Key Terms
Key Terms: Classification of Accounts and the Accounting Equation
Form 4 Chapter 2 rests on precise terms. Once you understand revenue, expense, asset, liability and owner's equity, classification and the accounting equation fall into place. Below are the key terms you need for the exam.
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Revenue and Expense (Operating vs Non-Operating)
- Revenue is income earned from business transactions that increases owner's equity, while an expense is a cost incurred to earn that revenue and reduces owner's equity. Both are reported in the Income Statement.
- Operating revenue comes from the core activity of the business (e.g. Sales for a goods trader, Service Revenue for a service business). Non-operating revenue arises outside the core activity (e.g. Rent Received, Interest Received, Commission Received, Discount Received).
- Operating expenses support the day-to-day core activity (e.g. Salaries, Rent, Rates, Utilities, General Expenses). Non-operating expenses are not directly tied to the core activity (e.g. Interest on Loan). A goods business has Cost of Sales, whereas a service business has no Cost of Sales.
- Memory hook: the same item can be classified differently by business type. 'Service Revenue' is operating revenue for a car workshop but does not exist for a grocery shop. Ask yourself: 'Is this the main job of the business?' If yes = operating, if no = non-operating.
- How it is tested: objective and structured questions ask you to classify a list of items into operating/non-operating revenue and operating/non-operating expense, and to distinguish them between goods and service businesses. A common error is treating every cash inflow as 'Sales'.
Assets: Current vs Non-Current Assets
- An asset is an economic resource owned or controlled by the business that provides future benefit. All assets are reported in the Statement of Financial Position.
- Current assets are short-term: they can be converted to cash, sold or used up within one accounting period (usually 12 months), e.g. Inventory, Receivables, Cash, Bank, Prepaid Expenses. Non-current assets are long-term: bought for continued use beyond 12 months, e.g. Land, Buildings, Vehicles, Equipment, Fittings.
- Key concept: an asset can be classified differently depending on the business. A car is a non-current asset for a grocery shop (used for deliveries), but a current asset (inventory) for a car dealer who sells it. What decides is the purpose of holding it, not the physical type of the asset.
- Memory hook: ask 'How long does the business intend to keep this asset?' 12 months or less, or held for sale = Current Asset; more than 12 months and for use = Non-Current Asset.
- How it is tested: you are asked to explain the characteristics of both categories, classify a list of assets, and explain why the same asset can be categorised differently in different businesses. Full marks require mentioning the time period and the purpose.
Liabilities: Current vs Non-Current Liabilities
- A liability is an obligation or debt of the business owed to outside parties that must be settled in the future. It is also reported in the Statement of Financial Position.
- Current liabilities must be settled within a short period (usually 12 months), e.g. Payables, Bank Overdraft, Accrued Expenses, Short-Term Loans. Non-current liabilities are settled beyond 12 months, e.g. Long-Term Bank Loan, Mortgage.
- Key concept: a non-current liability can become a current liability within the same business when its remaining term falls to 12 months or less. Example: the portion of a 5-year loan due within the final year becomes a current liability.
- Memory hook: 'When must this debt be paid?' Within 12 months = Current Liability; after 12 months = Non-Current Liability. A bank overdraft is always a current liability; do not confuse it with Bank (an asset) that has a debit balance.
- How it is tested: questions ask for the characteristics, classification of a liability list, and the reason a non-current liability can become a current liability (in the same and in different businesses). Tie your answer to the settlement period.
Owner's Equity: Capital, Profit/Loss and Drawings
- Owner's equity is the owner's interest or claim on the assets of the business after deducting liabilities. It represents the capital the owner has invested in the business.
- Items within owner's equity: Capital (owner's investment, increases equity), Net Profit (increases) or Net Loss (decreases), and Drawings (decreases). Simple formula: Closing Equity = Capital + Net Profit − Net Loss − Drawings.
- Drawings may be cash drawings, drawings of goods (owner takes inventory for personal use), or drawings of an asset. All drawings reduce owner's equity because they are not a business expense but a withdrawal by the owner.
- Memory hook: capital and profit 'feed' equity; loss and drawings 'eat' equity. Drawings of goods are recorded at cost, not selling price; a common mistake is using the selling price.
- How it is tested: you are asked to list the items in the owner's equity component and show the effect of drawings of goods and drawings of assets on the accounting equation. Remember: drawings do not go into the Income Statement.
The Accounting Equation
- Basic formula (without revenue and expense): Assets = Liabilities + Owner's Equity. This equation must always balance because every resource (asset) must be financed either by creditors (liabilities) or the owner (equity).
- Full formula (with revenue and expense): Assets = Liabilities + Owner's Equity + (Revenue − Expense) − Drawings. Revenue increases equity; expense and drawings decrease equity. This shows why net profit raises owner's equity.
- Every transaction has a dual effect and the equation stays balanced. Example: when furniture is bought for cash, one asset (Furniture) rises and another asset (Cash) falls; the total of both sides is unchanged.
- You can compute a missing value by rearranging the formula: Equity = Assets − Liabilities; Liabilities = Assets − Equity; Assets = Liabilities + Equity. This is a core skill often tested through calculation.
- Memory hook: 'ALE' (Assets = Liabilities + Equity). How it is tested: writing the formula, computing a missing value, and showing the effect (+/−) of each transaction (including drawings of goods) on Assets, Liabilities and Equity in table form.
Contra Entry and Chart of Accounts
- A contra entry is a transaction where one account is debited and another account is credited within the same books, without an outside party. It is usually an internal transfer between two related accounts of the business itself.
- Accounts commonly involved in a contra entry: the Cash account with the Bank account (e.g. depositing cash into the bank, or withdrawing cash from the bank), and the Receivable account with the Payable account when the same person is both a debtor and a creditor (a set-off).
- Effect if the contra entry is not made: the balances involved will be misstated. For example, if a receivable/payable set-off is not done, both the receivable and payable balances are overstated, so the Statement of Financial Position does not show the true position.
- The Chart of Accounts is a complete, organised list of all the business's accounts with account codes used in accounting software. Its functions: to classify and standardise accounts, and to make data entry, report generation and account searching quick and easy.
- Memory hook: 'contra = internal transfer, both sides in-house'; 'Chart of Accounts = a coded directory of accounts'. How it is tested: stating the meaning of contra, listing accounts that can be involved in a contra entry, showing/explaining the effect (and the effect if not done), and preparing a simple Chart of Accounts table with codes and account names.
| Item | Account Classification | Statement Component |
|---|---|---|
| Inventory | Current Asset | Statement of Financial Position |
| Vehicle | Non-Current Asset | Statement of Financial Position |
| Payable | Current Liability | Statement of Financial Position |
| Bank loan (5 years) | Non-Current Liability | Statement of Financial Position |
| Sales | Operating Revenue | Income Statement |
| Rent received | Non-Operating Revenue | Income Statement |
| Salaries | Operating Expense | Income Statement |
| Interest on loan | Non-Operating Expense | Income Statement |
Classification can differ by business type; always judge the purpose of holding an asset and the core activity of the business.
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