Profit margin

IGCSE Accounting (0452) – Study Notes

1. Fundamentals of Accounting

• Purpose of accounting: record, classify, summarise and interpret financial information to help users make informed decisions.
• Book‑keeping vs. accounting
  • Book‑keeping – systematic recording of every transaction.
  • Accounting – analysing the recorded data, preparing the financial statements and interpreting the results.
• Accounting equation (Statement of Financial Position) $$\text{Assets} = \text{Liabilities} + \text{Owner’s Equity}$$
  • Owner’s equity = Capital (opening) + Profits – Drawings.
• Key concepts (AO1)
  • Business entity – the business is separate from its owners.
  • Going‑concern – the business will continue to operate for the foreseeable future.
  • Money measurement – only transactions that can be expressed in monetary terms are recorded.
  • Historical cost – assets are recorded at the amount paid for them.
  • Accrual (matching) – revenues and expenses are recognised in the period to which they relate.

2. Sources and Recording of Data

• Primary source documents – invoices, receipts, bank statements, payroll records, credit notes, debit notes, petty‑cash vouchers, sales‑return forms, purchase‑return forms.
• Books of prime entry
  • Cash book (receipts & payments)
  • Petty‑cash book
  • Sales journal (including cash‑discounts & trade‑discounts)
  • Purchases journal (including returns)
  • Sales‑returns journal
  • Purchases‑returns journal
  • General journal (irregular or adjusting entries)
• Double‑entry system
  • Every transaction affects at least two accounts.
  • Total debits = total credits.
• Typical journal entries

  Date        Account                         Debit (£)   Credit (£)
  01‑03‑2025  Purchases (Stock)               5,000
              Creditors – XYZ Ltd.                       5,000
          

  Trade discount (recorded at net amount) – no journal entry.

  Cash discount (taken by the buyer) – recorded as a reduction of expense or purchase cost.

• Posting to the ledger – transfer each journal entry to the appropriate T‑accounts; post totals to the trial balance.

3. Verification of Accounting Records

• Trial balance – list of all ledger balances (debits and credits) to check that they agree.

  Account                Debit (£)   Credit (£)
  Sales                              120,000
  Purchases               70,000
  Operating expenses      30,000
  Interest expense         2,000
  Tax expense              4,000
  Capital                               150,000
          

  Total Debits = Total Credits → trial balance is balanced.
• Common error types (as listed in the syllabus)
  • Omission of a transaction
  • Commission (reversal) error
  • Compensating error
  • Complete reversal error
  • Original entry error
  • Principle error (e.g., treating a capital item as revenue)
  • Transposition & slide errors (affect the trial balance)
• Bank reconciliation statement (example)

  Bank reconciliation as at 31 Mar 2025
  Bank statement balance                £25,000
  Add: Deposits in transit                1,200
  Less: Unpresented cheques               800
  Add: Bank error (interest credited)    150
  Adjusted cash‑book balance             £25,550
          

• Control accounts – summary accounts that reconcile with subsidiary ledgers.

  Purchases Ledger Control (example)

  Opening balance (creditors)                £8,000
  Add: Purchases on credit                12,000
  Less: Payments to creditors               5,000
  Closing balance (creditors)               £15,000
          

  The total of the individual creditors’ balances in the subsidiary ledger must equal the control‑account balance.

4. Accounting Procedures

• Capital vs. revenue items
  • Capital receipts – loan received, issue of share capital, sale of a fixed asset (gain/loss recorded separately).
  • Revenue receipts – sales, interest received, rent received.
  • Capital expenditures – purchase of machinery, building, vehicle.
  • Revenue expenditures – wages, rent, utilities, repairs.
• Depreciation methods (required by the syllabus)
  • Straight‑line (SL) – $$\text{Depreciation per year}= \frac{\text{Cost}-\text{Residual value}}{\text{Useful life}}$$
  • Reducing‑balance (RB) – $$\text{Depreciation}= \text{Opening NBV}\times \text{Rate}$$
  • Revaluation (or units‑of‑production) – $$\text{Depreciation}= \frac{\text{Cost}-\text{Residual value}}{\text{Total estimated units}} \times \text{Units produced in the year}$$

  Journal entry – straight‑line example (machine £10,000, 5‑year life, no residual)

  Depreciation expense          2,000
      Accumulated depreciation – Machinery          2,000
          

• Accruals and pre‑payments
  • Accrued expense – expense incurred but not yet paid (e.g., wages payable).
  • Accrued revenue – revenue earned but not yet received (e.g., interest receivable).
  • Pre‑paid expense – payment made before the benefit is received (e.g., insurance paid in advance).
  • Deferred revenue – cash received before the service is performed.
• Irrecoverable debts & provision for doubtful debts
  • Write‑off a specific debt when it is identified as irrecoverable.
  • Provision – estimate of future bad debts, usually a % of trade receivables.

    Worked example

    Trade receivables (end of period)          £12,000
    Provision @ 5% of receivables               £   600
    Bad‑debt expense (adjusting entry)          600
        Provision for doubtful debts                     600
                    

• Inventory valuation
  • Recorded at the lower of cost or net realisable value (NRV).
  • Cost may be determined using FIFO, weighted‑average or specific identification (as required by the exam).

5. Preparation of Financial Statements

• Income statement (Profit & Loss Account) – shows revenue, cost of sales and expenses to arrive at net profit.
• Statement of Financial Position (Balance Sheet) – presents assets, liabilities and equity at a specific date.
• Adjustments for incomplete records – when only a cash book and trial balance are supplied, missing figures (e.g., purchases, sales, opening stock) are derived using:
  • The accounting equation.
  • The profit‑and‑loss relationship (Sales – COGS = Gross Profit, etc.).

5.1 Example – Sole Trader (Year ended 31 Mar 2025)

5.2 Incomplete Records – Simple Illustration

Given:

• Cash book ending balance: £9,200
• Trial balance shows Purchases £0, Sales £0, Opening Stock £5,000
• Closing Stock (from physical count) £4,000

Derivation:

1. Use the accounting equation:
   $$\text{Closing Stock} = \text{Opening Stock} + \text{Purchases} - \text{COGS}$$
2. From the income statement we know Gross Profit = £50,000 and Sales = £120,000, so COGS = Sales – Gross Profit = £70,000.
3. Insert values: £4,000 = £5,000 + Purchases – £70,000 ⇒ Purchases = £71,000.
4. Sales can be found from the profit‑and‑loss relationship:
   $$\text{Net Profit} = \text{Sales} - \text{COGS} - \text{Expenses}$$
   Rearranging gives Sales = Net Profit + COGS + Expenses = £14,000 + £70,000 + £30,000 = £114,000.

6. Analysis and Interpretation of Financial Statements

6.1 Profit‑Margin Ratios (AO2)

• Gross profit margin $$\text{Gross Profit Margin (\%)} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100$$
• Net profit margin $$\text{Net Profit Margin (\%)} = \frac{\text{Net Profit}}{\text{Sales}} \times 100$$

Worked example (figures from 5.1)

• Gross profit margin = $\frac{£50,000}{£120,000}\times100 = 41.7\%$
• Net profit margin = $\frac{£14,000}{£120,000}\times100 = 11.7\%$

6.2 Other Required Ratios (Cambridge Syllabus 6.2‑6.5)

6.3 Interpretation Tips (AO3)

• Compare ratios with previous years – spot trends (improving or deteriorating).
• Benchmark against industry averages or a main competitor.
• Consider the business context – e.g., a retailer may have a low current ratio because most assets are cash.
• Remember limitations:
  • Ratios are based on historical cost, not current market values.
  • They ignore qualitative factors (brand value, management quality).
  • One‑off items (extraordinary profit/loss) can distort results.

7. Accounting Principles and Policies (AO1)

7.1 Policy Choices Frequently Tested

• Depreciation method (SL, RB, Revaluation) – must be applied consistently.
• Inventory valuation method (FIFO, weighted‑average, specific identification) – affects COGS and profit.
• Treatment of discounts – trade discount is recorded at net amount; cash discount reduces the expense or purchase cost.
• Recognition of capital vs. revenue receipts – loans and sale of equipment are capital; sales and interest are revenue.
• Provision for doubtful debts – estimate must be disclosed in the notes and reflected in the trial balance.

Appendix – Summary of Key Accounting Ratios