Accounting Concepts (Grade 10 NSC Matric Accounting): Revision Notes
Accounting Concepts
Understanding business ownership
Before we explore accounting concepts, it's helpful to understand the different ways businesses can be owned. When someone wants to start a business, they need to think about how much money they have available, how much control they want, and whether they're willing to accept personal responsibility for the business.
There are three main forms of business ownership:
Sole proprietor (trader)
A sole proprietor is a one-person business. This means one individual owns and controls the entire business. This person makes all the decisions and keeps all the profits. The downside is that one person usually cannot contribute a large amount of capital on their own. In Grade 10, we focus on sole proprietors.
Partnership
A partnership involves between 2 and 20 partners working together. All partners have a say in how the business operates. Because multiple people contribute money, a partnership can start with more capital than a sole proprietor. The profits are shared among all partners.
Company
A company has many owners called shareholders. People become owners by buying shares in the company. Because so many people can invest, companies can raise much more capital than sole proprietors or partnerships. The profits, called dividends, are shared among the shareholders.
Throughout this course, we'll focus primarily on sole proprietorships. Understanding this form of business ownership will give you a solid foundation in accounting principles before moving to more complex business structures.
Types of businesses
A sole proprietor can choose between two main types of businesses:
Service businesses provide services to customers and earn fee income or commission income. Examples include doctors, plumbers, and garden services.
Retailing businesses buy finished products (goods that are manufactured and ready to sell), add a profit margin, and sell them to customers. Examples include grocery stores and clothing shops.
The accounting period
The accounting (financial) period is a 12-month period used for recording and reporting financial information. This period doesn't have to match the calendar year (January to December), though it can. For example, a business might choose to run its accounting period from 1 July to 30 June the following year. Many businesses in South Africa use the government financial year, which runs from 1 March to 28 February, especially for tax purposes.
Understanding the accounting period helps us define three important time concepts in accounting.
Current financial year, short-term and long-term
Let's use an example to understand these concepts. Suppose a business has an accounting period running from 1 January 2011 to 31 December 2011.
Understanding Time Periods in Accounting
Given: A business with an accounting period from 1 January 2011 to 31 December 2011
Current financial year: This is the 12-month period we're currently in.
- In our example: 1 January 2011 to 31 December 2011
Short-term: This refers to the next 12-month period after the current financial year.
- In our example: 1 January 2012 to 31 December 2012
- Short-term always falls within one financial year (12 months)
Long-term: This refers to any period longer than 12 months from the current financial year.
- In our example: Starting from 1 January 2013 onwards
These time periods are crucial because they help us classify assets and liabilities correctly. Understanding the difference between short-term and long-term will be essential when preparing financial statements.
Assets: What the business owns
Assets are the possessions and resources owned by a business. We divide assets into two main categories based on how long the business plans to keep them.
Non-current assets (long-term assets)
Non-current assets are possessions the business intends to keep and use for more than one year. The business doesn't buy these items to resell them. Instead, these assets help the business operate and generate income over many years.
Fixed assets (tangible assets)
Fixed assets are physical items the business can touch and use. These assets are permanent in nature and essential for daily operations. Examples include:
- Land and buildings: Factories, store rooms, houses, shops
- Vehicles: Motor cycles, motor vehicles, delivery vehicles
- Equipment: Furniture, cash registers, computers, shelves
Historical Cost Principle
Fixed assets are always recorded in the business books at their cost price (the price paid to purchase them). This is a fundamental accounting principle. Even if the value of a fixed asset changes over time, we continue to record it at the original purchase price.
Applying the Historical Cost Principle
Scenario: A business purchased land and buildings on 1 March 2008 for R500,000. On 1 March 2011, these properties were revalued at R650,000.
Question: What amount should appear in the business books?
Answer: R500,000 (the original purchase price)
Explanation: According to the historical cost principle, the business books would still show the original amount of R500,000, not the revalued amount of R650,000.
Including Installation Costs
When recording fixed assets, remember to include installation costs as part of the cost price. For instance, if a business purchased computers for R32,000 and paid R5,000 for installation, the Equipment account would show R37,000 (R32,000 + R5,000).
Financial assets
When a business is doing well and has extra cash available, it might decide to invest this money for a period of time at a fixed interest rate. This investment is called a fixed deposit or an investment. The original amount invested becomes a financial asset for the business. The interest earned on this fixed deposit is recorded as income for the business.
Financial assets represent the business's investments in financial institutions that will generate additional income over time.
Current assets (short-term assets)
Current assets are possessions that can be converted into cash within one year. These assets are temporary in nature and change frequently as the business operates.
Trading stock
Trading stock consists of goods or merchandise that the business acquires at a specific price and plans to sell at a higher price after adding a profit margin.
Trading stock is always entered in the business books at cost price (the price paid to purchase it), not at the selling price.
Debtors
When a business sells goods on credit (allowing customers to pay later), these customers become debtors. Debtors are people or businesses that owe money to the business. The business expects to collect this money within a year.
Bank
The bank account shows the amount of money the business has in its bank account. When the business has a positive balance, this is referred to as a favourable balance or a debit bank balance. The bank account is an asset because it represents money available to the business.
Cash float
Cash float is physical cash, in small denominations, kept in the cash register. This money is used to give change to customers when they pay for goods or services.
Petty cash
Petty cash is a small amount of cash kept on the business premises to make small payments for minor expenses.
The distinction between cash float and petty cash is important: cash float is specifically for making change at the point of sale, while petty cash is for minor business expenses like office supplies or small repairs.
Liabilities: What the business owes
Liabilities represent money owed to other enterprises or financial institutions. Like assets, we classify liabilities based on when the business must repay them.
Non-current liabilities (long-term liabilities)
Non-current liabilities are debts that the business will repay over a period longer than one year. These usually involve borrowing from financial institutions.
A common example is a loan. If a business needs money to purchase a vehicle, it might borrow the money from a bank or other financial institution. The business typically takes longer than a year to repay this loan, and it must pay interest at a certain rate each year. The original loan amount is recorded as a long-term liability, and the interest paid on the loan is recorded as an expense.
Current liabilities (short-term liabilities)
Current liabilities are debts the business expects to pay within one year. Common examples include:
Creditors
When a business purchases trading stock on credit (paying later), the supplier to whom the money is owed is called a creditor. The business plans to pay this debt within a short period, usually within 30 to 90 days.
Bank overdraft
If a business experiences cash flow problems, it might negotiate an overdraft facility with its bank. This allows the business to spend more money than it has in its account. In this situation, the bank becomes a liability because the business owes money to the bank. The business must repay this overdraft within a year.
Understanding Bank as Asset vs Liability
The bank account can be either an asset or a liability:
- When the business has a positive balance (favourable balance), the bank is an asset
- When the business has an overdraft (negative balance), the bank becomes a liability
Owner's equity: The owner's stake in the business
Owner's equity represents the money or capital the owner has invested in the business. This is the owner's interest or stake in the business. The owner can increase their capital contribution by:
- Depositing cash into the business
- Contributing fixed assets to the business
- Contributing trading stock to the business
When the owner withdraws money, fixed assets, or trading stock from the business during the year, these withdrawals are called drawings. Drawings decrease the owner's equity.
The business entity principle
The Business Entity Principle
A fundamental accounting principle is the business entity principle. This principle states that the owner and the business are two separate entities. Therefore, the bookkeeping records of the business and the owner must be kept strictly separate.
Applying the Business Entity Principle
Scenario: The owner wants to take out insurance for his wife's vehicle.
Question: Can the owner pay for this using business funds?
Answer: No, the owner cannot pay for this using business funds.
Explanation: The owner must pay for this from his personal funds because it's a personal expense, not a business expense. The business and the owner are separate entities, and their finances must remain separate.
How owner's equity changes
The main aim of any business is to make a profit. To make a profit, the business must conduct business activities or deliver services that generate income. However, to earn this income, the business must incur certain expenses. Both income and expenses affect the owner's equity in the business.
Operating expenses: The costs of running a business
Running a business requires money. The business needs to pay employees (wages and salaries), pay for necessary services like water, electricity and telephone, and if the business doesn't own a building, it must pay rent.
Operating expenses consist of:
- Payments for services: Rent, wages, salaries, water, electricity, telephone
- Consumables: Stationery, packing materials, fuel
- Cost of sales: The cost price of goods sold is an expense that decreases profits
Impact of Operating Expenses
Operating expenses have a direct influence on the profit of the business. Operating expenses decrease owner's equity.
Understanding which expenses are "operating" expenses is important. Operating expenses relate to the daily transactions and regular activities of the business.
Operating vs non-operating expenses
Operating expenses are costs directly related to the daily operations of the business. For example, the water and electricity used in the business is a daily expense and therefore an operating expense.
Non-operating expenses are costs not related to daily operations. For example, if the business took out a loan, the interest paid on that loan is not a daily expense. This interest is not part of the operating expenses of the business.
You'll learn more about the distinction between operating and non-operating expenses when studying financial statements. This classification becomes especially important when preparing the Income Statement.
Income: How the business earns money
There are two main ways a business can generate income:
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Current income: Earned by delivering a service to customers. Examples include income earned by plumbers, doctors, and electricians.
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Sales: A trader earns income by purchasing goods and selling the same goods at a profit. Examples include grocery stores and clothing shops.
These two methods represent the main sources of income for most businesses. However, businesses can also earn income in other ways. For example, a business might rent out part of its building to another business. This rental income would be recorded as operating income.
Impact of Income on Owner's Equity
Income received by the business increases the business's profits. Income increases profits, which results in an increase in owner's equity.
Operating vs non-operating income
Just as we distinguished between operating and non-operating expenses, we must also understand the difference with income.
Operating income comes from the daily activities of the business. If a business provides a service, the income received is a daily transaction and therefore operating income.
Non-operating income comes from sources outside the daily activities. For example, if a business invests money in a fixed deposit, the interest received from this fixed deposit is not part of the daily business activities. Therefore, interest on a fixed deposit is not operating income.
This distinction becomes clearer when preparing financial statements, where operating and non-operating items are reported separately to give a clearer picture of the business's core operations.
Remember!
Key Points to Remember:
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The accounting period is a 12-month period used for recording financial information. It doesn't have to match the calendar year.
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Assets are what the business owns. Non-current assets (long-term) are kept for more than one year, while current assets (short-term) can be converted to cash within one year.
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Fixed assets are always recorded at cost price (historical cost principle), and trading stock is always recorded at cost price.
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Liabilities are what the business owes. Non-current liabilities (long-term) are repaid over more than one year, while current liabilities (short-term) are repaid within one year.
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Owner's equity represents the owner's investment in the business. The business entity principle states that the owner and business are separate entities with separate records.
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Operating expenses decrease owner's equity, while income increases owner's equity. Both directly affect the business's profit.