Theory - Master Principles of Accounts

Define bookkeeping

Bookkeeping involves only the recording of business transactions.

Define accounting

Accounting is the process of recording, summarising, analysing, interpreting and reporting the financial information of an organisation.

Roles of Accounting

Stewardship: Refers to the role of managing business resources on behalf of stakeholders so that resources are effectively and efficiently used and safeguarded.
Decision-making: Accounting informs stakeholders with accounting information that helps them make decisions regarding the resources of the business.

Explain how the stewardship role leads to the creation of the accounting system

The accountant (the steward) sets up an accounting system to collate, record, organise and report financial information to the business owner.

Stakeholders and their use of Accounting Information

Creditors: use liquidity information to decide if the business can repay debts.
Government: use profitability information to decide on the amount of tax to collect.
Customers: decide if they should purchase from the business depending on price and after-sales services.
Other Stakeholders: Potential investors, management, banks, etc., use information for investment, operational, and lending decisions.

Professional Ethics: Integrity and Objectivity

Integrity: To be honest and straightforward in all professional and business relationships. Accountants must be upright in reporting the truth and provide accurate information.
Objectivity: To not let bias or undue influence of others override professional judgment. Accountants must report based on fact supported by evidence.

Importance of Integrity and Objectivity

As accountants provide information to stakeholders for decision-making, the information needs to be credible and accurate. False or inaccurate information will lead stakeholders into making poor decisions.

Differences between a Sole Proprietorship (SP) and a Private Limited Company (PLC)

Feature	Sole-proprietorship (SP)	Private Limited Company (PLC)
Liability	When the SP incurs debts and losses, the only owner is obliged to pay them using his or her personal assets (unlimited liability).	When the company incurs debts and losses, shareholders are not obliged to pay them using their personal assets. They only risk forfeiting their investment (limited liability).
Access to Finance	It is less likely for banks and other lenders to lend money to an SP. The owner often contributes all resources.	It is more likely for banks to lend money to a PLC as there are more business assets of high value to serve as collaterals. A company can also issue shares to raise funds.
Management & Control	The only owner usually runs the business by himself or herself and has absolute control over it.	Shareholders have no control over the running of the business unless they are part of the management team. The company hires professionals to manage the business.
Continuity	The SP exists as long as the owner is alive and desires to continue operation (no perpetual succession).	The company exists forever until wound up or struck off (perpetual succession).
Administration	SP has minimal administrative duties to adhere to.	PLC must comply with statutory requirements for general meetings, director’s reports, and file annual financial reports.

Difference between a Limited Liability Partnership (LLP) and a Private Limited Company

An LLP is owned by two or more partners where each partner contributes to set up the LLP. A Private Limited Company is owned by 50 or fewer shareholders where each shareholder buys shares and contributes capital.

Features of a Private Limited Company

Owned by 50 or fewer shareholders.
Exists indefinitely until wound up or struck off.
Shareholders have no control over the day-to-day running of the business (unless they are also management).
Must comply with statutory requirements and file annual financial reports.
Shareholders have limited liability.

Cash vs Credit Transactions

A cash transaction is when a customer pays at the point of purchase. A credit transaction is when cash is received from the customer at a later date from the date of purchase. The main difference is the timing of payment.

Accounting Concepts

Concept	Definition	Topics Related
Going Concern	States that a business entity is assumed to operate indefinitely unless there are signs that it has stopped operating.	Statement of financial performance, Statement of financial position
Objectivity	Transactions are recorded based on evidence that are reliable.	AIS (Source documents)
Matching	Expenses incurred in a given period must be matched against income earned to determine the profit or loss for the period.	Non-current assets (Depreciation), Trade Receivables (Impairment), Prepayments & Accruals
Accounting Entity	Only activities carried out by the business are to be recorded in the books.	Business entities (Drawings and capital)
Monetary	Only transactions that can be quantified can be recorded.	AIS
Accounting Period	Divides the life of a business into equal time periods.	Statement of financial performance, Statement of financial position
Consistency	Requires an entity to use the same accounting methods and procedures every period.	Non-current assets (Depreciation), Use of the same depreciation methods
Historical Cost	Transactions are to be recorded at historical costs initially.	AIS, Non-current assets
Accrual	Income earned and expenses incurred has to be recorded regardless of whether it is received or paid.	Prepayments & Accruals
Materiality	Information is considered material if it has a serious effect on the decision making of those who use it.	Non-current assets (Capital vs Revenue expenditure)
Prudence	Accounting treatment chosen should be one that least overstates assets or profits.	Prepayments & Accruals, Inventory, Non-current assets, Trade Receivables (Impairment)

The Accounting Cycle

The four stages are: Identify and Record, Adjust, Report, and Close.

Source Documents

Importance: The Objectivity theory requires all recordings to be verifiable and supported by source documents as evidence that a transaction has occurred.

Purpose of Key Source Documents

Document	Purpose
Invoice	Sent by a seller to a buyer to inform the buyer to pay for goods bought on credit.
Credit Note	Issued by a seller for reductions, e.g., for goods returned or an overcharge.
Debit Note	Issued by a seller to add charges, e.g., when a customer was undercharged.
Receipt	Used to acknowledge cash received. Issued by the seller.
Bank Statement	A summary of monthly transactions of the account holder, prepared by the bank.
Remittance Advice	Informs a creditor that payment by cheque has been made for a specific invoice.

Application of Accounting Entity Theory

Scenario: Eliza bought a laser printer ($1,200) for the business and a computer ($3,500) for her son using a business cheque.

Explanation: According to the accounting entity theory, the activities of a business are separate from the actions of the owner. Since Eliza paid for the computer for her son from the business bank account, she should record that transaction as drawings, not a business purchase.

The Accounting Elements (A.L.I.C.E)

Assets: Resources owned by businesses that are expected to provide future benefits.
Liabilities: Amounts that the business owes to external parties (banks/lenders) that are expected to be settled in the future.
Income: Earnings of a business through its activities by selling goods or providing services, including its revenue and other gains.
Capital (Equity): The claim by the owner on the net assets of a business, comprising contributions by owners and profits generated.
Expense: Amounts incurred by a business to generate income in the same accounting period.

The Basic Accounting Equation

Total Assets = Total Liabilities + Total Equity

The Expanded Accounting Equation

Total Assets = Liabilities + Income + Capital - Expense - Drawings

Double-entry Rules of Accounting

Each business transaction will have at least one debit entry to one account and at least one credit entry to another account.
The total amount recorded as a debit must always be equal to the total amount recorded as a credit, so that the accounting equation remains balanced.

Trade Discount vs. Cash Discount

Feature	Trade Discount	Cash Discount
Purpose	To encourage bulk purchases and customer loyalty.	To encourage prompt/early payment.
Calculation	A reduction off the list price.	A deduction off the invoiced amount.
Recording	It is not recorded in the business books.	It is recorded in the business books as ‘discount allowed’ or ‘discount received’.

Purpose of preparing bank reconciliation

Any one from:

To calculate the correct bank balance after updating the cash at bank account.
To reconcile the differences between records due to timing differences.
To identify any errors in the cash at bank account or bank statement.
To act as a deterrence against fraud.

Causes of differences between business cash at bank and bank statement

The causes could be due to the different timing at which transactions are recorded by the business and the bank, as well as due to errors in recording by either of the two parties.

Why items are recorded on opposite sides

The bank and the business view the items from an opposite perspective. The business views cash at bank as an asset (debit balance). The bank views the cash at bank as a liability it owes to the business (credit balance).

Credit Transfer vs. Direct Debit

Credit Transfer (Direct Deposit): An order to the bank to transfer money from a third party’s account to the business’s account.
Direct Debit (Direct Payment): An order to the bank to transfer money from the business’s account to another party’s account.

Define trial balance

A list of all the ledger accounts and their balances extracted from the General Ledger on a given date. It is used to verify that the total of all accounts with debit balances equals the total of all accounts with credit balances.

Purpose of trial balance

To check the arithmetic accuracy of the entries in the accounts and to help in the preparation of financial statements.

Limitations of trial balance

A trial balance does not reveal errors that do not cause the debit and credit totals to disagree.

Purpose of the Statement of Financial Performance

It shows the income earned and the expenses incurred during a financial period to generate that income. It shows the profitability of a business.

Trading Portion vs. Income Summary Portion

The trading portion shows the profit or loss from buying and selling goods and measures trading performance. The income summary portion shows the overall profitability of a business for the period.

Distinguish between financial statements of trading and service businesses

A trading business has both a trading portion (calculating gross profit) and a profit and loss portion, while a service business has only the profit and loss portion.
A trading business has inventory in the Statement of financial position while a service business does not (though it may have supplies).

Purpose of the Statement of Financial Position

It lists the assets, liabilities, and equity of a business at a specific point in time. It shows how the resources of a business are being acquired and used.

Non-Current vs. Current Assets

Non-current assets are items owned by a business for long-term use to help generate income and are not easily converted to cash.
Current assets are items owned by a business that are easily converted into cash within one accounting year.

Explain why inventory is classified as a current asset

Inventory is kept for resale purposes and is usually intended to be sold within one accounting period, hence it is classified as a current asset.

Non-Current vs. Current Liabilities

Non-current liabilities are amounts owed by the business that are due for settlement after more than one accounting year.
Current liabilities are amounts owed that must be settled within one accounting year.

Capital vs. Revenue Expenditure

Capital Expenditure: Cost incurred to buy and bring a non-current asset to its intended use, providing benefits for more than one financial year. It is recorded as a non-current asset.
Revenue Expenditure: Cost incurred to repair and maintain a non-current asset at working condition. The benefits are used within the financial year, and it is recorded as an expense.

Accounting Theories for Expenditure

Prudence Theory: A business should not overstate its assets or understate its expenses. Hence, costs must be correctly classified as capital or revenue.
Materiality Theory: If a transaction is immaterial (e.g., a $4 stapler), a business can record it as a revenue expenditure even if it’s technically a capital expenditure, because its cost is insignificant to decision-making.

Causes of Depreciation

Usage: consumption of the asset’s benefits.
Wear and tear: physical deterioration from use and exposure.
Obsolescence: becoming outdated due to technological advancement.
Legal limits: restrictions on the use of an asset (e.g., a lease period).

Depreciation Methods and Suitability

Straight-Line Method: Suitable for assets that provide uniform benefits throughout their useful life (e.g., fixtures and fittings).
Reducing-Balance Method: Suitable for assets that provide more benefits in earlier years and become less efficient over time (e.g., motor vehicles).
Consistency Theory: A business should use the same depreciation method over the years to facilitate fair comparison of performance.

Journal entries on the sale of non-current asset (G3 level)

Transfer original cost: Dr Sale of non-current asset, Cr Non-current asset
Transfer accumulated depreciation: Dr Accumulated depreciation, Cr Sale of non-current asset
Record sale proceeds: Dr Cash at bank/Other receivable, Cr Sale of non-current asset
Record gain or loss on sale:
- Gain: Dr Sale of non-current asset, Cr Income Summary
- Loss: Dr Income Summary, Cr Sale of non-current asset

Define Trade Receivables

The amount customers owe the business from the sale of goods or services on credit, expected to be paid in the near future.

Valuation of Trade Receivables

Trade receivables are valued at Net Trade Receivables (Total Trade Receivables less Allowance for Impairment). This is in accordance with the Prudence Theory, which aims to understate assets and profits when in doubt by adjusting for possible losses.

Purpose of Allowance for Impairment

To charge the likely expense to the income summary account so that profit and current assets will not be overstated. The business must adjust the book value of any asset if its value is likely to be reduced, ensuring the asset is not overstated.

Effect of Not Adjusting for Impairment Loss

Profit will be overstated, and Trade Receivables (Current Assets) will be overstated.

Define Equity, Share Capital, Dividends, and Retained Earnings

Equity (Shareholders’ Equity): The shareholders’ claim on the business assets, comprising issued share capital and retained earnings.
Share Capital: The cash raised by issuing shares to shareholders.
Dividends: A distribution of profits to shareholders. It is a contra-equity account that decreases retained earnings.
Retained Earnings: The accumulated profits that have not been distributed to shareholders.

Journal entries for Equity Transactions

Recording issued share capital: Dr Cash at bank, Cr Issued share capital
Dividends declared but not paid: Dr Dividends, Cr Dividends payable
Transferring profit to retained earnings: Dr Income Summary, Cr Retained earnings
Transferring loss to retained earnings: Dr Retained earnings, Cr Income Summary

Equation for Shareholders’ Equity

Shareholders' Equity = Share Capital + Retained Earnings (or Profits - Losses - Dividends)

Importance of being profitable

Profitability is crucial for survival and growth. With profits, a business can distribute dividends, attract investors, and expand operations. A business that is not profitable is likely to close down.

Importance of being liquid

Liquidity is vital for daily operations. Cash is needed to buy inventory, pay rent, salaries, and other expenses.

Differences between liquidity and profitability

Profitability measures the ability to earn a profit, while liquidity measures the ability to repay current debts. A business can be profitable but not liquid (e.g., high credit sales lead to high profit but low cash) and vice-versa.

Working capital

Refers to the excess of current assets over current liabilities. It is a measure of a company’s short-term liquidity. Working capital = total current assets - total current liabilities

Profitability Ratios

Gross profit margin = (Gross profit / Net sales revenue) × 100
Mark-up on cost = (Gross profit / Cost of sales) × 100
Expenses to net sales revenue = (Operating expenses / Net sales revenue) × 100
Profit margin = (Profit for the period / Net sales revenue) × 100
Return on equity = (Profit for the period / Average equity) × 100
Average equity = (Equity at start of period + Equity at end of period) / 2

What is inventory?

Inventory refers to goods bought by a business to resell to customers.

Why businesses need to store inventory

A business usually buys sufficient goods to keep on hand to prevent a stock-out situation, which often results in loss of sales.

How to manage inventory stock

The business should set up a perpetual inventory system to keep track of stock availability to ensure that they do not underbuy or overbuy inventory.

Method of calculating cost of sales

Cost of sales is calculated using the first-in-first-out (FIFO) method, where the inventory purchased earliest is assumed to be sold first.

Meaning of FIFO

FIFO (First-In, First-Out) means goods which are assumed to be bought first are sold first, and goods purchased last remain in inventory. This helps prevent old stock from becoming outdated.

Inventory Valuation

Basis: Inventory is valued at the lower of cost or net realisable value (NRV).

Accounting Theory: This is based on the Prudence Theory, which states that a business should not overstate its assets. If inventory’s value falls below its cost, it must be written down to its NRV.

Define Net Realisable Value (NRV)

NRV refers to the estimated selling price of inventory less all other possible selling expenses incurred in the process of the sale.

Accounting for Impairment Loss on Inventory

When the cost of inventory is higher than its NRV, the business must reduce the inventory value and record the potential loss as an impairment loss. This ensures that current assets and profit are not overstated, in line with the Prudence theory.

How to improve Gross Profit Margin / Mark-up

Increase unit selling price.
Source for cheaper suppliers or buy in bulk to enjoy trade discounts.
Reduce rates of trade discounts given to customers.

How to improve Profit Margin (Be specific)

Reduce rent expense by moving to another location with cheaper rent.
Reduce interest expense by finding cheaper sources of finance.
Reduce utilities expense by introducing energy-saving measures.
Reduce impairment loss on trade receivables by reviewing credit given to customers.

Effects of a low working capital

Businesses will not be able to pay day-to-day expenses.
Business will not be able to take advantage of any business opportunities or cash discounts.
Unable to pay creditors or short-term debts on time.
Loss of customer goodwill and sales as the business cannot stock sufficient quantity and variety of goods.

How to improve liquidity

Sell off excess non-current assets.
Obtain a bank loan or cash contribution from the owner.
Offer cash discounts to encourage trade receivables to pay.

Quick Ratio vs. Current Ratio

The quick ratio is a more reliable indicator of liquidity than the current ratio. The current ratio includes all current assets, while the quick ratio excludes inventory and prepayments, which are less liquid. It measures the ability to repay immediate debts with only the most liquid assets.

How to improve inventory turnover rate

Review inventory control procedures to avoid overstocking.
Reduce selling price or hold promotional sales to increase sales volume.
Offer a wider range of products that appeal to customers.

How to improve the rate of trade receivables turnover

Improve the credit granting process by monitoring collection patterns and ensuring credit is granted only to financially able customers.
Offer cash discounts to encourage credit customers to pay early.
Increase debt collection efforts by sending regular reminders.
Engage professional debt recovery agencies for financially distressed customers.