ACCT1110 Chap.1 Overview of Financial Accounting
Overview of Financial Accounting
Financial accounting exists because the people who fund a business are usually not the people running it. A lender weighing a facility, a supplier deciding whether to offer thirty day terms, a shareholder deciding whether to hold, and the tax authority all need the same underlying picture, prepared on rules agreed in advance so that two businesses can be read side by side.
This opening topic sets out that picture and the boundary it is drawn inside.
Three ideas do most of the work. The reporting entity fixes whose transactions are being measured, which is why a director buying a boat with her own money changes nothing in the company's records while a loan from her creates a liability.
The accounting equation, assets equal liabilities plus equity, holds after every transaction because every entry is itself balanced.
And the four statements hand over to one another in a fixed chain: profit lands in the statement of changes in equity, closing equity lands in the statement of financial position, and the movement in the cash line of that statement is what the cash flow statement exists to explain.
Reading a transaction straight into the equation, before any debit or credit is written, is the single cheapest preparation for the multiple choice paper.
A question that takes three minutes to reason through takes fifteen seconds once that reading is automatic, and thirty questions in ninety minutes leaves room for very little reasoning.
What this chapter covers
- 01
Why outsiders need a prepared report
- 02
The reporting entity and its boundary
- 03
Assets, liabilities and the residual
- 04
Where profit and dividends touch equity
- 05
Four statements and the chain between them
- 06
Temporary accounts against permanent accounts
- 07
Reading a transaction into the equation
Reading six transactions straight into the equation
- +1Share issue and equipment purchase: cash and equity both rise $120,000; then one asset becomes another, so the $38,000 saw leaves total assets unchanged and touches nothing on the right hand side.
- +1Timber on credit: inventory rises $14,500 and accounts payable rises $14,500. Nothing reaches profit, because nothing has been consumed yet.
- +1The invoice and the consumption: receivables rise $26,000 with equity, because income raises retained earnings; inventory falls $9,200 with equity, because an expense lowers it.
- +1Paying the supplier removes $14,500 from both cash and payables. Rebuild the closing balances rather than running a total forward: cash $67,500, receivables $26,000, inventory $5,300 and the saw $38,000 give assets of $136,800.
Key terms
- Reporting entity
- The unit the statements describe. Its owners' private transactions stay outside, which is why a loan from a director is recorded as a liability of the company rather than as extra capital.
- Residual
- What owners are left with once every outside claim is met, which is why equity is defined as assets less liabilities rather than measured directly.
- Going concern
- The assumption that the entity will keep operating, which is why a delivery van is carried at cost less depreciation rather than at the price it would fetch at auction.
- Temporary account
- An income or expense account whose balance is closed into retained earnings at period end, so it opens the following year empty.
- Permanent account
- An asset, liability or equity account whose closing balance becomes next period's opening balance, which is why questions so often ask you to adjust a balance rather than record an amount.
- Articulation
- The way the four statements hand figures to one another, so a number that appears in two of them has to agree in both.
Overview of Financial Accounting FAQ
What does the accounting equation actually guarantee?
It guarantees that the two sides of the records stay equal after every transaction, because each entry is itself balanced. It does not guarantee that either side is right. An omitted invoice, an amount posted to the wrong account of the right type, or an entry recorded twice all leave the equation intact, which is why the equation is a check on arithmetic rather than a check on completeness.
Why does buying equipment for cash leave profit untouched?
Because nothing has been consumed. One asset has become another asset of the same value, so total assets are unchanged and the right hand side of the equation does not move at all. The cost reaches profit gradually, as depreciation, across the years that benefit from the equipment. Students who expect an immediate expense here are applying cash thinking to an accrual system.
How do the four statements connect to each other?
Profit for the period is carried into the statement of changes in equity, where dividends are deducted and new capital added. The closing equity figure from that statement appears in the statement of financial position. The change in the cash balance shown in that position statement is precisely what the cash flow statement sets out to explain, section by section.
Is financial accounting the same as management accounting?
No. Financial accounting reports outward on a fixed timetable in a comparable format, which is why so much of it is rule bound. Management accounting reports inward, whenever it is useful, in whatever form helps a decision. This course is the first of the two, and the emphasis on rules is what makes one company's statements readable against another's.
Exam move
Spend the first fortnight making transaction reading automatic. Take any twenty events, say aloud which two elements move and in which direction, and only then write the entry. That habit is what turns a three minute multiple choice question into a fifteen second one, and the in-semester paper gives you three minutes a question for thirty questions.
Alongside it, learn which accounts reset and which carry forward.
Most of the questions later in the course that trip students up, from the allowance for doubtful debts to the warranty provision, do so because a balance was already sitting in the account and the answer ignored it. If you can name the permanent accounts from memory, you will not make that mistake.
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