Introduction to Financial Accounting cheat sheet

Key terms

Accounting

The process of identifying, measuring, recording, classifying, summarising, interpreting and communicating the financial transactions and events of an entity, so that those who rely on that information can make informed economic decisions. Note that recording is only one verb in that list. Accounting includes the judgement about what to record and the communication of the result, which is why it is a profession rather than a clerical task.

Accounting period

The span of time over which an entity measures and reports its performance, most commonly twelve months. Riverside Agrovet's runs 1 January to 31 December, so a sale on 31 December falls in one period and a sale on 1 January in the next. The period is the boundary that makes profit measurable at all: without it, profit could be computed only once, when the business finally closed.

Accrual basis of accounting

The basis on which income is recognised when it is earned and expenses when they are incurred, regardless of when cash is received or paid. Its opposite is the cash basis, under which nothing is recorded until money moves. IFRS requires the accrual basis for general purpose financial statements, and this paper uses it throughout except where a question expressly asks for a receipts and payments account.

Credit

An entry on the right hand side of an account. A credit increases a liability, an equity or an income account, and decreases an asset or an expense account. Note carefully what a credit is not: it is not a decrease, and it is not money coming in. The word carries none of the everyday meaning it has in the phrase "my account was credited".

Debit

An entry on the left hand side of an account. A debit increases an asset or an expense account, and decreases a liability, an equity or an income account. Debit and credit are directions, not values, and every transaction carries at least one of each in equal total amount.

Accruals

Expenses that have been incurred by the reporting date but not yet paid, and income that has been earned but not yet received. An accrued expense sits in the statement of financial position as a liability, because the entity owes it, while the matching charge has already been taken to profit or loss. The chapter on assets and liabilities accounts for these in full, under accruals and prepayments.

Closing the books

The end of period routine that transfers the balances on income and expense accounts to the statement of profit or loss, leaving those accounts at nil to start the new period, and carries the balances on asset, liability and equity accounts forward as opening balances. It is the mechanism that keeps each period's performance separate while the entity's position continues uninterrupted.

International Financial Reporting Standards

The standards issued by the International Accounting Standards Board (IASB), governing how transactions are recognised, measured, presented and disclosed. ICPAK adopted the International Accounting Standards from 1 January 1999. Standards issued from 2001 are titled IFRS while the earlier IAS keep their own names, so this paper cites both; IFRS is the collective term.

Bookkeeping

The routine recording and classifying of transactions as they occur, the input side of accounting. Wanjiru's daily sales book and her file of supplier invoices are bookkeeping.

Financial accounting

The preparation of general purpose financial statements for users outside the business, following IFRS. This is the subject of this paper.

Management accounting

The preparation of information for the people running the business, to plan, control and decide. It follows no external rulebook, because no external party relies on it. It is the subject of ATD Fundamentals of Management Accounting.

Assets

Present economic resources controlled by the entity as a result of past events, with the potential to produce economic benefits. Riverside Agrovet's delivery motorcycle, its stock of seed, and the money owed to it by a farmer on credit are all assets. Control matters more than ownership: goods held on hire purchase are an asset of the buyer once the risks and rewards have passed.

Liabilities

Present obligations of the entity to transfer an economic resource as a result of past events. The balance owed to a Nairobi wholesaler and Bidii Millers' Equity Bank loan are liabilities. The obligation must arise from something that has already happened, which is why an intention to buy stock next month is not a liability.

Equity

The residual interest in the assets of the entity after deducting all its liabilities. Equity is defined by subtraction, not measured directly, which is why it absorbs every gain and loss the entity makes.

Revenues

Inflows or enhancements of assets, or settlements of liabilities, arising from the entity's ordinary activities. Riverside Agrovet's sales of seed and feed are revenue.

Expenses

Outflows or depletions of assets, or incurrences of liabilities, arising from the entity's ordinary activities. Shop rent, casual wages and the cost of the goods sold are expenses.

Gains

Increases in equity from transactions that are peripheral or incidental to the entity's ordinary activities. If Riverside Agrovet sells its old motorcycle for more than its carrying amount, the surplus is a gain, not revenue, because selling motorcycles is not what the agrovet does.

Losses

Decreases in equity from peripheral or incidental transactions, the mirror of gains. Stock destroyed by flooding gives rise to a loss.

Investments by owners

Increases in equity from transfers of value to the entity by its owners, in order to obtain or increase an ownership interest. Wanjiru banking KES 300,000 of her own savings into the business account is an investment by owners. It is emphatically not income, because nothing was earned.

Distributions to owners

Decreases in equity from transfers of value by the entity to its owners. Drawings by a sole trader and dividends paid by a company are distributions to owners, not expenses.

Comprehensive income

The total change in equity during a period from all sources other than investments by, and distributions to, owners. It therefore comprises the profit or loss for the period plus other comprehensive income, being items such as revaluation surpluses that standards require to be recognised outside profit or loss.

Accrual principle

Transactions are recorded in the period in which they occur, not the period in which cash moves. Riverside Agrovet's December electricity bill, paid in January, is a December expense and a liability at 31 December. Without this principle a business could flatter its profit simply by delaying payment of its bills until after the year end.

Conservatism principle

Also called prudence. Where uncertainty exists, exercise caution so that assets and income are not overstated and liabilities and expenses are not understated. It does not license deliberate understatement: creating a hidden reserve by writing stock down below its real recoverable amount is as wrong as overstating it, because both mislead.

Consistency principle

The same accounting treatment is applied to the same class of item from one period to the next. If Bidii Millers depreciates its mill on the reducing balance basis this year, it does so next year too, and if a change is genuinely justified it is disclosed and its effect quantified. Without consistency, a comparison between two years says nothing about performance.

Cost principle

Assets are recorded initially at their historical cost, being what was actually paid to acquire them and bring them into use, rather than at what the owner believes they are worth. Historical cost is verifiable from a document, which is precisely why a stranger can rely on it.

Economic entity principle

The business is accounted for separately from its owners and from any other business they run. This holds even where the law makes no such separation: Riverside Agrovet is a sole trade, so Wanjiru is personally liable for its debts, yet her personal rent and school fees never enter its accounts. Money she takes out is drawings, which is the accounting mechanism that keeps the two apart.

Full disclosure principle

Any information that would influence the judgement of a user of the financial statements is disclosed, whether in the statements themselves or in the notes. A pending court case that might cost Bidii Millers a substantial sum is disclosed even though no figure is yet recorded.

Going concern principle

The financial statements are prepared on the assumption that the entity will continue in operation for the foreseeable future and has neither the intention nor the need to liquidate. This assumption is what allows an asset to be carried at cost less depreciation rather than at what it would fetch in a forced sale. Where the assumption fails, the basis of preparation changes and that fact must be disclosed.

Matching principle

Expenses are recognised in the same period as the revenues they helped to generate. The cost of the seed sold in November is a November expense; the cost of seed still on the shelf at 30 November is an asset, not an expense, because it has not yet earned anything.

Real accounts

Accounts for assets and properties, whether tangible like the motorcycle and the stock, or intangible like a software licence. Real accounts are not closed at the period end; their balances carry forward into the statement of financial position.

Personal accounts

Accounts for persons and organisations the entity deals with: individual customers, suppliers, the bank, the owner's capital account. Like real accounts, their balances carry forward.

Nominal accounts

Accounts for incomes, gains, expenses and losses: sales, rent, wages, discount received. Nominal accounts are closed off to the statement of profit or loss at each period end and begin the next period at nil, which is what 'closing the books' in the key terms refers to.

Creditors

Suppliers and lenders who are owed money, or are considering extending credit. A wholesaler deciding whether to give Riverside Agrovet 30 day terms is asking one question of the accounts: can this business pay, and does it pay on time? They look hardest at liquidity, meaning current assets against current liabilities, rather than at profit.

Investors

Existing and prospective providers of equity, who assess the return they are getting and the risk attached to it, in order to decide whether to hold, add to or exit their investment. Bidii Millers' three shareholders read the accounts for exactly this.

Government

Principally the Kenya Revenue Authority, which uses financial information to assess income tax, corporation tax and value added tax, and to check compliance through iTax and eTIMS. Government also uses aggregated accounting data for national statistics and economic planning.

Trading partners

Customers and other businesses in a continuing commercial relationship, who need to know the entity will still be there to honour it. A cooperative contracting Bidii Millers to mill its members' maize for a season needs assurance the mill will not fold mid contract.

Regulatory agencies

Bodies with statutory oversight of the entity or its sector, such as the Capital Markets Authority for listed companies, the Central Bank of Kenya for banks, and the Sacco Societies Regulatory Authority for deposit taking Saccos. They read the accounts to enforce the requirements of the sector they regulate.

International standardisation agencies

Standard setters such as the IASB, and locally ICPAK, which monitor how standards are applied in practice and use what they find to develop and revise them.

Owners

The providers of the entity's capital, who want to know the return the business is producing on what they put in, and whether to put in more or take it out. In a sole trade the owner is also the manager, which is why Wanjiru reads her accounts for two different purposes at once.

Directors

In a company, the persons charged with governing it. The Companies Act 2015 splits the duties: the company must keep proper accounting records (s.628), while the directors must prepare financial statements giving a true and fair view (ss.635 and 636). They therefore read the accounts as both preparers and stewards.

Managers

Those running the entity day to day, who need detailed and timely information to plan, control and decide. Their needs are largely met by management accounting rather than by the annual financial statements, which arrive too late and in too summarised a form to run a business by.

Employees

Assess the security of their jobs, the entity's capacity to pay wages and benefits, and the credibility of any promise made in a collective bargaining negotiation.