ACCOUNTING THEORY

chapter 1

Book keeping Accounting

Detailed recording of financial transactions of a Uses the book keeping records to prepare
business financial statements at regular intervals
(monthly, annually)
Uses double entry principle to record in Function: In order to calculate profit/loss made
accounting books by a business

Assets Liabilities Owner’s equity = capital

Things owned by the business What business owes to the 3rd Total value of owner’s
to generate future earnings party creditors contribution to the business

e.g. motor vehicles, fixtures & e.g. loans, mortgages, e.g. drawings (comes under
fittings, trade receivables*1 debentures, trade payables*2, owner’s equity in I/S) &
bank overdraft profit/loss for the year
Provided by owner/purchased Doesn’t owe to the owner Represents what the business
with business’ funds owes to the owner
1
* – debtors/customers who purchase goods from the business on credit term
*2 – creditors/suppliers who supply goods to the business on credit term

ACCOUNTING EQUATION:
Assets = liabilities + owner’s equity
! to find any other, just switch the equation

Difference between financial year & calendar year:

Financial year:
12-month period no matter what kind of months there are. If it adds up to 12-month, then it is
considered as financial year.

Calendar year:
12-month period according to the Gregorian calendar

Why business compare financial statements:

1. To measure the ‘progress of the business’
2. Helps in decision-making of business owners (e.g. decision to pay bonus to employees,
business expansion or diversification)

Functions:
1. Can be compared with other businesses’ financial statements
chapter 2

double entry system – a system with 2 columns (debit & credit) to record daily business transactions

ledger account = t-account

RULE OF DOUBLE ENTRY:

Category Account names:

Assets (up, down) 1. Bank
2. Cash on hand
3. Trade receivable
4. Inventory (do not record here when
new goods are bought)
5. Motor vehicles
6. Premises/building
7. Land
8. Fixtures & fittings
9. Office equipment
10. Other receivables (accrued, prepaid)

Negative asset (down, up) 1. Provision for depreciation

2. Provision for doubtful debts
Liabilities (down, up) 1. Trade payables
2. Bank overdraft
3. Bank loan
4. Mortgage loan
5. Debentures
Expenses (up, down) 1. Purchases
2. Carriage inwards & outwards
3. Advertising expense
4. Interest payable
5. Rent payable
6. Commission payable
7. Salaries
8. Wages
 9. Discount allowed
10. General expenses
11. Insurance expenses
12. Utilities expense
13. Stationery

Negative expense (down, up) 1. Depreciation expense

2. Irrecoverable debts
3. Doubtful debts
4. Purchase returns
Owner’s equity (down, up) 1. Capital

Negative owner’s equity (up, down) 1. Drawings

Revenues (down, up) 1. Sales (income from sales of
goods/stock/inventory)
2. Rent receivable
3. Commission receivable
4. Interest receivable
5. Discount received

Negative revenue (up, down) 1. Sales returns (return inwards)

NOTE:
1. Revenue is in income statement
2. Balance b/d is always at increasing side (balance c/d is the opposite)
chapter 3

trial balance: a list of closing balances of every ledger account, on a certain date

closing balance (each ledger account): listed as debit/credit balance on trial balance

total debit balances = total credit balances

purpose:
1. Helps to locate arithmetical errors
2. Useful in preparing financial statements
6 types of errors:
CROP – CO
1. Error of commission
a. Correct amount is recorded in the accounts BUT recorded in the wrong account from
the same category of accounts (放錯戶口的名字，可是 type 是一樣的)
2. Error of reversal
a. Correct amount is recorded in the accounts BUT entered in the wrong side of each
account (entered the figures into debit instead of credit)
3. Error of omission
a. Transaction was omitted (完全沒有紀錄到)
4. Error of principle
a. Correct amount is recorded in the accounts BUT recorded in the wrong account from
a different category of account (比如 A 應該紀錄在 asset 的戶口，可是不小心紀錄
到了 expense 的)
5. Compensating errors
a. 2/more errors cancel each other out
b. There is zero effect on the trial balance
6. Error of original entry
a. Incorrect amount was recorded
b. e.g. purchases of inventory at $100 from Trade Payable (TP), was wrongly recorded
as $1,000 in the Purchases account and TP account. Both accounts were overcast by
900)

chapter 4

types of ledger: general, purchase, sales

NOTE:
It is necessary to divide the ledgers into 3 specialist areas because:
1. it enables checking procedures
2. fraud can be reduced

general ledger = nominal ledger:

records all other accounts from A, L, OE, R, E categories EXCEPT cash, bank, trade payables and
receivables

purchase ledger:
includes all trade payables ledger (suppliers on credit term only)

sales ledger:
keeps all trade receivables ledger (customers on credit term only)

cash book: a Book of Original Entry & also a ledger account

Debit (up) Credit (down)

Receipt of cash Payment of cash
Cheque Cheque
Online transfer Online transfer
 1. It Is a book of original entry cuz it is where cash transactions are first recorded b4 being
transferred to the ledger

2. It’s just part of the double entry

3. Represents a combined cash ledger & bank ledger

Contra entries: surplus cash on hand is paid into the bank, or money is withdrawn from bank to be
placed in the cash on hand
- Appear on both sides of cash book

Bank overdraft: a loan provided by a bank that allows a customer to pay for bills and other expenses
when the account reaches zero

Dishonoured cheque: a cheque received by business, the debtor’s bank refuses to pay
Possible reasons:
1. Insufficient fund in issuer’s bank account
2. Error on the cheque – e.g: no signature, no date, the amount in words and the amount in
figures do not match

Discount allowed: the business gives discount allowed to credit customers (TR) who pays promptly.
(expense for the business)
Discount received: the business receives discount from credit suppliers (TP) when the business pays
promptly to suppliers. (income for the business)

Cash discount Trade discount

Given to reward payor for early settlement of Given as reduction in price of goods due to bulk
debt quantity purchase
Recorded in the cash book Not recorded in cash book

chapter 5

Petty cash book: record low (petty) value payments

It is:
1. Book of prime entry
2. Ledger
3. Part of the double entry system

Purpose:
1. Lists the transactions for transferring to ledger accounts
2. Acts as ledger account for petty cash transactions (expense transactions)

What is managed by a petty cashier?

Imprest amount = float amount

This only occurs when the petty cashier runs out of cash. They will need to top-up the imprest
amount should their cash runs out.

Imprest system: sufficient cash which the cashier will receive to restore the petty cash book to its
float/imprest amount

Advantages:
1. It can be controlled because Chief Cashier will know how much has been spent
2. Imprest amount can be adjusted if it is too much/not enough
3. Helps to reduce fraud because petty cash book is managed by another staff

FORMAT:
EDMUND
PETTY CASH BOOK
Total Date Detail Total Cleanin Stationer Travel Ledger
Received s Paid g y expenses account
$ $ $ $ $ $
Original amount must minus the total paid to find out the x amount.

The total paid will be entered as “cash” into a new column. It serves as an imprest amount to replace
back whatever is spent for the cashier.

chapter 6

6 types of Definition Information contained/reason why they do so:

business
document:
Invoice A document where 1. Names of seller and customer
when a business sells 2. Date, description, price & quantity of goods
goods on credit term, sold
seller issues an
invoice to the
customer

Trade discount Trade discount is

(TD): recorded in invoice

Debit note Customer issues to

the seller when they
return the goods

Credit note When seller receives As evidence of “sales returns” (seller)

debit note from
customer, they issue As evidence of “purchases returns” (customer)
 credit note to
customer in return

Statement of A document issued As a reminder to its TR of the amount unpaid

account by seller at the end
of each month

Cheque Issued by TR To pay money to the seller

In cash book/ledger:
Seller records as debit in the form of bank/cheque

Customer records it as credit

 Receipt An official
acknowledgement of
money received

chapter 7

books of prime entry: groups similar type of transactions then posting to ledgers

books of prime entry = books of original entry/subsidiary books

function:
1. Helps to remove excessive details from the ledgers

Advantages:
1. Different books of prime entry can be maintained by different people
2. Provide evidence of transaction as they are extracted from source documents
3. Reduce the amount of details in the ledger as only totals are posted to the ledger
4. Group similar types of transactions in one book, chronological order

Ledgers under books of prime entry:

1. General ledger
2. Purchases ledger
3. Sales ledger
Types of journals: Description
Sales journal 1. Sales of goods on credit term
2. Invoices issued to TR
Sales returns journal 1. Goods are returned by customer with debit note
2. Business issue credit note to customer
Both sales & sales returns
journal
Purchase journal 1. Receive invoices from TP
Purchase returns journal 1. Goods are returned to supplier with a debit note
2. Receive credit note from supplier
Both purchases &
purchase returns journal
chapter 8

financial statements of sole trader: a document that is prepared at the end of each financial year

financial statements:
1. Not part of double entry system
2. Prepared from trial balance
3. Every item only appear once (either in IS or SOFP)

2 types of financial statements:

1. Income statement
2. Statement of financial position

Income statement:
Consists of trading section, profit & loss section

Trading section: concerned with selling & buying

Purpose: calculate the profit earned on the goods sold (gross profit)

Gross profit = revenue – cost of sales

NOTE:
Carriage outwards is indirect expense because it is a selling expense for seller that transfer the goods
to the customer

Profit & loss section of income statement: calculates the FINAL PROFIT after adding other income
and deducting all expenses

Profit for the year = gross profit + other revenue – expenses

Income statement of a service business:
1. Don’t buy/sell goods, but service only
2. Occupations example: accountant, insurance company
3. Excludes trading section (no cost of sales)

chapter 9

SOFP: reports assets, liabilities, owner’s equity of a business on a certain date

Classifications Details
Non-current assets 1. Land and building
2. Machinery
3. Fixtures
4. Office equipments
5. Motor vehicles
Current assets 1. Inventory
2. TR
3. Bank
4. Cash
Owner’s equity 1. Opening capital
2. profit/loss for the year (+profit, -loss)
3. drawings (-)
4. closing capital (opening + p/l – d)
Non-current liabilities 1. long term loan
2. mortgage loan
Current liabilities 1. TP
2. Bank OD

chapter 10

Accounting rules/principle: collective system of accounting policies

Principles Details
Business entity Business is treated as separate from the owner of business for accounting
purposes

Consistency Once an accounting method is selected for use in the business, it must be
used consistently from one accounting period to the next.
Duality Every transaction is recorded twice ~ debit entry on one account, and credit
entry on another account.

Going concern It is assumed that the business will continue to operate for an indefinite
period of time.

Historic cost All assets and expenses are initially recorded at their original or actual cost.

Money Information which can be expressed in terms of money can be recorded in the
measurement accounting records.
Matching Revenue of the accounting period is matched against the costs incurred
during the same accounting period to calculate Profit for the Year.
Materiality Individual items which will not significantly affect the decision-making of
users of financial statements, will not be mentioned as a separate item in
financial statements.

Prudence Accounting records present a realistic picture of the position of the business.
Profits and assets should not be overstated, while losses and liabilities should
not be understated.
 e.g If you reasonably believe that a Trade Receivable, Mr X may not repay the
debt he owes, you should make an accounting entry to record this potential
loss, eventhough you know that the ‘actual loss’ has not occured yet.
Realisation Revenue is regarded as being earned when the legal title of goods or services
pass from the seller to the buyer, who has an obligation to pay for those
goods.

4 Objectives (in Details

selecting accounting
policies)
Comparability 1. Can be compared over a period of time
2. Can be compared with other businesses

Answer technique:
Importance:
+ any changes and the effect of changes in a company’s accounting policies
should be disclosed
+ acc policies should be applied consistently
Relevance 1. Info must be relevant to users of financial statements
2. Helps businesses to improve financial decision-making process

Answer technique:
Importance:
+ info is relevant if it is capable of influencing the decisions being made
+ relevant info helps the directors to evaluate past, present & future
events
Reliability 1. Free from bias & errors
2. Trustable by users as true representation of the business
3. Able to verify against evidence
Understandability 1. Financial statements can be understood by users BUT it is
subjected to the abilities of the users as well

Expenditure Receipts
Capital 1. Money spent by business on 1. Money is received by a business
(does not purchasing and improving NCA but not from normal trading
happen on Include: activities
daily basis) 1. Purchase costs
2. Legal costs incurred (purchase Include:
NCA) 1. Capital contribution from owner
3. Carriage costs NCA (delivery 2. Borrowed a bank loan and
fee) received the money from
4. Installation costs (air-con on commercial bank
 wall) 3. Reported in SOFP, not IS
Revenue 1. Money spent on running 1. Money received by business
(recurring) business on a daily basis from normal trading activities
Include:
1. Administration expenses Include:
e.g. salaries of office staff 1. Sales of goods/inventory
2. Selling expenses 2. Service fees received (by lawyers,
e.g. advertising expenses accountants & other
3. Financial expenses professionals)
e.g. bank charges 3. Recorded in IS
4. Recurring costs of maintaining a
NCA
e.g. petrol costs

Recorded as expenses in IS, therefore

reduce total profit for the year

Valuation of Inventory:
Monetary value of unsold stock
Formula: quantity x cost/NRV (choose the
lowest one)

Cost:
The original purchase cost of inventory +
additional costs incurred in bringing the
inventory to the shop

Net Realizable Value:

Estimated selling price – costs of
completion – selling expenses

Normal circumstances: NRV > cost

If NRV < cost, it means the inventories are now worth lesser than the Purchase cost

Why a business needs to use the rule of Lower of Cost/NRV?

Principle applied: prudence
Reason for the principle: required the business not to overstate assets and profit

Answer to the question: need to use this rule if

not higher closing inventory, lower cost of sales,
gross profit and profit for the year will be
overstated. This will affect IS. As for SOFP, asset
and owner’s equity will be overstated as well. It
affects the doc.
chapter 11

accrued: liability cuz unpaid

prepaid: asset cuz paid in advance

principle applied for this ch: matching principle

reason: so can be matched accurately against the expenses incurred during the same accounting
period to calculate Profit For the Year

types of year end adjustments:

AR/PE – CA
AE/PR – CL

Accrued expenses example:

Postpaid telephone charges

Prepaid expenses example:

Rent payable, insurance
expense, prepaid telephone
expense

Accrued revenue example:

Commission receivable, interest receivable

Prepaid revenue example:

Rent receivable

chapter 12

depreciation: estimated loss in value of non-current assets over its expected useful life
acts as an expense in income statement

principle used: consistency principle (method must be consistent for every financial year

just an:
1. Acc entry
2. No cash has been paid
3. No cash movement involved

4 causes of depreciation:
1. Physical deterioration
2. Economic reasons
3. Passage of time
4. Depletion
a. Worth reduces as value is taken from this asset (e.g. tin mine)
Methods of Details
depreciation
Straight-line value∗¿
annual depreciation expense=historic cost−residual ¿
useful life (¿ yrs)

OR

annual depreciation expense

¿ ( historic cost−residual value ) × depreciation rate %

Residual value: NCA will have some resale value/end of its useful life
Depreciation expense is the same amount each year

Reducing annual dep . exp .=net book value x depreciation rate %

balance
OR

( historic cost− provision for dep . ) × depreciation rate %

Provision for depreciation: total depreciation expense that has been accumulated
to-date

Its suitable when greater benefits will be gained in the early years of the NCA’s
useful life

NCA with lower maintenance costs in the early years

 Always select the historic cost!
Revaluation annual dep . exp . for NCA
¿ opening balance+ purchases−closing balance

Difficult to keep track of dep. exp. of NCA assets which are small in size, but large
in quantities
Popular question in exam:
Reducing balance

depreciation slides
summary of depreciation
chapter 13
irrecoverable debt = bad debt

possible reasons that can happen:

1. Unable to pay
2. Customer disappeared
3. TR bankrupt

It will be written off as Irrecoverable Debt if business is not able to recover the debt after a long time

Solutions to avoid:
1. Obtain credit reference on the customer
2. Fix credit limit for each credit customer
3. Cash discounts to encourage early payment from TR
4. No further supplies of goods unless the overdue amount paid
5. Legal action against defaulters

Recovery of debts written off: when TR pays back some amount/all of the money
Provision for doubtful debts: an estimate of amount which a business may not recover from debtors
in a financial year

provision for doubtful debts (-ve assets)

Income statement Provision for doubtful debts

In order to estimate doubtful debts:

1. Use past experience to estimate (e.g. 2% of TR may not pay)
2. Use ageing schedule to analyse the length of time of outstanding debts
a. Older debts pose a greater risk of non-payment

If there is debt in IS, profit for the year will decrease

If PFDD is recorded as negative asset in SOFP (under TR), assets will not be overstated
Principle complied:
1. Prudence principle
a. Don’t overstate profit and asset
2. Matching principle

NOTE:
PFDD may increase/decrease based on the situation

More details:
https://docs.google.com/presentation/d/1DJFbGqBlu5pcKHjaF1AfNQTisBp1WCp1hmio6iy1
wI8/edit#slide=id.p20
chapter 14

bank statement: a copy of customer’s account in the books of the commercial bank

debit = credit
credit = debit

When money is paid into the bank, the customer’s account would be CREDITED. This means the
amount owed by the bank to the customer.

When money is taken out of the bank (Maybank), the customer’s account will be DEBITED. This
means it reduces the amount owed by the bank to the customer.

A Bank Statement will:

1. Show positive balance as a CREDIT balance at the end of the month.
2. Show the overdrawn balance as a DEBIT balance.

Cash book and bank statement might differ because:

1. Items not recorded in cash book
2. Timing differences

Effect on Entry
Example of Transactions cash book in
Cash
Book

a. Bank Charges & Interest Charges ⇣ Credit

b) Dishonoured Cheque ⇣ Credit

(Cheque received by business and debited Cash Book, but later dishonoured
by Bank due to insufficient funds. So need to reverse the Cash Book entry)

c) Online payment ⇣ Credit

(via Standing Orders*, Direct Debits*)

d) Dividend Received ⇡ Debit

e) Amount received directly into Bank account through online credit ⇡ Debit
transfer

Standing order: authorization to the bank to pay ‘fixed’ amount to 3rd party, on regular basis
e.g. rent expense (same amount every month)

direct debit: authorization to the bank to pay “varied” amount to 3rd party on regular basis
when its due
e.g. utility bills

QUICK SUMMARY
Items in Cash Book Items in Bank Statement
but not in Bank Statement but not in Cash Book
Unpresented Cheques Bank charges, Bank Interest

Amounts not yet credited Dishonoured cheques

Errors in Cash Book** Online payment (standing order, direct debit)

Online receipt of money (Credit transfers)

Dividend received

Errors in Bank Statement**

Use bank reconciliation to record these (update the business cash book
items Debit entry – if increase of money
Credit entry – if decrease)
 Quick tips
How to do?
What?
Items appeared in Bank Update Cash Book
Statement,
but not in Cash Book
Items appeared in Cash Include in Bank Recon
Book,
but not in Bank Statement

Purpose of bank reconciliation statement:

1. Shoe the Bank account and the bank statement balances are reconciled
2. Helps to know/show the accurate ‘bank balance’

Advantages:
1. Accurate bank balance is available after updating the cash book
2. Errors in cash book/bank statement can be identified
3. Help in discovering fraud

More details: https://youtu.be/HLkN6hwi3DM

chapter 15

general journal (chapter 7)

narrative: brief explanation of what is being recorded and why the entry is made
COMPULSORY TO WRITE IN EXAM

there’s barely any theories here…

Format:
chapter 16

control account = total account

set up for purchase ledger and sales ledger only

purchase ledger control account: an account that summarises all the accounts of trade payable

sales ledger control account: an account that summarises all the account of trade receivable

advantages:
1. Assist to locate errors when trial balance fails to balance
2. Can prove the arithmetical accuracy of purchases ledger and sales ledger
3. info about total TR & total TP are readily available
4. draft financial statements can be prepared quickly
5. help to reduce fraud

NOTE:
1. All control accounts sum up to TR
grand total
2. Sales are always in credit term
(sales credited to (credit customer))
3. Cash term sales cannot be
recorded because it is immediate,
which means there is no
interference between TR
4. Interest charged is income for
supplier because this is when
debtors pay their interest late
a. to obey the double entry
rule, debit to SLCA and
credit to interest receivable
Total of SLCA (sales ledger control account) should agree with total of each individual Sales ledger
acc at the end of the month

Errors in individual sales ledger account or SLCA should be investigated

These 2 statements go the same for purchase ledger control account

SLCA and PLCA are both under GL (general ledger)

Reasons for TR to show credit balance:

1. overpayment by TR
2. TR returned goods after account has been paid
3. TR paying in advance b4 goods are delivered
4. Cash discount not deducted b4 payment was made

*it goes the same for TP

Contra entries:
1. Happens when a trader sells goods to business XY and also buys different goods from
business XY
2. Purchase and sales ledger are involved. So can both contra account

chapter 17
statement of affairs:

Calculation of profit:

Closing capital = opening capital + additional capital + profit – drawings

∴ profit = closing capital – opening capital – additional capital – drawings

chapter 22

ROCE – the higher it is, the more efficient the capital is being employed in the future

limitations of accounting statements:

1. Time factor – a record of a past, not a guide for the future

2. Historic cost – financial transactions are recorded on its original cost

a. Can change over time, so can be inaccurate comparisons

3. Accounting policies – different policies might have not so meaningful comparisons

4. Different definitions

5. Money measurement – accounts only record info that can be expressed in monetary terms
a. Non-financial info are not recorded, but can affect (negatively/positively) on income
statements