiserÊs income statement.

Merchandiser or traderÊs revenues come from selling goods to customers.
You will learn in detail how to prepare the income statement for
merchandisers in Topic 6.

Figure 1.9: Income statement of a merchandiser
(b) Balance Sheet

Balance sheet reports the financial position of a business entity. It contains
information about the entityÊs assets, liabilities and ownerÊs equity.
Assets are categorised into two types:

(i) Current assets are assets that are expected to provide benefits for twelve
months or less from the reporting date. Examples are cash, account
receivables, inventories, prepaid expenses and short-term investments.
(ii) Non-current assets are assets that will provide benefits for a period
longer than twelve months from the reporting date, which include land
and building, motor vehicles, furniture and fittings, equipment and
long-term investments.

Liabilities are also categorised into two types:

(i) Current liabilities are liabilities that are due within twelve months from
the reporting date. Examples are account payables and short-term
loans.
(ii) Non-current liabilities are expected to be settled in a period longer than
twelve months from the reporting date, for example, long-term bank
loan.
There are several formats of balance sheet, namely in ÂTÊ format or in

statement format. There are also differences in reporting the ownerÊs equity
depending on the form of business whether it is a sole proprietorship,
partnership or corporation. However, at this initial stage of the lesson, the
focus will be on sole proprietorshipÊs balance sheet. Figures 1.10 and 1.11
show a sole proprietorshipÊs ÂTÊ format and the statement format of the
balance sheet, respectively.
Figure 1.10: The ÂTÊ format of the balance sheet

Figure 1.11: The statement format of the balance sheet
There are several different formats available when preparing the balance
sheet. You might read one textbook shows one format while another textbook
shows another format. One format might show the working capital which is
current assets minus current liabilities. Another format might list current
assets first and then only the non-current assets are listed.

At first, you might find that this is confusing as one format is slightly different
from the other. Do take note that whichever format is used, all the assets,
liabilities and ownerÊs equity, regardless if they are current or non-current,
will be categorised accordingly.
(c) Statement of Changes in OwnerÊs Equity

Statement of changes in ownerÊs equity reports how the ownerÊs equity has
changed over the reporting period. It reports how opening capital has
increased through net income and how it has decreased through net losses
and drawings.
Figure 1.12: Statement of changes in ownerÊs equity
(d) Cash Flow Statement

Cash flow statements shows the inflow and outflow of an organisationÊs cash
according to three main activities, which are operating, investing and
financing. The format is shown Figure 1.13. However, as stated earlier,
preparing the cash flow statement is not part of the syllabus.

Figure 1.13: Cash flow statement
ACTIVITY 1.4
Do you know your net worth? Let us calculate your net worth.
(a) List all your assets. These are items that you own such as house,
car and computer. Estimate how much it is worth in the market.
In other words, you might have spent RM5,000 for your computer
but if you were to sell your computer now, the shop is only willing
to pay RM300 for it. Therefore, RM300 is the value of your
computer.
(b) List all your liabilities. These include any outstanding loans you
have on your house, education and even credit card.
(c) Determine the difference (total assets minus total liabilities). This
is your net worth or capital.

Many online resources for accounting glossary and terms are available on the
Internet. If you need to look up certain accounting terms, do visit:
http://www.ventureline.com/accounting-glossary/A/
Ć Luca Pacioli described the methods used by Italian merchants to record their
business transactions in his book Everything about Arithmetic, Geometry and
Proportion.
Ć Accounting can be defined as a process of collecting, identifying, measuring,

recording, summarising and communicating the results of business or
economic transactions to users in order for them to make informed or better
decisions.
Ć Accounting information is important as it helps users make decisions.
Ć Financial accounting provides financial information for external users as well

as internal users while management accounting provides financial and non-
financial information for internal users.
Ć For accounting information to be useful and valuable to decision makers, it

must be relevant, faithful representation, comparable and consistent. Useful
information should also be understandable, material and timely.
Ć The main function of financial statements is to provide information on the

financial position and financial performance of the business to users.
Ć The four main components of financial statements are as follows:
 Income statement;
 Balance sheet;
 Statement of changes in ownerÊs equity; and
 Cash flow statement.
Ć Income statement reports the financial performance of a business entity.
Ć Balance sheet reports the financial position of a business entity.

Ć Statement of changes in ownerÊs equity reports how the ownerÊs equity has
changed over the reporting period.
Ć Cash flow statements show the inflow and outflow of an organisationÊs cash
from three main activities, namely operating, investing and financing.
Accounting Materiality
Comparability Relevance
Consistency Reliability
Faithful representation Timeliness
Financial statement Understandability
1. Define accounting and explain the four components of accounting.
2. List the qualitative characteristics of accounting information.
3. What are the items reported in the income statement?
4. For each of the following users, can you identify the type of accounting
information they require?
External Users Type of Information Required

Ć Lenders
Ć Suppliers
Ć Government agencies
Ć Customers
Internal Users Type of Information Required
Ć Employees
Ć Sales managers
Ć Production managers
Ć Budget officers

1. Explain the comparability concept and its role in making accounting

information useful.
2. What are the items reported in the balance sheet?
3. What are the items reported in the statement of changes in ownerÊs equity?
4. What are the items reported in the cash flow statement?
5. The following are the account balances of Smart Tuition Centre as at

31 December 2019.
RM
Accounts receivable 8,855
Accounts payable 2,200
Bank loan 15,000
Supplies 8,480
Supply expenses 6,300
Advertising expense 4,200
Salary expenses 18,000
General expenses 1,265
Rental expenses 14,400
Utility expenses 7,350
Tuition fees 75,750
Computer equipment 17,800
Cash 20,000
Capital (1/1/2019) 23,700
Drawings 10,000
You are required to prepare:

(a) Income statement for Smart Tuition Centre for the year ended
31 December 2019.
(b) Statement of changes in ownerÊs equity for Smart Tuition Centre for the
year ended 31 December 2019.
(c) Balance sheet for Smart Tuition Centre as at year ended 31 December
2019.

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Topic  Accounting

Copyright © Open University Malaysia (OUM)

This information is provided through the financial statements of a business. It is

1.1 THE IMPORTANCE OF ACCOUNTING

Copyright © Open University Malaysia (OUM)

about it such as selling it or trying to improve the situation by changing their

So what is accounting? Before we go on to discuss the definition of accounting, let

Figure 1.1: Luca Pacioli

In your own words, justify the need for us to study accounting.

Copyright © Open University Malaysia (OUM)

1.2 DEFINITION OF ACCOUNTING

Accounting is described as a system or process that provides reports on an

Accounting can be defined as a process of collecting, identifying, measuring,

Figure 1.2: The information flow in an accountancy system

There are four components in accounting:

Copyright © Open University Malaysia (OUM)

Accounting systems process inputs, namely business transactions (such as making

Figure 1.3: The accounting process

Copyright © Open University Malaysia (OUM)

1.3 USERS OF ACCOUNTING INFORMATION

1.3.1 Internal Users

Management accounting is the area of accounting that provides information

On the other hand, financial accounting provides financial statements to be

Copyright © Open University Malaysia (OUM)

1.3.2 External Users

(c) Government Agencies

1.4 BRANCHES OF ACCOUNTING

Figure 1.4: Accounting disciplines

Copyright © Open University Malaysia (OUM)

This introductory accounting course will only cover financial accounting.

Table 1.1: Comparison between Financial Accounting and Management Accounting

Financial Accounting Management Accounting

Users External users and internal users. Internal users only.

Reports Provides the financial statements Provides financial and non-financial

1.5 QUALITATIVE CHARACTERISTICS OF

Copyright © Open University Malaysia (OUM)

Figure 1.5: Six characteristics of accounting information

Copyright © Open University Malaysia (OUM)

All the information ă quantitative and/or qualitative ă is relevant as it will assist

1.5.2 Faithful Representation

To provide a faithful representation, information must be complete (nothing

Copyright © Open University Malaysia (OUM)

Figure 1.6: How faithfully represented is the accounting practice?

Consider this example.

It is a requirement that a company must provide the previous yearÊs information

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

1.6 FINANCIAL STATEMENTS

Copyright © Open University Malaysia (OUM)

1.6.1 Purpose of Financial Statements

Figure 1.7: MFRS 101 (para 9)

In other words, the objective of preparing the financial statements is to provide

The information provided in the financial statements together with other

Copyright © Open University Malaysia (OUM)

1.6.2 Components of Financial Statements

You may visit Bursa MalaysiaÊs website for further information:

(a) Income Statement

Copyright © Open University Malaysia (OUM)

Figure 1.8: Income statement of a service provider