relevance

7.2 Accounting Policies – Relevance (and Full IGCSE Accounting Overview)

1. The Fundamentals of Accounting

• Purpose of accounting: provide information to users (owners, managers, investors, creditors, tax authorities) to help them make economic decisions.
• Profit‑loss concept: profit = total income – total expenses for a period. It shows whether the business is successful.
• Accounting equation: Assets = Liabilities + Equity. This must balance after every transaction.
• Book‑keeping vs. accounting:
  • Book‑keeping – recording transactions in journals and ledgers.
  • Accounting – interpreting, analysing and reporting the recorded information.
• Key terminology (brief):

  Term	Meaning
  Revenue	Inflow from ordinary activities (sales, services)
  Expense	Outflow incurred to generate revenue
  Capital	Long‑term investment in the business (assets, equity)
  Revenue expenditure	Cost that is expensed in the period it occurs
  Capital expenditure	Cost that creates or enhances an asset and is capitalised

2. Sources & Recording of Data

2.1 Business documents (source of data)

Document	Purpose
Invoice (sales/purchase)	Evidence of a transaction; basis for journal entry
Receipt	Proof of cash received or paid
Bank statement	Used for bank reconciliation
Credit note	Adjusts a previously issued invoice
Petty‑cash voucher	Records small cash payments (imprest system)
Debit note	Requests payment for goods/services received

2.2 The double‑entry system

1. Every transaction affects at least two accounts – one debit, one credit.
2. Debits increase assets and expenses; decrease liabilities, equity and revenue.
3. Credits do the opposite.

2.3 From journal to ledger to trial balance

Example – Purchase of goods on credit for £2,000:

Journal	Debit (£)	Credit (£)
Purchases	2,000
Creditors		2,000

Post to ledger, total each T‑account, then list all balances in a trial balance to check that total debits = total credits.

2.4 Trade & cash discounts

• Trade discount – reduction off the list price, not recorded separately.
• Cash discount – incentive for early payment; recorded as a reduction of the expense or revenue (e.g., Purchases – Cash discount received).

2.5 Imprest (petty‑cash) system

1. Set a fixed cash amount (e.g., £100) in a petty‑cash box.
2. Pay small expenses and keep vouchers.
3. When the cash runs low, reimburse the box by writing a cheque and record a Petty‑cash imprest entry.

3. Verification of Accounting Records

3.1 Trial balance

• Prepared after posting all transactions.
• Ensures total debits equal total credits – a first check for arithmetic errors.

3.2 Common error types (identify the error)

Error	Effect on Trial Balance
Omission of a transaction	No effect – totals still balance
Commission error (wrong amount)	Totals will not balance
Single‑sided entry (debit without credit)	Totals will not balance
Transposition error (e.g., £540 recorded as £450)	Totals will not balance
Posting to wrong account	Totals still balance – error not detected by trial balance

3.3 Bank reconciliation

1. Start with the cash book balance.
2. Add deposits in transit; subtract outstanding checks.
3. Adjust for bank errors and direct credits/debits.
4. The adjusted cash book balance should equal the bank statement balance.

3.4 Control & suspense accounts

• Control account – summary of a group of subsidiary ledger balances (e.g., Debtors Control).
• Suspense account – temporary holding place for differences that cannot yet be identified.

4. Accounting Procedures (Key IGCSE Topics)

4.1 Capital vs. Revenue Expenditure/Receipts

• Capital expenditure – creates or improves an asset; recorded as an asset and depreciated (e.g., purchase of machinery).
• Revenue expenditure – incurred to maintain earning capacity; expensed immediately (e.g., repairs, electricity).
• Capital receipt – from issuing shares or selling a non‑current asset.
• Revenue receipt – from ordinary sales or services.

4.2 Depreciation (methods & revaluation)

• Straight‑line: (Cost – Residual value) ÷ Useful life.
• Reducing balance: Depreciation % × Carrying amount each year.
• Units of production: (Cost – Residual) × (Units used ÷ Total estimated units).
• Revaluation (optional for IGCSE) – adjust carrying amount to fair value; recorded in a revaluation reserve.

4.3 Disposal of assets

1. Calculate profit or loss: Sale proceeds – (Carrying amount).
2. Record cash received, remove asset and accumulated depreciation, and recognise any gain/loss in the profit‑and‑loss account.

4.4 Accruals and Pre‑payments

• Accrued expense – expense incurred but not yet paid (e.g., wages payable).
• Accrued income – revenue earned but not yet received (e.g., interest receivable).
• Pre‑payment – cash paid in advance for a future expense (e.g., insurance prepaid).
• Deferred income – cash received before the related revenue is earned.

4.5 Provision for doubtful debts

• Estimate the amount of trade receivables that may not be collected.
• Record as Provision for doubtful debts (contra‑asset) and expense it as Bad debts expense.

4.6 Inventory valuation

• FIFO (First‑In, First‑Out) – oldest costs are assigned to cost of goods sold (COGS).
• Weighted average – average cost per unit = Total cost of inventory ÷ Total units.
• Inventory is reported at the lower of cost and Net Realisable Value (NRV).

5. Preparation of Financial Statements

5.1 Types of entities covered in the IGCSE syllabus

• Sole trader
• Partnership
• Limited company
• Clubs / societies (non‑profit)
• Manufacturing businesses (require a manufacturing account)
• Businesses with incomplete records

5.2 Common statement formats

1. Statement of Financial Position (Balance Sheet)
   • Assets (current then non‑current)
   • Liabilities (current then non‑current)
   • Equity (capital, reserves, retained profit)
2. Statement of Profit or Loss (Income Statement)
   • Revenue – Cost of Sales = Gross Profit
   • Minus operating expenses = Operating profit
   • ± other income/expenses = Net profit before tax
   • – Tax = Net profit after tax
3. Statement of Changes in Equity (limited companies) – shows movements in share capital, reserves and retained profit.
4. Appropriation Account (partnerships & clubs) – allocates profit to partners’ drawings, reserves, etc.

5.3 Example: Sole Trader – Income Statement (excerpt)

Item	£
Sales	45,000
Cost of goods sold	28,000
Gross profit	17,000
Rent	3,200
Wages	4,500
Depreciation (straight‑line)	800
Net profit	8,500

5.4 Incomplete records – the “adjusted trial balance” method

1. Prepare a trial balance from the information given.
2. Identify missing items (e.g., unrecorded purchases, unearned income).
3. Make adjusting entries, then produce an adjusted trial balance.
4. From the adjusted trial balance, draft the income statement and balance sheet.

6. Analysis & Interpretation

6.1 Key ratios (definition, formula, interpretation)

Ratio	Formula	What it tells you
Gross margin	Gross profit ÷ Sales × 100%	How much profit is retained after the cost of sales.
Profit margin	Net profit ÷ Sales × 100%	Overall profitability of the business.
Return on capital employed (ROCE)	Profit before interest & tax ÷ (Capital + Reserves) × 100%	Efficiency of capital use.
Current ratio	Current assets ÷ Current liabilities	Short‑term liquidity – ability to pay debts due within a year.
Acid‑test (quick) ratio	(Current assets – Inventory) ÷ Current liabilities	Liquidity without relying on inventory.
Inventory turnover	Cost of goods sold ÷ Average inventory	How quickly inventory is sold.
Receivables turnover	Credit sales ÷ Average trade receivables	Speed of collecting debts.
Payables turnover	Credit purchases ÷ Average trade payables	Speed of paying suppliers.

6.2 Using ratios – a short analysis example

Company A (sole trader) – figures (£):
Sales = 50,000; COGS = 30,000; Net profit = 6,000; Current assets = 12,000; Current liabilities = 4,000; Inventory = 3,000.

• Gross margin = (50,000‑30,000)/50,000 = 40% → decent control of production costs.
• Current ratio = 12,000/4,000 = 3.0 → strong short‑term liquidity.
• Acid‑test = (12,000‑3,000)/4,000 = 2.25 → still healthy even without inventory.
• Interpretation: The business is profitable and well‑positioned to meet its short‑term obligations, but the high current ratio may indicate excess cash that could be invested.

7. Accounting Policies – Relevance

7.1 What is an Accounting Policy?

An accounting policy is a set of principles, bases, conventions, rules and practices that a company adopts for the preparation and presentation of its financial statements. It determines how transactions and events are recognised, measured and disclosed.

7.2 Why are Accounting Policies Important?

• Ensure consistency over time – the same treatment is applied each period.
• Facilitate comparability between entities and periods.
• Help users understand how figures have been derived.
• Support the qualitative characteristic of relevance – information must be capable of influencing economic decisions.
• Align with the IGCSE framework (historic cost, prudence, IAS/IFRS equivalents).

7.3 Relevance – Predictive & Confirmatory Value

• Predictive value – information that helps users forecast future cash flows, earnings, or financial position.
• Confirmatory value – information that enables users to confirm or correct earlier expectations.

7.4 How Accounting Policies Contribute to Relevance

• Reflect the substance of transactions rather than merely legal form.
• Provide timely data with predictive or confirmatory value.
• Applied consistently, they allow trend analysis and period‑to‑period comparison.
• Only material items (those that could influence decisions) are disclosed.

7.5 Criteria for Selecting an Accounting Policy

Criterion	Explanation
Compliance with standards	Must conform to the relevant IAS/IFRS or the IGCSE framework.
Reliability	Based on verifiable evidence and objective measurement.
Neutrality	Free from bias; does not favour any particular outcome.
Comparability	Allows users to compare the entity’s performance with other entities or periods.
Understandability	Clear and concise so users can grasp the treatment.
Materiality	Only matters that could influence decisions are disclosed; immaterial items may be omitted.

7.6 Accounting Policies Required for the IGCSE Exam

• Depreciation method – straight‑line, reducing balance, units of production.
• Inventory valuation – FIFO, weighted average (LIFO not required).
• Revenue recognition – when revenue is earned and measurable.
• Research & Development costs – expense immediately or capitalize.
• Capital vs. revenue expenditure – determines asset vs. expense treatment.
• Accruals and pre‑payments – matching principle for expenses/revenues.
• Provision for doubtful debts – estimate of uncollectible receivables.

7.7 Steps to Develop an Accounting Policy

1. Identify the transaction or event that requires a policy.
2. Review the relevant accounting standards and guidance.
3. Consider the impact on relevance, reliability and materiality.
4. Select the most appropriate method and document it clearly.
5. Apply the policy consistently in all periods.
6. Disclose the policy in the notes to the financial statements.

7.8 Disclosure Requirements (IGCSE wording)

Notes to the financial statements must include:

• A description of each significant accounting policy.
• The basis of measurement (e.g., historic cost, fair value).
• Any changes in policies and the reasons for those changes.

7.9 Impact of Changing an Accounting Policy

• The change must be justified on the basis of relevance (or another qualitative characteristic).
• Applied retrospectively, restating prior periods, unless impracticable to do so.
• Notes must explain:
  1. The nature of the change.
  2. The reason for the change.
  3. The financial impact on the current and prior periods.

7.10 Example: Choosing a Depreciation Method

Machine cost £10,000; residual value £2,000; useful life 5 years.

Method	Annual charge (Year 1)	Profit impact (Year 1)	Relevance consideration
Straight‑line	(10,000‑2,000)/5 = £1,600	Higher profit (lower expense).	Stable expense pattern – good for trend analysis but may not reflect actual usage.
Reducing balance (20 %)	20 % × £10,000 = £2,000	Lower profit (higher early expense).	Matches higher early consumption of benefits – gives a more realistic view of asset utilisation.

XYZ selects reducing‑balance because it better reflects the pattern of economic benefits, enhancing the relevance of profit figures for investors.

7.11 Illustrating Predictive vs. Confirmatory Value

• Predictive example: Using reducing‑balance depreciation, the finance team can forecast future depreciation charges and cash‑flow impacts, helping investors predict future profitability.
• Confirmatory example: After switching from FIFO to weighted‑average inventory, the resulting change in gross profit confirms that earlier profit figures were overstated due to rising purchase prices.

8. Summary

Relevance is a fundamental qualitative characteristic of accounting information. Selecting and applying appropriate accounting policies – while ensuring compliance, reliability, neutrality, comparability, understandability and materiality – guarantees that the financial statements provide useful, timely and comparable information that can influence users’ economic decisions. Mastery of the underlying fundamentals, recording procedures, verification techniques, preparation of statements, and ratio analysis completes the IGCSE candidate’s toolkit for success.

9. Practice Questions (IGCSE command‑words)

1. Explain why consistency of an accounting policy contributes to relevance.
2. Discuss how changing from FIFO to weighted‑average inventory valuation might affect the relevance of profit figures for Company ABC.
3. Identify two accounting policies that could be considered less relevant if applied inappropriately, and explain why.
4. Analyse the effect of treating a £5,000 purchase of a new computer as revenue expenditure rather than capital expenditure on the statement of financial position and profit‑and‑loss account.
5. Evaluate the statement: “Accruals improve the relevance of the accounts because they ensure that expenses are recorded when cash is paid.”
6. Calculate the gross margin, current ratio and inventory turnover for the data given in the “Analysis & Interpretation” example.
7. Describe the steps involved in preparing a bank reconciliation.
8. Compare the impact on profit of using straight‑line depreciation versus reducing‑balance depreciation for a 5‑year asset costing £12,000 with a £2,000 residual value.