business entity

7.1 Accounting Principles – Business Entity

Learning Objective

Explain the business‑entity principle and apply it when recording transactions for a sole trader, partnership or limited company. Show how the principle links to the other accounting principles and to later parts of the Cambridge IGCSE Accounting (0452) syllabus.

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1. The Accounting Framework (Syllabus Block 1)

• Purpose of accounting – to provide information that helps users make economic decisions.
• Accounting equation – Assets = Liabilities + Owner’s/Shareholders’ Equity.
• Profit‑and‑loss account – measures the results of the business for a period (revenues – expenses = profit).
• Balance sheet (statement of financial position) – shows the financial position at a point in time (assets, liabilities, equity).
• All of the above rely on the business‑entity principle: only the affairs of the business are recorded.

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2. Accounting Principles at a Glance (Exam‑relevant one‑sentence definitions)

Principle	Definition (AO1)	Typical example in accounts
Business Entity	Only the affairs of the business are recorded; owners’ personal affairs are kept separate.	Owner’s withdrawal recorded as Drawings, not as an expense.
Dual Aspect (Debit‑Credit)	Every transaction affects at least two accounts – one debit and one credit – keeping the accounting equation in balance.	Cash + $5 000 / Owner’s Capital + $5 000 for an investment.
Matching	Expenses are recognised in the same period as the revenues they help generate.	Depreciation expense recorded in the year the equipment is used.
Consistency	Accounting methods are applied from one period to the next unless a justified change is made.	Using straight‑line depreciation every year.
Going‑Concern	Financial statements are prepared on the assumption that the business will continue to operate for the foreseeable future.	Assets are recorded at cost, not at liquidation values.
Historic Cost	Assets are recorded at the amount of cash (or cash equivalent) paid for them at the time of acquisition.	Equipment purchased for $2 000 is shown at $2 000.
Materiality	Only items that could influence the decisions of users need to be recorded and disclosed.	Small office stationery may be expensed immediately.
Money Measurement	Only transactions that can be expressed in monetary terms are recorded.	Employee morale is not recorded, but salaries are.
Prudence (Conservatism)	Potential losses are recognised as soon as they are known; gains are only recorded when realised.	Provision for doubtful debts is created when a risk of non‑payment is identified.
Realisation	Revenue is recorded when it is earned, not necessarily when cash is received.	Sales on credit are recognised as revenue at the point of delivery.

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3. The Business‑Entity Principle in Detail (Syllabus Block 2)

• Separate the affairs of the business from the personal affairs of its owners and from any other business.
• Only transactions that relate to the business are recorded in the business’s books.
• Each legal form – sole trader, partnership, limited company, club, manufacturing concern – has its own set of accounts and its own statement of financial position.

Why it matters

• Capital & revenue concepts (Section 5.1‑5.3) – Capital is the owner’s/ shareholders’ investment; revenue is the result of business operations. The principle ensures they are not mixed.
• Financial‑statement preparation (Section 5.4‑5.5) – Only business items appear in the profit‑and‑loss account and balance sheet.
• Ratio analysis (Section 6) – Ratios such as current ratio, gross profit margin, etc., use only business figures.
• Legal compliance for limited companies – Companies law requires distinct records, separate bank accounts and filing of annual accounts.

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4. Sources of Accounting Data & Double‑Entry (Syllabus Block 2)

• Primary documents – invoices, receipts, bank statements, payroll sheets, purchase orders.
• Books of prime entry
  • Cash book (receipts & payments)
  • Sales journal (credit sales)
  • Purchases journal (credit purchases)
  • General journal (adjustments, errors)
• Ledger – each account (Cash, Sales, Drawings, etc.) has a T‑account; postings are made from the books of prime entry.

Double‑entry refresher

Transaction type	Debit (Dr)	Credit (Cr)
Cash received from owner	Cash	Owner’s Capital
Cash paid for a business expense	Expense (e.g., Rent)	Cash
Owner withdraws cash	Drawings	Cash
Purchase on credit	Asset (e.g., Inventory)	Trade Payables
Sale on credit	Trade Receivables	Sales Revenue

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5. Verification of Records (Syllabus Block 3)

• Trial Balance – list of all ledger balances; total debits must equal total credits.
• Bank Reconciliation – adjusts the cash‑book balance for deposits in transit, outstanding cheques, bank fees, etc.
• Control Accounts – summary accounts for large groups (e.g., Trade Receivables Control).
• Error correction – common errors (single‑sided entry, transposition, omission) and the journal entries required to correct them.

Sample trial balance (after the sole‑trader example)

Account	Debit	Credit
Cash	$7,700
Equipment	$2,000
Drawings	$800
Owner’s Capital		$5,000
Sales Revenue		$3,500
Total	$10,500	$8,500

Note: The trial balance is not balanced because the profit (£3,500) has not yet been transferred to the Capital account. After closing, Capital will increase to $8,500 and the trial balance will balance.

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6. Accounting Procedures (Syllabus Block 4)

• Capital vs Revenue – Capital items (equipment, buildings) are recorded as assets; revenue items (rent, wages) are recorded as expenses.
• Depreciation (Straight‑line) – Depreciation expense = (Cost – Residual value) ÷ Useful life. Example: $2 000 equipment, 4‑year life, no residual value → $500 per year.
• Accruals – Record expenses incurred but not yet paid (e.g., wages payable) and revenues earned but not yet received (e.g., services performed on credit).
• Provision for doubtful debts – Estimate % of trade receivables that may become unrecoverable; create a contra‑asset “Allowance for Doubtful Debts”.
• Inventory valuation – Use the “lower of cost or net realizable value” rule. For IGCSE, the simple “cost” method is sufficient.

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7. Preparation of Financial Statements (Syllabus Block 5)

7.1 Sole Trader

1. Prepare a Trading/Profit‑and‑Loss Account – separate trading (sales – cost of goods sold) from other income and expenses.
2. Prepare a Statement of Financial Position – list assets, liabilities and Owner’s Capital (adjusted for profit and drawings).

7.2 Partnership

• Two or more owners – each has a separate Capital account and a Drawings account.
• Profit is shared according to the partnership agreement (e.g., 60 % / 40 %).
• Closing entries transfer profit to each partner’s Capital account.

7.3 Limited Company

• Separate legal entity – owners are shareholders.
• Equity section: Share Capital, Retained Earnings (profit retained after dividends).
• Dividends are recorded as a reduction of Retained Earnings, not as an expense.

7.4 Clubs & Societies (non‑profit)

• Statement of Financial Position shows “Funds” instead of “Capital”.
• Surplus (income – expenses) is added to “Funds”.

7.5 Manufacturing Concerns

• Three‑step income statement: Sales – Cost of Goods Sold = Gross Profit; Gross Profit – Operating Expenses = Net Profit.
• Cost of Goods Sold = Opening Stock + Purchases + Production Costs – Closing Stock.

7.6 Incomplete Records (single‑entry)

• When only a cash book is kept, use the “cash‑book method” to reconstruct the trial balance and profit.
• Key steps: list all cash receipts and payments, identify non‑cash items (depreciation, drawings), and calculate net profit.

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8. Business‑Entity Principle – Common Mistakes & How to Avoid Them

• Recording personal purchases as business expenses – treat them as Drawings (or ignore them if they never entered the business bank).
• Paying personal debts from the business account without a drawing entry – always Debit Drawings, Credit Cash.
• Mixing the accounts of two separate businesses owned by the same person – maintain separate ledgers, separate bank accounts and distinct capital accounts.
• Forgetting to transfer profit to Capital at year‑end – close the profit‑and‑loss account to the appropriate Capital/Retained Earnings account.

Checklist (AO1)

1. Identify whether a transaction is business‑related or personal.
2. Record only business‑related transactions in the ledger.
3. When the owner takes money for personal use, record a Drawings entry (Debit Drawings, Credit Cash).
4. Maintain separate bank accounts for business and personal use.
5. Prepare a trial balance each month and verify that debits = credits.
6. At year‑end, close the profit‑and‑loss account to Capital/Retained Earnings.

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9. Diagram – Separation of Transactions

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10. Illustrative Example – Sole Trader (Business‑Entity in Action)

John runs “John’s Bakery”. The transactions below occur in one month.

#	Transaction	Journal Entry (Dr / Cr)	Effect on Business Accounts
1	John invests $5 000 cash into the bakery.	Cash Dr $5 000 / Owner’s Capital Cr $5 000	Cash ↑, Owner’s Capital ↑
2	Purchases ovens for $2 000 cash (business use).	Equipment Dr $2 000 / Cash Cr $2 000	Cash ↓, Equipment ↑
3	Cash sales of $3 500.	Cash Dr $3 500 / Sales Revenue Cr $3 500	Cash ↑, Sales Revenue ↑
4	John withdraws $800 for personal expenses.	Drawings Dr $800 / Cash Cr $800	Cash ↓, Drawings ↑ (reduces Owner’s Capital)

Profit Calculation (AO2)

Only business expenses are deducted from revenue. The purchase of ovens is a capital item, not an expense for the period.

Profit = Sales Revenue – Business Expenses

Sales Revenue = $3 500

Business Expenses = $0 (drawings are not expenses)

Profit = $3 500

Closing entry (year‑end)

Profit Dr $3 500 / Owner’s Capital Cr $3 500

New Owner’s Capital = $5 000 (initial) + $3 500 (profit) – $800 (drawings) = $7 700

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11. Illustrative Example – Partnership

Emily and Sam start “DesignCo” as a partnership. Capital contributions: Emily $6 000, Sam $4 000. Profit for the year is $5 000 and the profit‑sharing ratio is 60 % (Emily) / 40 % (Sam). Emily draws $1 200, Sam draws $800.

Transaction	Journal Entry
Capital contributions	Cash Dr $10 000 / Emily’s Capital Cr $6 000 / Sam’s Capital Cr $4 000
Profit allocation	Profit Dr $5 000 / Emily’s Capital Cr $3 000 / Sam’s Capital Cr $2 000
Emily’s drawings	Emily’s Drawings Dr $1 200 / Cash Cr $1 200
Sam’s drawings	Sam’s Drawings Dr $800 / Cash Cr $800

Resulting Capital balances: Emily $8 800, Sam $5 200.

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12. Illustrative Example – Limited Company

“Tech Repairs Ltd.” issues 1 000 ordinary shares at $10 each (share capital $10 000). During the year it makes a profit of $4 200 and pays a dividend of $1 200.

Transaction	Journal Entry
Issue of shares	Cash Dr $10 000 / Share Capital Cr $10 000
Profit for the year	Profit Dr $4 200 / Retained Earnings Cr $4 200
Dividend paid	Retained Earnings Dr $1 200 / Cash Cr $1 200

Closing equity: Share Capital $10 000 + Retained Earnings $3 000 = $13 000.

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13. Practice Questions (All Assessment Objectives)

1. AO1 – Recall
   Emily runs a graphic‑design partnership. She invests $10 000 cash and later pays $2 500 for a personal gym membership from the business bank account. Explain how each transaction should be recorded.
2. AO2 – Application / Analysis
   The following mixed list of transactions relates to “Tech Repairs Ltd.” Identify which items should be recorded in the business accounts, re‑classify any personal items as drawings, and state the impact on the trial balance.
   
   

   #	Transaction
   1	Owner transfers $4 000 from personal savings into the company bank account.
   2	Company purchases a laptop for $1 200 cash (business use).
   3	Owner pays $600 for his personal mobile phone bill from the company account.
   4	Company receives $3 500 cash from a customer for repair services.
   5	Owner withdraws $1 000 cash for personal weekend travel.

3. AO3 – Evaluation
   Discuss the advantages and limitations of the business‑entity principle for a limited company compared with a sole trader. Consider legal protection, tax treatment, record‑keeping burden and the effect on financial analysis.

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14. Suggested Mark‑Scheme Highlights

1. • Investment – Debit Cash $10 000 / Credit Partners’ Capital $10 000.
   • Gym membership – Debit Drawings $2 500 / Credit Cash $2 500 (personal expense, not an expense).
2. • Business transactions: 1, 2, 4 – normal journal entries.
   • Personal transactions: 3, 5 – each recorded as Debit Drawings, Credit Cash.
   • Resulting trial‑balance impact (simplified):
     • Cash = $4 000 + $3 500 – $1 200 – $600 – $1 000 = $4 700
     • Share Capital = $4 000 (from item 1)
     • Drawings = $1 600 (items 3 + 5)
3. • Advantages – separate legal identity, limited liability, clearer profit measurement, easier external financing, more credible financial analysis.
   • Limitations – statutory filing and audit requirements, higher administrative cost, need for strict internal controls, dividends taxed separately, less flexibility in withdrawing cash without formal drawing procedures.

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15. Quick Reference – Business‑Entity Principle Summary

Key Point	What to do
Separate records	Maintain distinct ledgers, bank accounts and capital accounts for each legal entity.
Owner’s withdrawals	Record as Drawings (debit) – never as an expense.
Owner’s investments	Record as a credit to Capital (or Share Capital for a company).
Personal expenses paid from business	Re‑classify as Drawings; adjust cash accordingly.
Year‑end closing	Transfer profit to Capital/Retained Earnings; reset profit‑and‑loss to zero.

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16. Further Reading & Resources

• Cambridge IGCSE Accounting (0452) – Official syllabus (Sections 1‑5).
• Past paper questions on the business‑entity principle (search “0452 2019/20 Paper 2 – Question 4”).
• Video tutorial: “Separating Personal and Business Transactions” – available on the Cambridge YouTube channel.