1. What is Accounting — and Why Does It Matter? 7707
Every business — whether a small stationery shop in Lahore, a textile factory in Faisalabad, or a bank in Karachi — conducts financial transactions every day. Money comes in. Money goes out. Assets are bought. Debts are incurred. Without a systematic way to record and interpret all of this, a business owner has no idea whether the business is profitable, whether it can pay its debts, or whether it is growing or shrinking.
Accounting answers four fundamental questions about any business:
💰 How much profit did we make?
Answered by the Income Statement (also called Profit & Loss Account) — showing revenue earned and expenses incurred over a period.
🏦 What do we own and what do we owe?
Answered by the Balance Sheet (Statement of Financial Position) — a snapshot of assets, liabilities, and capital at a specific date.
💵 Where did our cash go?
Answered by the Cash Flow Statement — showing how cash moved in and out of the business during a period.
📊 How are we performing?
Answered by Ratio Analysis — comparing key figures to assess profitability, liquidity, and efficiency.
Bookkeeping vs Accounting
| Bookkeeping | Accounting |
|---|---|
| Recording financial transactions systematically day by day | Classifying, summarising, and interpreting the recorded data |
| A mechanical, clerical process — writing entries in books | A professional process requiring judgement and interpretation |
| Part of the accounting process | The complete process — includes bookkeeping plus analysis |
| Example: writing a payment into the cash book | Example: preparing the annual financial statements and ratio analysis |
2. Users of Accounting Information 7707
| User | What They Need | Why |
|---|---|---|
| Owner / Proprietor | Profit figures, capital position, business performance | To know if the business is viable and to make investment decisions |
| Manager | Detailed cost information, budgets, variances | To control costs, plan operations, and make day-to-day decisions |
| Bank / Lender | Ability to repay loans, liquidity position | To decide whether to lend money and on what terms |
| Supplier (Trade Creditor) | Whether the business can pay its debts | To decide whether to supply goods on credit |
| Customer | Whether the business will continue to operate | To know if long-term supply contracts are safe |
| Employee | Job security, profitability of business | To assess future employment and wage negotiation |
| Government / FBR | Profit figures, accurate financial records | To calculate tax owed and ensure legal compliance |
| Investor / Shareholder | Dividends, growth, return on investment | To evaluate whether to invest, hold, or sell shares |
3. Key Accounting Terms 7707
The following terms appear throughout the Cambridge syllabus. You must know their precise definitions — not approximate descriptions.
| Term | Definition | Example (Pakistan context) |
|---|---|---|
| Asset | Something of value owned by the business — a resource it controls that will provide future economic benefit. | Delivery van, stock of stationery, cash in bank, money owed by customers |
| Liability | An obligation of the business — a debt it owes to an outside party. | Bank loan, money owed to suppliers, unpaid electricity bill |
| Capital (Equity) | The amount invested in the business by the owner — also called the owner's equity or net worth. It is what the business owes back to the owner. | PKR 500,000 invested by the owner to start a shop |
| Revenue (Income) | Money earned by the business from its normal trading activities — selling goods or providing services. | Cash received from customers buying stationery |
| Expense | The cost incurred to earn revenue — money spent in running the business. | Rent of shop, salaries of staff, electricity, transport costs |
| Profit | The surplus remaining after all expenses are deducted from revenue. Profit increases the owner's capital. | Revenue PKR 200,000 − Expenses PKR 150,000 = Profit PKR 50,000 |
| Loss | When expenses exceed revenue. A loss reduces the owner's capital. | Revenue PKR 100,000 − Expenses PKR 130,000 = Loss PKR 30,000 |
| Drawings | Cash or goods taken out of the business by the owner for personal use. Drawings reduce capital — they are NOT an expense. | Owner withdraws PKR 20,000 from the business to pay household bills |
| Trade Receivable (Debtor) | A customer who owes money to the business for goods or services already received on credit. | A school that bought supplies on credit and has not yet paid |
| Trade Payable (Creditor) | A supplier to whom the business owes money for goods or services already received on credit. | A paper manufacturer waiting to be paid for goods delivered last month |
Drawings reduce the owner's capital directly — they are a withdrawal of the owner's investment, not a cost of running the business. Never include drawings in the Income Statement. This is one of the most frequently penalised errors in Cambridge examinations.
4. The Accounting Equation 7707
This can be rearranged in two equivalent ways:
Standard Form
What the business owns = What it owes to the owner + What it owes to outsiders
Capital Calculation Form
Used to find the owner's equity. Net assets = Net worth of the business.
How the Accounting Equation Changes with Transactions
Every business transaction changes at least two items in the equation — but the equation always remains in balance. This is the dual effect principle — the foundation of double entry bookkeeping.
📐 Worked Example 1 — Effect of Transactions on the Equation
Naseem starts a stationery business in Lahore. Analyse the effect of each transaction on Assets, Capital, and Liabilities.
Cash (Asset) +500,000 Capital +500,000
Equation: Assets 500,000 = Capital 500,000 + Liabilities 0 ✓
Van (Asset) +150,000 Cash (Asset) −150,000
Equation: Assets 500,000 = Capital 500,000 + Liabilities 0 ✓
(One asset increases, another decreases — total assets unchanged)
Stock (Asset) +80,000 Trade Payable (Liability) +80,000
Equation: Assets 580,000 = Capital 500,000 + Liabilities 80,000 ✓
Cash (Asset) +20,000 Capital +20,000 (profit increases capital)
Equation: Assets 600,000 = Capital 520,000 + Liabilities 80,000 ✓
Cash (Asset) −5,000 Capital −5,000
Equation: Assets 595,000 = Capital 515,000 + Liabilities 80,000 ✓
🧠 Memory Aid — The Accounting Equation
"A = C + L" — think of it as "All Comes from Capital and Loans."
Everything a business owns (Assets) was funded either by the owner (Capital) or by borrowing (Liabilities). If the equation does not balance, there is an error somewhere.
5. Classifying Assets and Liabilities 7707
Types of Assets
Non-Current Assets (Fixed Assets)
Assets the business intends to use for more than one year — not bought for resale.
- Land and buildings
- Machinery and equipment
- Vehicles
- Furniture and fixtures
- Computer equipment
Current Assets
Assets expected to be used or converted to cash within one year through normal business activity.
- Inventory (stock of goods)
- Trade receivables (debtors)
- Prepaid expenses
- Bank balance
- Cash in hand
Types of Liabilities
Non-Current Liabilities (Long-term)
Debts not due for repayment within one year.
- Bank loans (long-term)
- Mortgage on property
- Long-term finance leases
Current Liabilities (Short-term)
Debts due for repayment within one year.
- Trade payables (creditors)
- Bank overdraft
- Accrued expenses
- Short-term loans
- Income received in advance
6. The Dual Effect Principle 7707
| Transaction Type | Effect 1 | Effect 2 | Equation Effect |
|---|---|---|---|
| Owner invests cash | Cash (Asset) ↑ | Capital ↑ | A↑ = C↑ + L |
| Buy asset for cash | New asset ↑ | Cash (Asset) ↓ | A unchanged |
| Buy asset on credit | Asset ↑ | Liability ↑ | A↑ = C + L↑ |
| Pay a creditor | Cash ↓ | Liability ↓ | A↓ = C + L↓ |
| Make a cash sale (profit) | Cash ↑ | Capital ↑ (profit) | A↑ = C↑ + L |
| Pay an expense | Cash ↓ | Capital ↓ (expense reduces profit) | A↓ = C↓ + L |
| Owner takes drawings | Cash ↓ | Capital ↓ | A↓ = C↓ + L |
📝 Exam Practice Questions
Q1 [2 marks] — Explain the difference between bookkeeping and accounting.
Accounting is the complete process of recording, classifying, summarising, and interpreting financial information so that users can make informed decisions. Accounting includes bookkeeping but extends beyond it to analysis and reporting.
Q2 [3 marks] — State three users of accounting information and explain what each user needs from the accounts.
Bank/Lender: needs liquidity information and the ability to repay debts, to decide whether to grant or extend a loan.
Government/FBR: needs accurate profit figures to calculate the correct amount of income tax owed and to ensure the business is complying with tax law.
Q3 [4 marks] — Tariq starts a wholesale business in Karachi. Complete the table to show the effect of each transaction on the accounting equation. The first row is done for you.
| Transaction | Assets (PKR) | Capital (PKR) | Liabilities (PKR) |
|---|---|---|---|
| Tariq invests PKR 300,000 cash | +300,000 | +300,000 | — |
| Buys shelving for PKR 40,000 cash | ? | ? | ? |
| Buys stock worth PKR 60,000 on credit | ? | ? | ? |
| Pays PKR 20,000 to a creditor | ? | ? | ? |
Running totals: Assets 300,000 = Capital 300,000 + Liabilities 0
Buy stock PKR 60,000 on credit: Assets +60,000. Capital: —. Liabilities +60,000.
Running totals: Assets 360,000 = Capital 300,000 + Liabilities 60,000
Pay creditor PKR 20,000: Assets −20,000 (cash). Capital: —. Liabilities −20,000.
Running totals: Assets 340,000 = Capital 300,000 + Liabilities 40,000
Q4 [3 marks] — Classify each of the following as: Non-current asset / Current asset / Non-current liability / Current liability / Capital.
(a) Bank loan repayable in 5 years (b) Trade receivables (c) Machinery (d) Bank overdraft (e) Owner's investment in the business
(b) Trade receivables → Current asset
(c) Machinery → Non-current asset
(d) Bank overdraft → Current liability
(e) Owner's investment → Capital
Q5 [2 marks] — Explain why drawings are NOT included as an expense in the Income Statement.
Q6 [3 marks] — At the end of a financial year, a sole trader has total assets of PKR 850,000 and total liabilities of PKR 320,000. During the year, the owner made drawings of PKR 60,000 and the business made a profit of PKR 120,000. Calculate the opening capital at the start of the year.
Step 2 — Work back from closing capital:
Closing Capital = Opening Capital + Profit − Drawings
530,000 = Opening Capital + 120,000 − 60,000
Opening Capital = 530,000 − 60,000 = PKR 470,000