Financial Accounting · Lesson 1 of 49
Introduction to Accounting
A repair shop earns a profit in June but collects the cash in July. Accounting explains both results. It identifies, records and communicates economic activity so people can see what a business has, owes, earns and spends.
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What accounting does
Accounting helps you see how a business performed, what it has and owes, and whether it can pay its bills. Like a dashboard, it gives people readings they can use to decide what to do next.
- 1. IdentifyFind the event and the evidence that supports it.
- 2. Record and classifyMeasure the effect, record the entry and group it by account.
- 3. CommunicateSummarise the results in reports and explain what the figures mean.
From a repair invoice to a business decision
A shop completes a repair for 500 in June, pays 180 for parts, and collects the invoice in July. The invoice and job record show when the work was completed. The bank record shows when cash moved.
| Measure | June | July |
|---|---|---|
| Revenue | 500 earned | No new revenue |
| Expense | 180 for parts | No new expense |
| Profit from the job | 320 | No additional profit |
| Cash movement | 180 paid | 500 received |
| Customer still owes | 500 at month-end | 0 after payment |
Amounts in currency units. All bars use a scale from 0 to 500.
- Revenue500
- Parts cost180
- Profit320
Why accounting matters
- Owners can see how managers used the money they entrusted to the business.
- Managers can compare costs, plan spending and decide where to use scarce resources.
- Lenders can compare repayment dates with expected cash receipts.
- Records help the business prepare financial and tax reports under the rules that apply.
Keep the accounting equation in view
Assets = liabilities + equity. If the owner invests 2,000 and the business borrows 1,000, assets are 3,000, liabilities are 1,000 and equity is 2,000. Buying 600 of equipment for cash changes the mix of assets, while their total stays at 3,000.
Exam memory hook. Remember IRC. identify, record, communicate. Recording an invoice is bookkeeping. Measuring and explaining its effect are also part of accounting.
Watch the timing. A job interview alone usually creates no entry. Wages earned by employees may create an expense and a payable before payday. Cash movement is only one clue.
Try it. When the customer pays in July, does the shop earn another 500 of revenue?
No. The shop already recorded the revenue in June. In July, cash rises by 500 and the amount owed by the customer falls by 500.
Quick knowledge check
The shop finishes a repair in June and is paid in July. When does it record the revenue under accrual accounting?
Show the answer and explanation
June, when the work is completed. The shop earned the revenue by completing the repair in June. The July payment settles the receivable.
How accounting developed
Accounting developed as people needed records that could explain more complicated trade, financing and operations.
- Early record keepingPeople tracked deliveries, goods held and obligations.
- Merchant bookkeepingBusinesses linked sales, purchases, payments and debts.
- 1494Luca Pacioli published a description of double-entry bookkeeping already used by merchants.
- Industrial businessesFactories increased the need to track labour, materials, machinery and output.
- Modern reportingStandards and disclosures helped readers compare financial reports across entities and periods.
- Digital systemsSoftware processes entries and helps flag unusual items for human review.
Why linked records were useful
A cloth merchant receives 300 of fabric on credit. A record of the fabric alone cannot explain the bill that will fall due. Double entry records both effects. Later, payment reduces cash and clears the amount owed.
| Event | Debit | Credit |
|---|---|---|
| Fabric arrives on credit | Inventory 300 | Payables 300 |
| Supplier is paid | Payables 300 | Cash 300 |
What software can check
- It can check whether debit and credit totals agree.
- It can match invoice references and flag duplicates for review.
- It still needs people to decide which account, amount and period are appropriate.
Exam reminder. Pacioli described and helped spread double entry in print. Merchants had used the method before 1494. Equal debit and credit totals are an arithmetic check.
Try it. A computer accepts a balanced entry. Does that prove the entry is correct?
No. Both sides can agree even when the wrong account, amount or date is used. Compare the entry with the evidence.
Quick knowledge check
What did Pacioli’s 1494 publication contribute?
Show the answer and explanation
It described double entry already used by merchants. The printed account helped spread a method merchants already used.
Who uses accounting information
Internal users help run the entity. External users assess it from outside. The same person can use different information depending on their role.
| User | Decision they face | Information to start with |
|---|---|---|
| Operations manager | Should we add an evening shift? | Order forecast, labour hours and extra costs |
| Owner-manager | Can the shop afford new equipment? | Cash forecast, financing and expected benefit |
| Employee representative | Can the business sustain proposed pay changes? | Financial results and relevant workforce information |
| Outside investor | Is this a suitable investment? | Financial statements, trends and risks |
| Lender | Can this business repay on time? | Cash flows, loan terms and payment schedule |
| Trade supplier | Should we offer 30-day credit? | Upcoming liabilities and expected collections |
| Tax authority or regulator | Has the entity met applicable requirements? | Required returns, reports and supporting records |
One shop, three priorities
A shop reports 12,000 profit but has 2,000 in the bank and owes a supplier 5,000 next week. The owner-manager may ask which invoices can be collected before the bill is due. The supplier may ask whether to extend credit again. The investor may want to know whether profit is likely to continue.
- At a dateRead the balance sheet for assets, liabilities and equity.
- Over a periodRead the income statement for performance and the cash flow statement for cash movements.
- Before a future decisionUse forecasts and payment schedules to see what may happen next.
Exam reminder. Classify users by their role in the question. A shareholder who manages the business may use internal budgets, while an outside shareholder typically relies on published reports.
Try it. Who would use a forecast of staff hours?
A manager planning next month’s work. A lender assessing repayment would normally focus more on cash and debt commitments.
Quick knowledge check
A supplier must decide whether to offer 30-day credit. What should it check first?
Show the answer and explanation
The buyer’s upcoming bills and expected cash receipts. The decision is about payment timing. Sales can be high even when cash is scarce.
Branches of accounting
Financial accounting explains the entity’s results, cost accounting measures resources used, and management accounting helps managers choose what to do.
- ReportFinancial accounting prepares financial statements and disclosures.
- MeasureCost accounting tracks what products, services or jobs consume.
- DecideManagement accounting combines cost, demand and capacity information for decisions.
- CheckAuditing evaluates evidence within a defined scope.
| Area | Question it answers | Example |
|---|---|---|
| Financial accounting | What did the entity earn and what does it have and owe? | Prepare financial statements for owners and lenders |
| Cost accounting | What resources did an activity use? | Calculate materials and labour for a workshop job |
| Management accounting | What should managers do next? | Compare the costs and benefits of adding a shift |
| Auditing | What does the evidence support? | Examine inventory records and bank confirmations |
| Tax accounting | How do local tax rules treat the transaction? | Prepare a tax computation and supporting records |
| Forensic accounting | What can the records explain about a dispute or suspected fraud? | Trace altered payments and document the evidence |
| Government and nonprofit accounting | How were public or donor resources received and used? | Report spending against a grant or budget |
| Accounting information systems | How can the entity capture and check information reliably? | Design invoice approval and reconciliation controls |
Follow a workshop’s wages
The financial accountant records wages and amounts due. A cost accountant traces hours to customer jobs. A manager compares overtime with demand. The tax team checks deductions and filing obligations under applicable rules. One payroll record can support all four tasks.
Exam reminder. An audit assesses evidence. Management is responsible for preparing the financial statements. Forensic work can investigate a specific issue, such as missing funds or a disputed payment.
Try it. Which branch helps a workshop estimate the labour cost of one customer order?
Cost accounting measures labour used by the order. Management accounting uses that estimate when deciding how to price it.
Quick knowledge check
A team traces altered payments to document a suspected fraud. What kind of work is this?
Show the answer and explanation
Forensic accounting. Forensic work investigates financial evidence and may support a dispute or legal proceeding.
Compare financial, cost and management accounting
A statement, a unit-cost calculation and a decision forecast can all start with the same café transactions. Each output answers a different question.
| Feature | Financial | Cost | Management |
|---|---|---|---|
| Purpose | Explain overall performance and position | Measure and analyse resources used | Help managers plan and choose |
| Typical reader | Owners, lenders and other report users | Cost analysts and operations teams | Managers responsible for decisions |
| Level of detail | Entity or group, with relevant disclosures | Product, service, job or activity | Whatever the decision requires |
| Typical timing | A completed reporting period | Actual or estimated costs | Past results and future scenarios |
| Example output | Income statement | Cost of a latte | Forecast for a new location |
Worked case. A small café chain
- Financial viewSummarise sales and expenses across locations for the reporting period.
- Cost viewWork out the selected ingredients and supplies used by one drink.
- Management viewCompare opening hours or locations using sales forecasts, staffing and capacity.
| Item | Cost per drink |
|---|---|
| Coffee beans | 0.35 |
| Milk | 0.40 |
| Cup and lid | 0.15 |
| Selected variable utilities | 0.10 |
| Total of listed costs | 1.00 |
If the café sells the latte for 4.75, the difference after these listed costs is 3.75. That amount must also cover any other costs that apply, such as staff time, rent and equipment. It does not establish the café’s profit margin.
You be the accountant. The café considers staying open an extra hour.
Compare the expected sales for that hour with the costs that would change, including wages, supplies and utilities. Also check whether the extra hour would shift sales from another time rather than increase total sales.
How capacity can change a decision
A separate bakery order earns 240 after extra costs. If accepting it displaces regular sales that would earn 300 of contribution, total profit falls by 60. The contribution lost is an opportunity cost.
Exam reminder. Internal reports can be tailored to the decision. Cost information used in published financial statements may still have to meet the applicable reporting requirements.
Try it. Why did we leave rent out of the decision calculation?
The existing rent stays the same whether the bakery accepts or refuses the order. It remains a business cost, but it does not change this comparison.
Quick knowledge check
The special cake order adds 240 of profit before lost sales. It displaces 300 of contribution. What is the net effect?
Show the answer and explanation
Profit falls by 60. The lost 300 is an opportunity cost. The additional 240 less 300 gives a 60 decrease.
Bookkeeping, accounting and accountancy
Bookkeeping records transactions. Accounting also measures and explains them. Accountancy is the wider field and profession.
| Level | Typical work | Machine example |
|---|---|---|
| Bookkeeping | Enter the transaction and file the evidence | Record the 2,400 payment and attach the supplier invoice |
| Accounting | Apply reporting rules, make estimates and explain the result | Decide whether to recognise equipment and estimate depreciation |
| Accountancy | Apply professional knowledge across accounting and related services | Use accounting, tax or assurance expertise within the relevant role |
Worked example. Equipment bought for cash
A business buys a machine for 2,400. Assume it is recognised as equipment, has no residual value and is depreciated evenly over three years. It is used for a full year in the first period shown.
- At purchase. Cash falls by 2,400 and equipment rises by 2,400.
- After one full year. Depreciation expense is 800, calculated as 2,400 ÷ 3.
- At that year-end. The machine’s carrying amount is 1,600, before any other adjustments.
- Cash and expense. The business paid 2,400 when it bought the machine. Recording annual depreciation does not pay that amount again.
Debit and credit basics
Debit and credit mean the left and right sides of an account. They are not shorthand for good and bad. In the purchase example, debit Equipment 2,400 to increase the asset, and credit Cash 2,400 to reduce the cash asset. Total debits equal total credits.
Memory hook. Record the purchase, measure the asset, explain the result. These are three parts of one transaction and can be carried out by the same person.
Try it. Which part is bookkeeping when an employee receives a supplier invoice?
Entering the invoice in the records and keeping the evidence are bookkeeping. Deciding how the cost should be measured and reported involves accounting judgement.
Quick knowledge check
Which task involves accounting judgement beyond recording the equipment purchase?
Show the answer and explanation
Estimating the equipment’s useful life. Useful life is a measurement judgement that affects depreciation. The invoice and payment are source records.
Accounting as the language of business
Check the title, reporting date or period, and units. A balance today and a result over a month answer different questions.
| Statement | When it measures | Question it answers |
|---|---|---|
| Balance sheet | At a date | What does the business have and owe? |
| Income statement | Over a period | How much income, expense and profit did it report? |
| Cash flow statement | Over a period | Where did cash come from and where did it go? |
| Statement of changes in equity | Over a period | How did profit, owner contributions and distributions change equity? |
Read the week in numbers
At week-end, a shop has 6,000 in assets and 2,500 in liabilities. Equity is 3,500. During the week it earned 2,200 revenue and incurred 1,500 expenses, so profit was 700.
- Position at week-end. 6,000 assets less 2,500 liabilities leaves 3,500 equity.
- Performance during the week. 2,200 revenue less 1,500 expenses gives 700 profit.
- Owner transactions. If the owner also contributes 1,000, it adds to equity separately from the 700 profit.
- Cash movements. You need cash receipts and payments to explain how the bank balance changed. Profit alone cannot give you the answer.
Terms students often mix up
| Term | Meaning | Watch out for |
|---|---|---|
| Revenue | Income from ordinary activities | A customer can pay later |
| Profit | Income less expenses for the period | Profit is not the bank balance |
| Receivable | An amount someone owes the business | The business has yet to collect it |
| Payable | An amount the business owes someone else | The business has yet to settle it |
Memory hook. Position is a photo at a date. Performance, cash flow and equity movements are stories about a period.
Try it. Which statement shows assets and liabilities on 31 December?
The balance sheet, also called the statement of financial position, shows these balances at that date.
Quick knowledge check
Which report answers how equity changed over a year?
Show the answer and explanation
Statement of changes in equity. The statement of changes in equity explains movements such as profit, contributions and distributions.
Accounting as an information system
Collect evidence, check it, post it to the accounts, reconcile the totals and prepare reports.
- CaptureKeep the customer order and delivery record.
- CheckConfirm customer, quantity, price and date.
- RecordPost the sale and the amount due from the customer.
- ReviewMatch totals and report what customers still owe.
From journal to reports
| Record | Job it does | What to check |
|---|---|---|
| Source document | Supports a transaction | Amount, date and authorisation |
| Journal | Records events in entry order | Accounts, explanation and debits equal credits |
| Ledger | Groups entries by account | Running balances and unusual items |
| Trial balance | Lists balances to check total debits and credits | Differences and unexpected balances |
| Financial statements | Summarise results for users | Adjustments, classification and reporting period |
Worked example. A receivables mismatch
Three customers owe 400, 700 and 900. The customer ledger totals 2,000. The general ledger shows 2,700. Start with the 700 difference. It may be a duplicate posting, a misclassified entry or a transaction entered in only one place. Check the invoice references before making a correction.
- Prevent errors. Check for duplicate invoice numbers and restrict who can edit customer accounts.
- Find errors. Reconcile customer balances to the control account and investigate differences.
- Keep a trail. Record who made each correction, when and why.
Exam trap. A trial balance checks whether debits equal credits. It cannot show by itself whether all transactions were entered or whether each used the right accounts.
Try it. Does a balanced trial balance prove every transaction was recorded?
No. A completely omitted transaction leaves both debit and credit totals unchanged. Check source evidence and use other controls as well.
Quick knowledge check
Customer balances total 2,000 and the control account is 2,700. What is the first useful step?
Show the answer and explanation
Trace the 700 difference to the source records. A difference is a signal to investigate. A correction needs evidence of which record is wrong.
Limitations of financial accounting
Accounting helps answer financial questions. Estimates, reporting choices and missing operating information can affect what you conclude.
| Limit | Example | What to do |
|---|---|---|
| Estimates | Useful life of a machine can change | Read the assumptions and consider how a different estimate affects profit |
| Reporting dates | Year-end cash may differ from cash next week | Check payment dates and recent developments |
| Nonfinancial information | Statements do not show customer waiting times | Use operating measures alongside the reports |
| Comparability | Businesses may have different policies or conditions | Read the notes before comparing figures |
Same profit, different cash pressure
Two stores each report 20,000 profit. Store A collected most sales immediately. Store B sold on long credit terms. Store B could struggle to pay suppliers even though it reports the same profit. Check receivables, collection dates and cash flows before making a judgement.
Revision notes for the full lesson
- Event. Name what happened, when it happened and which business it affected.
- Evidence. Find the record that supports the amount and date.
- Effect. Identify which assets, liabilities, equity, income or expenses changed.
- Report. Decide whether you need position, performance or cash flow.
- Decision. Ask who is using the figures, what they need and what the figures leave out.
Before an exam. Practise explaining profit versus cash, position versus performance, and the reason every entry needs evidence. Use the print button to save these notes for revision.
Final practice. A designer earns 900 on credit and pays 240 for materials used. What are the profit, receivable and cash effect?
Profit is 660, the receivable is 900, and cash falls by 240. When the customer later pays, cash rises by 900 and the receivable falls by 900. The collection does not create additional profit.
Quick knowledge check
Two shops earn the same profit. One sells on longer credit terms. What could help explain different cash pressures?
Show the answer and explanation
When customer balances are expected to be collected. Longer collection times can leave less cash available to pay bills even when reported profits match.
You Be the Accountant
A photographer finishes a 750 job on 28 June and invoices the customer. The customer pays on 8 July. The photographer pays 200 in June for supplies used on the job. Assume accrual accounting and no other costs.
- Record the sale in July when the customer pays.
- Record the sale and receivable in June, then clear the receivable in July.
- Record the sale in both months because there is an invoice and a receipt.
Teacher’s solution and reasoning
Choose option 2. In June, debit receivables 750 and credit service revenue 750. Debit supplies expense 200 and credit cash 200. June profit from the job is 550. In July, debit cash 750 and credit receivables 750. Option 1 shifts June revenue into the wrong period. Option 3 counts one sale twice.
60-second knowledge check
An owner contributes 1,000 cash. What changes?
A. Revenue and cash rise. B. Equity and cash rise. C. Profit rises and cash stays the same.
Check question 1
B. The contribution increases equity and cash. A treats funding as a sale. C mistakes a contribution for profit and ignores the cash received.
A supplier wants to know whether a customer can pay next week. What should it check first?
A. Annual sales alone. B. Current inventory alone. C. Cash available, expected collections and bills due.
Check question 2
C. The decision depends on payment timing. A omits collection timing. B ignores how quickly stock can turn into cash and when bills are due.
3 mistakes students make on exam day
- Equating cash with revenue. Put the service date and the payment date on a timeline.
- Treating every deposit as profit. Label each deposit as a sale collection, borrowing, owner contribution or another type before calculating profit.
- Trusting a balanced total without checking the entry. Match the entry to the source document and verify both the account and the date.
Memory hook
IRC means identify the event, record its effects and communicate the result. For reports, remember that position is a snapshot and performance covers a period.
Introduction to Accounting revision sheet
- Identify the business event and use evidence to decide when it belongs in the accounts.
- Separate operating results, cash movements and owner or lender financing.
- Choose the report that answers the reader’s question and check what its figures leave out.
Key formulas. Assets = liabilities + equity. Profit = income − expenses. Total debits = total credits for every journal entry.
Reference. The IFRS Conceptual Framework introduces the elements of financial statements and the purpose of general-purpose financial reporting. The framework and standards that apply depend on the entity and reporting requirements.
Frequently asked questions
- What is accounting in simple terms?
- Accounting identifies, records and communicates economic information. It helps readers understand what a business has, owes, earns and spends.
- What’s the difference between accounting and bookkeeping?
- Bookkeeping records transactions and keeps the evidence. Accounting also includes measurement, reporting and interpretation.
- Why can a business earn a profit and have less cash?
- A business may sell on credit and pay its costs before collecting from customers. Profit reflects earned income and incurred expenses, while cash reflects actual receipts and payments.
- What are the basic financial statements?
- A balance sheet shows financial position at a date. The income statement, cash flow statement and statement of changes in equity explain different movements over a period.
- How do financial, cost and management accounting differ?
- Financial accounting reports the entity’s results and position. Cost accounting measures resources used, and management accounting applies those figures and other information to planning and decisions.