0452 · 7.1Accounting concepts

Business entity and owner’s equity

0:00Imani repairs a customer’s bicycle in December, but the customer pays in January. The work and the payment belong to different periods. The agreed rules that decide when to record income, which costs belong alongside it and how to value resources are called accounting concepts. This video covers business entity, duality, money measurement, realisation, matching or accruals, historic cost, going concern, consistency, prudence and materiality. Our examples follow Imani’s Bike Repairs, which she runs as a sole trader.

0:30A sole trader is a business owned and controlled by one person. Financial statements are summaries that show a business’s profit or loss for a period and what it owns and owes at a date. Each concept guides which information enters these summaries and at what amount. Revenue is the income a business earns from its main activity, such as selling goods or providing services. For Imani’s Bike Repairs, revenue comes from fixing customers’ bicycles.

0:55Expenses are the costs used up in running the business and earning revenue during a period. Profit for the year is the amount by which revenue exceeds expenses over one financial year. Under the business entity concept, Imani and Imani’s Bike Repairs are treated as two separate parties. The owner’s capital is therefore owed by the business to the owner. Owner’s equity, also called capital, is the owner’s investment in the business, or the amount the business owes the owner.

1:20The records show the shop’s activities and leave out Imani’s private spending. Drawings are money or goods taken from the business by its owner for private use. They are not a business expense, so they never reduce the profit for the year. Imani pays for her household shopping from the business bank account. Debit the drawings account because the amount taken for her private use rises, and credit the bank account because money held there falls.

1:44Owner’s equity goes down because she has taken back part of her investment.

Duality and money measurement

1:48Assets are resources owned or controlled by a business that bring future benefit, while liabilities are amounts the business owes to others. The accounting equation states that assets equal liabilities plus owner’s equity. Owner’s equity sits on the same side as liabilities because the business owes that amount to Imani. Separating the owner from the business keeps her investment apart from amounts owed to outside parties. Duality means that every transaction has two aspects.

2:14Buying equipment through the bank, for example, adds one asset and reduces another. Double entry means every transaction is recorded as a debit in one account and a credit of the same amount in another. A debit is an entry on the left side of an account, while a credit belongs on the right. Non-current assets are assets held for continuing use in the business rather than for resale. Imani buys repair equipment for two thousand six hundred dollars through the bank.

2:39Debit the equipment account because the business now owns more equipment, and credit the bank account because the money in the bank decreases. One asset replaces another by the same amount, so total assets remain unchanged. Liabilities and owner’s equity are untouched, so the accounting equation still balances. Other transactions change an asset and a liability, or an asset and owner’s equity, by the same amount. Duality describes the two effects, while double entry is the method that records them.

3:08Every entry therefore shows what changed in the business, not just whether money arrived or left. Money measurement means only items that can be expressed in monetary terms are recorded. The equipment qualifies because its purchase has a measurable price. Imani’s repair skills attract customers, but no reliable amount in dollars can be attached to her ability. Her skill is therefore never recorded as an asset. The same treatment applies to a helpful employee or a convenient shop location.

3:34These features can improve business performance without appearing as separate amounts in the records. Money measurement therefore limits what the financial statements show. A business can have valuable qualities that are absent from its recorded assets.

Revenue recognition and accruals

3:47Realisation means revenue is recognised when goods or services pass to the customer, not when cash is received. For a repair service, this happens when the agreed work is completed and the bicycle is handed back. Receiving money is a separate event that may occur earlier or later. What matters is that Imani’s Bike Repairs has earned the amount through its main activity. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services.

4:13Imani completes and hands back a repair worth nine hundred dollars in December, and payment is due in January. Debit the trade receivables account because the customer now owes more, and credit the revenue account because repair income rises. December contains the revenue even though the money arrives later. When the customer pays in January, debit the bank account because money in the bank rises, and credit trade receivables because the unpaid amount falls.

4:38This payment settles an existing amount owed. The repair revenue has already been recorded in December. Recording it again in January would count one repair twice. The matching or accruals concept means income and expenses are recorded in the period to which they relate, not when cash is received or paid. Electricity used during December belongs to December even if its bill is paid later. Similarly, advance payments must be allocated to the periods that receive the benefit.

5:04An accrued expense is a cost of the current year that is still unpaid at the year end. Imani’s Bike Repairs paid two thousand three hundred dollars for electricity used during the year. Another five hundred dollars relates to that year but remains unpaid. To find the year’s electricity expense, include both the paid portion and the unpaid portion. Two thousand three hundred dollars plus five hundred dollars equals two thousand eight hundred dollars.

5:29That is the electricity expense belonging to the year. The unpaid five hundred dollars also remains an amount the business owes. Matching recognises the cost now, while the records keep the obligation to pay later. Current liabilities are amounts due for payment within twelve months. Unpaid expenses and money received before it is earned are grouped as other payables, which are current liabilities. Imani’s unpaid electricity of five hundred dollars therefore belongs in other payables at the year end.

5:56The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period. Its electricity line contains two thousand eight hundred dollars. A statement of financial position shows assets, liabilities and owner’s equity at a particular date. Within its current liabilities, other payables include the five hundred dollars. One amount measures the year’s use of electricity, while the other is the unpaid part.

6:22A prepaid expense is a cost paid in advance that belongs to a future period. Imani pays eighteen hundred dollars for twelve months of insurance, but three months fall after the year end. Eighteen hundred dollars divided by twelve gives one hundred and fifty dollars per month. Three times one hundred and fifty dollars equals four hundred and fifty dollars for the future period. Eighteen hundred dollars minus four hundred and fifty dollars equals thirteen hundred and fifty dollars.

6:47Only thirteen hundred and fifty dollars belongs in this year’s insurance expense. Current assets are assets expected to be turned into cash or used up within twelve months. The unused insurance benefit qualifies because the business will receive that protection during the coming months. Other receivables are current assets, such as amounts due to the business and payments for benefits not yet used. The prepaid insurance appears there at four hundred and fifty dollars.

7:11This treatment separates protection already used from protection still available. Matching assigns each portion to the period that receives its benefit.

Asset valuation and consistency

7:20Historic cost means assets are recorded at the price paid when they were acquired. Imani’s equipment enters the records at its purchase price of two thousand six hundred dollars. A later rise in the price of similar equipment does not replace that original amount. This original amount is backed by evidence of the actual purchase, so it can be checked. Going concern means the business is assumed to continue operating for the foreseeable future.

7:44Imani expects to keep using her equipment, so it is valued for continued use, not at its sale value. Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use. Accumulated depreciation is the running total of depreciation charged on an asset since it was acquired. By the year end, Imani’s equipment has accumulated depreciation of six hundred dollars.

8:10Carrying amount is the asset’s cost less its accumulated depreciation. Two thousand six hundred dollars minus six hundred dollars gives a carrying amount of two thousand dollars. That two thousand dollars is based on cost less accumulated depreciation, not the amount obtainable from an immediate sale. Historic cost supplies the starting amount, while going concern supports valuation for continued operation. Matching also applies because depreciation allocates an expense to the years of use.

8:38Several concepts can therefore support the same treatment. Consistency means the same accounting methods are used from year to year, so results can be compared. Straight-line depreciation allocates an equal charge to each full year of use. Imani chose this method for her equipment, so she keeps it in later years. A change in profit for the year then comes from the business’s activities, not from a new way of calculating depreciation.

9:03Consistency does not require every type of asset to use the same method. What matters is that similar items are treated the same way across periods. A justified change can occur, but methods are never changed merely to produce a preferred result.

Prudence and materiality

9:17A figure recorded too high is overstated, and one recorded too low is understated. Prudence means that profits and assets are not overstated, and losses and liabilities are not understated. Estimates must therefore take reasonable account of possible losses. Prudence supports cautious figures based on evidence, not deliberately pessimistic amounts. An allowance for irrecoverable debts is an estimate of trade receivables that may not be paid. Imani’s Bike Repairs has trade receivables of four thousand two hundred dollars and estimates an allowance of three hundred dollars.

9:47Four thousand two hundred dollars minus three hundred dollars equals three thousand nine hundred dollars. The statement of financial position reports that reduced amount within current assets. Prudence also guides the valuation of inventory. Inventory means goods held for resale. Imani’s shop sells bicycle lights. Cost is the purchase price plus costs of bringing goods to their present location and condition. Her lights cost eight hundred dollars, but some now have scratched cases.

10:16Net realisable value is the expected selling price minus costs to complete and sell the goods. Imani now expects to sell the lights for seven hundred and fifty dollars, and selling them will cost fifty dollars. Seven hundred and fifty dollars minus fifty dollars gives a net realisable value of seven hundred dollars. Inventory is valued at the lower of cost and net realisable value, so the lights are shown at seven hundred dollars.

10:39The expected loss of one hundred dollars is recognised now, before any light is sold. Materiality means an item is significant if its omission or misstatement would affect users’ decisions. Imani’s equipment is large enough to be treated as a non-current asset and depreciated. A stapler costing twelve dollars may also last several years, yet it is recorded simply as an expense. Spreading such a small cost over its life would not change any user’s decision.

11:06Materiality depends on both the size and the nature of an item. There is no single monetary threshold suitable for every business and every situation. A relatively small amount can still matter if its nature influences a decision. The concept permits proportionate treatment, but significant information must remain in the records.

Applying concepts in exam questions

11:24In Paper One, forty multiple-choice questions can include short scenarios that ask you to select the relevant concept. Paper Two contains five compulsory structured questions and can require explanations of accounting treatments. Identify means name or select, while explain means give reasons why and how, supported by evidence. Link the concept directly to the event described. Imani pays for a family holiday from her personal bank account, and the shop’s records leave it out.

11:52The answer is business entity, because the holiday is her private spending, not an activity of the business. When a customer pays in January for a repair handed back in December, realisation places the revenue in December. Recording a new machine in both the equipment account and the bank account shows duality. Treating a twelve-dollar stapler as an expense straight away is an example of materiality. Similar machines now cost more, yet the equipment stays at its cost of two thousand six hundred dollars, so historic cost applies.

12:21Keeping straight-line depreciation for another year is consistency, because results stay comparable. Loyal customers never appear as an asset, since money measurement records only items with a reliable value in dollars. The allowance for irrecoverable debts reflects prudence, because it stops trade receivables being overstated. Going concern explains why the equipment appears at its carrying amount while the business keeps trading. For the electricity scenario, a concise answer is that the matching or accruals concept applies.

12:49The electricity was used before the year end, so the unpaid five hundred dollars belongs to that year’s expenses. The payment date does not decide when the expense is recognised. The unpaid amount is also included in other payables because the business still owes it. Naming the concept answers identify, and the link to the year of use answers explain. Business entity separates the owner’s activities from the business, and duality records both aspects of each transaction.

13:15Money measurement limits records to items with a value in dollars, while materiality asks whether information would change decisions. Realisation sets when revenue is earned, and matching places income and expenses in their own periods. Historic cost and going concern decide how non-current assets are valued. Consistency keeps methods the same each year, and prudence stops profits and assets being overstated.