Cambridge IGCSE and O Level Accounting Coursebook Study Notes

Introduction to Accounting

  • Accounting is regarded as the "language of business" and is divided into two sections: book-keeping and accounting.

  • Book-keeping: The detailed recording of all financial transactions of a business. It provides the basis for records using double-entry systems.

  • Accounting: The use of book-keeping records to prepare financial statements at regular intervals (usually yearly) and assist in decision-making.

  • Purposes of measuring Profit and Loss:
        - If a profit is earned, the owner receives a return on investment and funds are available for expansion.
        - If a loss is made, the business may close as there is no return and no funds for maintenance.

  • Monitoring Progress: Owners use financial statements to compare performance with previous years or similar businesses using accounting ratios.

Assets, Liabilities, and Capital

  • Entity Principle: From an accounting viewpoint, the owner is regarded as completely separate from the business.

  • Capital: Representing the total resources provided by the owner; it is what the business "owes" the owner. Also called Owner’s Equity.

  • Assets: Represent everything owned by or owing to the business (resources used by the business).

  • Liabilities: Represent anything owed by the business to external parties.

  • The Accounting Equation:
        - Assets=Capital+Liabilities\text{Assets} = \text{Capital} + \text{Liabilities}
        - Assets=Owner’s Equity+Liabilities\text{Assets} = \text{Owner's Equity} + \text{Liabilities}

  • Inventory: Goods available for resale.

  • Trade Payables: Amounts owed to credit suppliers (trade creditors).

  • Trade Receivables: Amounts owed to the business by credit customers (trade debtors).

The Statement of Financial Position

  • Shows the assets and liabilities of a business on a specified date.

  • It is not part of the double-entry system but is prepared periodically from ledger balances.

  • Structure:
        - Non-current Assets: Long-term assets obtained for use, not resale (e.g., land, buildings, machinery). Arranged in increasing order of liquidity.
        - Intangible Assets: Assets without substance but possessing value (e.g., goodwill, brand names).
        - Current Assets: Short-term assets whose amounts constantly change (e.g., inventory, trade receivables, bank, cash).
        - Non-current Liabilities: Owed amounts not due within 12 months (e.g., long-term loans).
        - Current Liabilities: Amounts due within 12 months (e.g., trade payables, bank overdraft).

Principles of Double-Entry Book-keeping

  • Double Entry: Every transaction is entered twice—on the debit side of one account and the credit side of another.

  • Debit (dr): The left-hand side, representing the account receiving or gaining value.

  • Credit (cr): The right-hand side, representing the account giving value.

  • Folio Number: Used for reference purposes to show the page of the ledger where the related entry appears.

  • Drawings: Value taken from the business by the owner for personal use (money, assets, or goods). Debited to Drawings account; total transferred to Capital at year-end.

  • Balancing Accounts (Monthly process):
        1. Add each side.
        2. Enter the difference as "Balance c/d" (carried down) on the smaller side.
        3. Total both sides to the same level.
        4. Enter "Balance b/d" (brought down) on the opposite side below the totals for the next period.

Division of the Ledger and Specialised Books

  • Sales Ledger: Personal accounts of credit customers (Trade Receivables).

  • Purchases Ledger: Personal accounts of credit suppliers (Trade Payables).

  • Nominal (General) Ledger: All other accounts (Assets, Liabilities, Expenses, Income).

  • Cash Book: Dual function as a book of prime entry and a ledger account for Cash and Bank. Includes:
        - Contra Entry: Transactions affecting both cash and bank (e.g., withdrawing cash for office use or depositing cash into the bank). Marked with 'c' in folio.
        - Bank Overdraft: When payments exceed deposits, resulting in a credit balance in the bank column.

  • Petty Cash Book: Records low-value payments using the Imprest System.
        - Imprest (Float): A fixed amount given to the petty cashier at the start of a period.
        - Restoration: At the end of the period, the chief cashier Provides enough cash to restore the float to its original amount.

Business Documents

  • Invoice: Issued by the supplier for credit sales; recorded as a purchase by the customer.

  • Debit Note: Issued by the purchaser to request a reduction in the invoice (due to returns or overcharges).

  • Credit Note: Issued by the seller to notify of a reduction in the invoice.

  • Statement of Account: Monthly summary of transactions sent by supplier to customer.

  • Trade Discount: Reduction in price for bulk buying or same-trade businesses; deducted on the invoice but not entered in ledger accounts.

  • Cash Discount: Allowance for prompt payment; recorded in the three-column cash book as Discount Allowed (expense/debit) or Discount Received (income/credit).

The Trial Balance and Errors

  • Trial Balance: A list of balances on ledger accounts at a certain date to check arithmetical accuracy.

  • Debit Balances: Assets, Expenses, Drawings, Purchases, Sales Returns, Carriage Inwards/Outwards.

  • Credit Balances: Liabilities, Income, Capital, Sales, Purchases Returns.

  • Errors Not Revealed by Trial Balance:
        1. Commission: Correct amount/side, wrong account of same class.
        2. Complete Reversal: Correct accounts, wrong sides.
        3. Omission: Transaction completely missing.
        4. Original Entry: Incorrect figure used for the initial entry.
        5. Principle: Correct amount/side, wrong class of account (e.g., repairs debited to Machinery).
        6. Compensating: Errors cancel each other out.

  • Suspense Account: A temporary account used to balance an arithmetically incorrect trial balance while errors are located.

Accounting Principles (Concepts and Conventions)

  • Consistency: Methods must be used consistently year-to-year to allow comparison.

  • Duality: Every transaction has two aspects.

  • Going Concern: Assumption that the business will continue indefinitely.

  • Historic Cost: Assets are initially recorded at their actual cost.

  • Matching (Accruals): Revenue of a period is matched against the costs of that same period.

  • Materiality: Low-value items (e.g., staplers) are treated as expenses rather than non-current assets.

  • Money Measurement: Only information expressible in money is recorded.

  • Prudence: Profits and assets should not be overstated; losses and liabilities should not be understated. "Anticipate no profit, provide for all possible losses."

  • Realization: Revenue is realized when legal title passes (goods are delivered), not necessarily when cash is received.

Year-End Adjustments

  • Adjustments for Expenses/Income:
        - Accrued Expense: Unpaid at year-end; added to expense and shown as a Current Liability.
        - Prepaid Expense: Paid in advance; deducted from expense and shown as a Current Asset.
        - Accrued Income: Earned but not received; added to income and shown as a Current Asset.
        - Prepaid Income: Received but not yet earned; deducted from income and shown as a Current Liability.

  • Depreciation: The estimate of the loss in value of a non-current asset over its life.
        - Straight Line Method: Cost−Residual ValueYears of Life\frac{\text{Cost} - \text{Residual Value}}{\text{Years of Life}}
        - Reducing Balance Method: Percentage calculated on Net Book Value (Cost−Accumulated Depreciation\text{Cost} - \text{Accumulated Depreciation}).
        - Revaluation Method: Opening Value+Additions−Closing Value\text{Opening Value} + \text{Additions} - \text{Closing Value}.

  • Irrecoverable Debts: Written off to the income statement as an expense when a customer cannot pay.

  • Provision for Doubtful Debts: An estimate of potential losses from credit customers to apply prudence.

Analysis and Interpretation (Accounting Ratios)

  • Profitability Ratios:
        - Return on Capital Employed (ROCE): Profit for the year before interestCapital Employed×100\frac{\text{Profit for the year before interest}}{\text{Capital Employed}} \times 100
        - Gross Margin: Gross ProfitRevenue×100\frac{\text{Gross Profit}}{\text{Revenue}} \times 100
        - Profit Margin: Profit for the yearRevenue×100\frac{\text{Profit for the year}}{\text{Revenue}} \times 100

  • Liquidity Ratios:
        - Current Ratio: Current Assets:Current Liabilities\text{Current Assets} : \text{Current Liabilities} (Standard $1.5 : 1$ to $2 : 1$)
        - Liquid (Acid Test) Ratio: Current Assets−InventoryCurrent Liabilities:1\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} : 1 (Standard $1 : 1$)
        - Rate of Inventory Turnover: Cost of SalesAverage Inventory\frac{\text{Cost of Sales}}{\text{Average Inventory}}
        - Trade Receivables Turnover: Trade ReceivablesCredit Sales×365 days\frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365\, \text{days}
        - Trade Payables Turnover: Trade PayablesCredit Purchases×365 days\frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365\, \text{days}