Accounting: Business Entities and the Accounting System — Revision Notes

Condensed for the final weeks. For the full explanation, use the Business Entities and the Accounting System study guide.

Business structures

Entity	Liability	Accounts
Sole trader	Unlimited	Capital account, drawings
Partnership	Unlimited (usually)	Capital and current accounts, appropriation account
Limited company	Limited	Share capital, reserves, dividends
Non-profit / club	Varies	Receipts and payments, income and expenditure

Unlimited liability means personal assets can be taken to settle business debts. That phrase is what mark schemes reward.

The business entity concept treats the business as separate from its owner — which is why capital appears alongside liabilities, since the business owes it back to the owner, and why drawings reduce capital rather than profit.

The accounting system

source documents -> books of prime entry -> ledgers -> trial balance -> financial statements

Books of prime entry: sales journal and purchases journal (credit transactions only), returns journals, cash book, petty cash book, general journal.

Cash sales go straight to the cash book, not the sales journal — the standard error.

Ledgers: sales ledger (credit customers), purchases ledger (credit suppliers), general ledger (everything else).

A balanced trial balance proves nothing. Six errors leave it balanced: omission, commission (wrong account of the right type), principle (wrong type of account), original entry, complete reversal, and compensating.

Financial statements

Income statement — revenue less cost of sales gives gross profit; less expenses gives profit for the year.

Statement of financial position — assets, liabilities and capital at a point in time.

The distinction that matters: the income statement covers a period; the statement of financial position is a snapshot at one date. Questions on why both are needed hinge on that.

Capital expenditure buys or improves a non-current asset (including delivery and installation); revenue expenditure is running costs including repairs. Misclassifying capital as revenue understates both profit and non-current assets — and stating the effect on both statements is what earns full marks.

Partnership accounts

Governed by the partnership agreement; where none exists, the Partnership Act applies — profits shared equally, no interest on capital, no salaries.

Capital account records permanent investment; current account records the year’s share of profit, salaries, interest and drawings. Keeping them separate makes each partner’s permanent stake distinguishable from their fluctuating entitlement.

Appropriation account — shows how profit is divided: interest on capital, partners’ salaries, then the residual shared in the profit-sharing ratio. Interest on drawings is charged, not credited, since drawings reduce the funds available to the business.

Limited companies

Share capital — ordinary shares (voting, variable dividend, paid last on winding up) and preference shares (fixed dividend, paid first, usually no vote).

Reserves — retained earnings (accumulated profit), and capital reserves such as share premium.

Dividends are an appropriation of profit, not an expense, so they do not appear in the income statement — they are shown as a deduction from retained earnings.

Fundamental accounting concepts

Concept	What it governs
Money measurement	Only items that can be expressed in monetary terms are recorded
Consistency	The same accounting methods are used period to period
Prudence	Profits are not overstated; losses and liabilities are not understated
Realisation	Revenue is recorded when earned, not necessarily when cash is received
Duality	Every transaction has two effects — the basis of double entry
Materiality	Only items significant enough to affect decisions need precise treatment
Objectivity	Accounts are prepared free from personal bias, based on verifiable evidence
Matching/accruals	Income and expenses are recorded in the period they relate to, not when cash moves
Substance over form	Transactions are recorded by their real economic substance, not just their legal form

Prudence versus realisation is a common pairing question: realisation says record revenue once it is earned; prudence says don’t anticipate profit before that point is reached — the two work together, not against each other.

Computerised accounting systems

Computerised systems apply the same double-entry principles as manual ones, but record and process transactions electronically. Advantages: speed, reduced arithmetic error, easier report generation. Disadvantages: setup and training cost, and reliance on system reliability and data security — passwords, access levels and regular backups are the standard safeguards expected in an answer.

Exam traps

• Putting cash sales in the sales journal.
• Treating drawings as an expense.
• Assuming a balanced trial balance means no errors.
• Confusing commission with principle.
• Treating dividends as an expense.
• Giving only one effect of misclassifying expenditure.
• Confusing prudence (not overstating profit) with realisation (recording revenue when earned).
• Naming a computerised system’s advantages without also acknowledging the security and reliability risks.

Self-test

1. Why does capital appear with liabilities?
2. What goes in the sales journal, and what does not?
3. Why are partners’ capital and current accounts kept separate?
4. Distinguish an error of commission from one of principle.
5. Why are dividends not an expense?
6. Distinguish the prudence concept from the realisation concept.
7. State two advantages and one disadvantage of a computerised accounting system.

Answers: 1. Under the business entity concept the business is separate from its owner, so capital is an amount the business owes back to the owner. 2. Credit sales of goods only; cash sales go to the cash book and sales of non-current assets go to the general journal. 3. The capital account records each partner’s permanent investment while the current account records their fluctuating entitlement from profit, salaries, interest and drawings — separating them keeps the permanent stake clear. 4. Commission is posting to the wrong account of the correct type, such as the wrong customer; principle is posting to an entirely wrong category of account, such as recording an asset as an expense. 5. They are an appropriation of profit already earned, not a cost of earning it, so they are deducted from retained earnings rather than charged in the income statement. 6. Realisation says revenue should be recorded once it is earned, not necessarily when cash is received; prudence says profits and asset values should not be overstated, nor losses and liabilities understated, so profit should not be anticipated before it is actually earned. 7. Advantages: speed, and reduced arithmetic error (or easier report generation); disadvantage: setup and training cost, or reliance on system reliability and data security.