explain the difference between a trading business and a service business

5.1 Sole Traders – Cambridge IGCSE Accounting (0452)

1 Fundamentals of Accounting

• Purpose – to provide reliable, comparable and understandable information about the financial performance and position of a business for users such as owners, lenders, suppliers and tax authorities.
• Accounting Equation

  Assets = Liabilities + Owner’s Equity

  This equation underpins every transaction recorded in the books.
• Basic Accounting Concepts – entity, duality (double‑entry), going‑concern, historic cost, prudence, matching, consistency, materiality and realisation. (See section 8 for a concise table.)

2 Sources & Recording of Data

1. Business documents (source evidence) – invoices, receipts, credit notes, purchase orders, bank statements, payroll sheets, etc.
2. Books of prime entry – where transactions are first recorded:
   • Sales journal (credit sales)
   • Purchases journal (credit purchases)
   • Cash book (receipts & payments)
   • General journal (non‑recurring or adjusting entries)
3. Ledger posting – each transaction is posted to the appropriate ledger accounts (sales ledger, purchases ledger, asset, liability, capital, etc.).
4. Trial Balance – a list of all ledger balances at a point in time; used to check that total debits equal total credits before preparing statements.

3 Verification of Accounting Records

• Trial Balance check – ensures the double‑entry system is mathematically correct.
• Bank reconciliation – compares the cash book balance with the bank statement and records any differences (outstanding cheques, deposits in transit, bank charges, errors).
• Control accounts – summary accounts for the sales ledger and purchases ledger; help detect posting errors.
• Error correction – common errors and their journal entries (e.g., omission, commission, principle of double‑entry).

4 Accounting Procedures (Adjustments)

Depreciation methods – quick reference

5 Trading Business vs. Service Business

6 Preparation of Financial Statements

6.1 Income Statement (Profit & Loss Account)

Two formats are accepted – single‑step (used in the examples below) or multi‑step. The key is to show gross profit (if applicable) and net profit (or loss).

Trading Business – single‑step example

Service Business – single‑step example

6.2 Statement of Financial Position (Balance Sheet)

The same layout is used for sole traders, partnerships, limited companies and clubs/societies.

6.3 Other Forms Required by the Syllabus

• Partnership accounts – separate capital accounts for each partner, profit‑sharing ratios, drawings per partner.
• Limited company accounts – share capital, retained earnings, statutory disclosures (e.g., directors’ report – not required for IGCSE but recognised).
• Clubs & societies – membership fees (income), grants, and often a simpler statement of financial position.
• Manufacturing accounts – conversion of raw materials into work‑in‑process and finished goods; includes calculation of prime cost, conversion cost and total manufacturing cost.
• Incomplete‑records techniques – used when the ledger is missing; involves reconstructing the trial balance from the income statement and balance sheet figures.

7 Analysis & Interpretation of Accounts

7.1 Key Ratios (AO2 – analysis)

7.2 Users of Accounting Information

• Owner/partners – assess profitability, decide on reinvestment or drawings.
• Lenders & suppliers – evaluate credit risk (liquidity and solvency).
• Tax authorities – calculate income tax or corporation tax.
• Management (internal users) – plan, control and make operational decisions.
• Potential investors – consider the viability of the business.

7.3 Limitations of Financial Statements (AO3 – evaluation)

• Historical cost may not reflect current market values.
• Only quantitative information; qualitative factors (e.g., brand reputation) are omitted.
• Based on estimates (e.g., depreciation, doubtful debts) which involve judgment.
• Unaudited accounts for small sole traders may contain errors or bias.

8 Accounting Principles & Policies (AO1)

9 Year‑End Adjustments – Journal Entries Summary

• Depreciation (choose method) – Dr Depreciation Expense Cr Accumulated Depreciation
• Asset disposal – see table in section 4.
• Accrued expenses – Dr Expense Cr Accrued Expenses
• Pre‑paid expenses – Dr Expense Cr Pre‑paid Expense
• Accrued income – Dr Accrued Income Cr Revenue
• Unearned income – Dr Unearned Income Cr Revenue (when earned)
• Bad debt (specific) – Dr Bad Debt Expense Cr Trade Receivables
• Provision for doubtful debts – Dr Bad Debt Expense Cr Provision for Doubtful Debts

10 Summary Checklist for the IGCSE Exam (AO1‑AO3)

1. State the purpose of accounting and write the accounting equation.
2. Identify at least three advantages and three disadvantages of operating as a sole trader.
3. List the main source documents and the flow of data: source → books of prime entry → ledger → trial balance → statements.
4. Explain how a trial balance, bank reconciliation and control accounts are used to verify records.
5. Distinguish clearly between a trading business and a service business (use the comparison table).
6. Prepare a single‑step Income Statement for each type of business and calculate gross profit (if applicable) and net profit.
7. Draw a basic Statement of Financial Position, label all sections, and show the flow of profit into Owner’s Equity.
8. Show journal entries for:
   • Depreciation (all three methods)
   • Asset disposal
   • Accrued & pre‑paid expenses/income
   • Irrecoverable debts and provision for doubtful debts
9. Calculate and interpret at least two profitability ratios and one liquidity ratio.
10. Discuss who uses the accounts and why, and evaluate two limitations of the information presented.
11. State the key accounting principles and give a brief example of how each influences the preparation of accounts.