1.2 The four fundamental financial questions
Users of financial information, both inside and outside organisations, want answers from accountants to the following four fundamental financial questions:
Question 1: What does an enterprise own i.e. what are its assets?
Question 2: What does an enterprise owe i.e. what are its liabilities?
Question 3: How did the enterprise perform i.e. what is its profit or loss?
Question 4: How did the enterprise obtain and use cash i.e. what is its cash flow?
All the assets and liabilities of a business are summarised in a primary financial report called a balance sheet, also known as the statement of financial position. Such a report, as well as the underlying accounting records, give the answers for the first two fundamental accounting questions above.
Box 1 The difference between assets and liabilities
An asset is a resource with financial value that is owned by a business with the expectation that it will provide future financial benefit. A liability is a financial claim owing to lenders and suppliers of goods or services on credit.
Later in this course you will learn the system, double-entry accounting, which keeps track of all assets and liabilities in double-entry records that are used as the basis of the balance sheet. At this stage it is more important that you develop a good understanding of the difference between assets and liabilities.
Activity 1 Understanding assets and liabilities
For the items below, type in the box provided whether they are assets or liabilities.
Table 1 Choosing between assets and liabilities
|Item||Asset or liability|
|Inventory (goods for sales)||Asset|
Buildings and machinery are assets that are common in a business. A patent, which is an exclusive right to make, use or sell an invention for a specified period, is a less common asset. While buildings and machinery are tangible or physical assets, a patent is classified as an intangible (non-physical) asset. Receivables or debtors refers to the total money owed to a business by credit customers and is thus an asset. Inventory are goods for sale in a business and are thus assets that are owned.
All the other items are liabilities. An overdraft is when a bank balance is negative and the customer owes the bank a sum of money. A mortgage is a loan agreement secured on a business premise, for instance, in which the lender can take possession of the premise if the borrower fails to pay back the loan as agreed. Payables or creditors is the total money owed by a business to credit suppliers of goods or services.
The answer to the third fundamental question, ‘What is its profit or loss?’ is provided by the income statement, which is the second primary financial report. This report gives summary totals of all the income and expense items in a business that have been aggregated from the underlying double-entry accounting records. If total income (also known as revenue) is greater than total expenses then this positive difference is referred to as a profit. If total income is less than total costs, then this negative difference is referred to as a loss.
Box 2 Stop and reflect
What is the difference between the cash made or lost in a period and the profit or loss in the same period?
The amount of cash any business has made or lost in a period is simple to calculate. It is merely the difference in cash held at the beginning and the end of that period. If the cash position is greater at the end of the period than the beginning, then the business has generated a positive cash flow. If less, then the result will be a negative cash flow.
The profit or loss made in the same period is all income earned less all expenses incurred in generating that income. (It is important to recognise that ‘all income’ and ‘all expenses’ include cash as well as credit transactions.) If total income is greater than total expenses in a period, then a profit has been made regardless of whether a positive or negative cash flow has occurred. If less, a loss has been suffered irrespective again of whatever may have happened to the cash position of the enterprise.