Edexcel IGCSE Accounting: Types of business organisation and accounting concepts (4AC1)

This guide covers sections 1.1 (Types of business organisation) and 1.2 (Accounting concepts) of Topic 1, The accounting environment, in the Pearson Edexcel International GCSE in Accounting (4AC1) specification, Issue 1, October 2016. The specification says Paper 1 draws exclusively on Topics 1 to 3, and Paper 2 builds on those topics as well as Topics 4 and 5, so this material can matter in both papers. Every amount is in dollars ($) and every business and person below is invented.

Links: Edexcel IGCSE Accounting hub, printable checklist, all free 10-minute diagnostics. Next in this set: the revision notes and the practice questions.

What this unit covers

Spec point	What you must be able to do
1.1 a	Explain the characteristics of public sector organisations, private sector organisations, sole traders and partnerships
1.1 b	Explain the connection between stakeholders and a business, identifying how stakeholders use its financial statements
1.2 a	Understand the significance of consistency, prudence, accruals, materiality, money measurement and business entity

1.1 a: Types of business organisation

What the specification says and what is added here. The specification names the four types and asks you to explain their characteristics, and it asks you to explain stakeholders’ use of financial statements. It does not list the individual characteristics or the stakeholder groups. The characteristics, the stakeholder table and the points about unlimited liability and partnership agreements below are standard accounting knowledge, given as a working guide to answering, not as specification wording.

An organisation is either in the public sector or the private sector. Sole traders and partnerships are both private sector.

Public sector organisations

These are owned and controlled by the government, national or local. Examples are a state hospital, a state school, a city council’s refuse service and a public library.

• The main aim is to provide a service to the public, not to make a profit for owners.
• They are mainly paid for out of taxes, with some income from charges.
• They are accountable to the government and, through it, to the public.

Private sector organisations

These are owned by individuals or groups of individuals, not by the government.

• The main aim is usually to make a profit for the owners.
• Money comes from the owners’ capital, loans and the profits the business keeps.
• The owners decide how the business is run. The specification lists all four types (public sector, private sector, sole traders, partnerships) as ones whose characteristics you must explain.

Sole traders

A sole trader is a business owned by one person. The owner may employ staff, but only one person owns it.

Characteristic	Detail
Ownership	One owner, who is also usually the manager
Profit	The owner keeps all of it
Liability	Unlimited: the owner is personally responsible for all the business debts
Capital	Limited to the owner’s savings, profits kept and borrowing
Decisions	Made quickly by one person, with no one to agree with
Setting up	Simple and cheap

Partnerships

A partnership is a business owned by two or more people, the partners, who usually agree terms in a partnership agreement.

Characteristic	Detail
Ownership	Two or more partners
Profit	Shared between the partners in the agreed ratio
Liability	Partners are personally responsible for the debts of the business
Capital	More than a sole trader, because each partner contributes
Decisions	Shared, which brings more ideas but possible disagreement
Skills	Partners can bring different skills

Worked example 1: liability. Odalis Vandeleur trades as a sole trader. Her business owes 80,000 and its assets would raise only 52,000 if sold.

Shortfall = 80,000 − 52,000 = 28,000. Because her liability is unlimited, creditors can look to her personal assets for the 28,000. If she were instead in a partnership with one other partner, the partners would be personally responsible for the shortfall between them. Owners of an unlimited-liability business risk personal property, not only the money they put in.

1.1 b: Stakeholders and their use of financial statements

A stakeholder is a person or group with an interest in a business. The connection runs both ways: the business affects them, and they can affect the business. Each group wants the financial statements for a different reason.

Stakeholder	Interest	What they look for
Owner(s)	Return on the money invested	Profit for the year, and whether capital is growing
Managers	Running the business well	Profit and costs, to control and plan
Employees	Job security and pay	Whether the business is profitable enough to keep and pay them
Lenders (for example a bank)	Loan repaid with interest	Profit and assets, to judge ability to repay
Suppliers	Being paid on time	Whether the business can pay what it owes
Customers	Continued supply	Whether the business is stable and will survive
Government and tax authority	Tax due	Profit, on which tax is worked out
Local community	Jobs and local impact	Whether the business will grow, stay or close

Worked example 2: matching stakeholders to figures. Brandvold Print Studio is a sole trader business owned by Sigrun Brandvold. For the year ended 31 December:

	$
Revenue	126,500
Cost of sales	70,800
Gross profit	55,700
Expenses	31,250
Profit for the year	24,450

At the year end it owes a bank loan of 18,000 (repayments of 6,000 a year), has trade payables of 9,600, trade receivables of 11,300 and 4,100 in the bank.

• The bank. Profit for the year is 24,450, which is 24,450 ÷ 6,000 = 4.075 times the yearly repayment, so repayment looks affordable.
• A supplier. Receivables plus bank = 11,300 + 4,100 = 15,400, more than the 9,600 owed, so it is likely to be paid.
• Sigrun. She compares profit with her drawings and decides whether to reinvest.
• The tax authority. It uses the profit of 24,450 as the starting point for tax due.

The method: name the stakeholder, name the figure in the statements, say what decision it supports.

1.2 a: Accounting concepts

Concepts are the agreed ground rules that make financial statements consistent and fair. For each one, know what it says and why it matters.

Consistency

Once a method is chosen, use the same method from one period to the next. This lets users compare one year with another, and it stops owners from changing methods to flatter profit.

Worked example 3. Brandvold buys a vehicle for 15,000 and depreciates it at 20% a year. Year 1 straight line: 15,000 × 20% = 3,000, leaving a net book value of 12,000. In year 2, straight line gives 3,000 again. Switching to reducing balance would give 12,000 × 20% = 2,400, so year 2 profit would be higher by 3,000 − 2,400 = 600, only because the method changed. The two years then cannot be compared fairly. Consistency is why the method should stay the same unless there is a good reason.

Prudence

Do not overstate profit or assets. Recognise expected losses as soon as they are foreseen, but do not recognise profits until they are realised. Where in doubt, choose the figure that gives the lower profit or asset value.

Worked example 4. Brandvold has 150 reams of paper in inventory at a cost of 14 each. Their net realisable value is now 11 each, because the price has fallen.

Value at cost = 150 × 14 = 2,100. Value at net realisable value = 150 × 11 = 1,650. Under prudence the lower value is used, so inventory falls by 2,100 − 1,650 = 450 and profit falls by 450. A loss that is likely is recorded now, not left until the stock is sold.

Accruals (matching)

Revenues and expenses are recorded in the period they are earned or incurred, not when cash is received or paid.

Worked example 5. On 1 October Brandvold pays 2,400 insurance for 12 months. The year ends on 31 December.

Monthly cost = 2,400 ÷ 12 = 200. Only 3 months belong to this year, so the expense is 3 × 200 = 600. The other 9 months, 1,800, are for next year and are treated as a prepayment. Likewise, goods sold on credit on 30 December count as this year’s revenue, even though the cash arrives in January.

Materiality

An item is material if leaving it out or misstating it could change the decisions of the users of the statements. Small items are not worth the effort of detailed treatment.

Worked example 6. Brandvold has revenue of 126,500. It buys a stapler for 18 and a printing press for 14,500.

• Stapler: 18 ÷ 126,500 × 100 = 0.014% of revenue. It is immaterial, so it is treated as an expense, not a non-current asset.
• Press: 14,500 ÷ 126,500 × 100 = 11.5% of revenue. It is material, so it is recorded as a non-current asset.

Materiality is a matter of judgement. The same 18 could be material to a very small business.

Money measurement

Only items that can be measured in money are recorded. A skilled workforce, a good reputation, or a loyal customer base all have real value, but none has an exact money figure, so none is in the statement of financial position. There is a second limit: the value of money changes over time, so figures from different years are not exactly like for like.

Business entity

The business is treated as separate from its owner. Only the business’s transactions are recorded. This holds even for a sole trader, who is not legally separate from the business.

Worked example 7. During the year Sigrun takes 14,000 in cash from the business bank account. She also takes goods that cost 300 for home use and pays a 410 household bill from the business account.

None of these is a business expense. All three are drawings: 14,000 + 300 + 410 = 14,710. Profit stays at 24,450, because personal spending is not a business cost. Closing capital = opening capital + profit − drawings = 41,000 + 24,450 − 14,710 = 50,740. Her private home and car are kept out of the business’s records for the same reason.

Common errors

• Saying a sole trader has limited liability.
• Describing the private sector as “run for profit” without saying it is owned by individuals.
• Listing a stakeholder without saying what they use the statements for.
• Writing the name of a concept with no link to the facts in the question.
• Treating prudence as “always choose the lowest number” instead of not overstating profit.
• Treating accruals as the same thing as cash paid.
• Putting the owner’s personal spending through the expenses.

Next steps

Test yourself with the practice questions, then use the revision notes. Check your readiness with the free diagnostics.

Frequently asked questions

What is the difference between the public sector and the private sector? Public sector organisations are owned and controlled by the government and aim mainly to provide a service, funded largely by taxes. Private sector organisations are owned by individuals or groups and usually aim to make a profit for the owners.

Does a sole trader have limited liability? No. Sole traders and partners in an ordinary partnership have unlimited liability, so creditors can claim the owners’ personal assets if the business cannot pay its debts.

How do stakeholders use financial statements in Edexcel IGCSE Accounting? Each stakeholder uses different figures: a bank checks whether profit covers loan repayments, a supplier checks whether receivables and bank cover what it is owed, and the tax authority starts from profit. Name the stakeholder, the figure and the decision it supports.

What are the six accounting concepts in the 4AC1 specification? The six concepts are consistency, prudence, accruals (matching), materiality, money measurement and business entity. Each is a ground rule that makes financial statements consistent and fair.

Does the business entity concept apply to a sole trader? Yes. The business is treated as separate from its owner even though a sole trader is not legally separate from the business, so the owner’s personal spending from the business is drawings, not an expense.

Official syllabus

Pearson Edexcel International GCSE in Accounting (4AC1) specification, Issue 1, October 2016, published by Pearson Education Limited – Topic 1 The accounting environment, sections 1.1 Types of business organisation and 1.2 Accounting concepts.