Financial Position of an Individual or Business

What is a person’s financial position? What is your financial position? How would you be able to find this out? Take a look at the following example of how an accountant determines the financial position of an individual or a business.

Meet Clara Chow. Clara’s dream is to start her own business but first she needs to go to her financial institution for a loan to help her get started. A financial institution is a company (i.e. bank) that deals with transactions that involve deposits, loans, investment and other financial transactions. Clara is able to apply for a traditional loan but it is important to note that the Canadian government, credit unions and community groups have developed programs that offer startup micro loans (small, low or no interest business loans) for people who may not qualify for typical loans.

She would like to borrow $20,000. The assistance bank manager sits down with Clara and works out her financial position.

Clara’s financial position is an important consideration in deciding whether to offer Clara a loan. To help her decide, the assistant manager follows these three steps:

Step 1: Calculate the value of all the assets

First, she lists the items that Clara owns and adds up the total dollar value.

In accounting, items owned that have a dollar value are called assets.

In accounting, items owned are called assets. Clara has assets totalling $58,000.

Step 2: Calculate the value of all the liabilities

Next, she lists the amounts that Clara owes to others and adds up the total dollar value.

In accounting, the amounts owed, referred to as creditors, are called liabilities.

Clara has liabilities of $16,500.

Step 3: Calculate the difference between total assets and total liabilities.

Finally, she calculates Clara’s financial position by subtracting her total liabilities from her total assets.

In accounting, the difference between total assets and total liabilities is called equity and often times referred to as owner’s equity, financial net worth or capital. Owner’s equity is basically the entitlement that the owner has on the assets of the company after all the claims of the creditors are paid first. Clara’s equity is determined by making the following calculation:

Total Assets (value of items owned) - Total Liabilities (value of items owed) = Owner's Equity

$58,000 – $16,500 = $41,500

This calculation shows that Clara’s equity or financial net worth is $41,500. This is what she would be worth, financially, if all her debts were paid. Even though she has assets of $58,000, her claim on those assets is only $41,500 since she has to take into account the amount she owes her creditors.

Since there is a significant difference between Clara’s assets and her liabilities with the assets being larger, the financial institution decides to give Clara the loan she needs to start her business.

If on the other hand her total liabilities were greater than her assets, the financial institution would probably not give her a loan. The reason for this is because the financial institution always confirms that there are enough assets to repay the loan if necessary.

This calculation is also known as the fundamental accounting equation and is sometimes referred to as the balance sheet equation.

Fundamental Accounting Equation

The fundamental accounting equation is very important in accounting and is the same for all entities regardless of the type or nature of the business organizations which you will learn about in the next learning activity.

Use the three steps as we did with Clara above to launch your own imaginary startup company.

Your personal finances include:

• Car: $12,000
• Car Loan: $8,500
• Cash: $3,250
• Equipment: $8,000
• Owed to a friend: $2,200
• Credit Card Owing: $500

Congratulations! You are already an accountant in the making!

Are you ready to dive into the world of accounting? First we need to understand the importance and value of accounting. Let’s go!

Purpose of Accounting

The oldest professions

Accounting is one of the oldest professions in history. Accounting dates back to ancient Mesopotamia, in fact archeologists have found records of taxes and rations to workers dating back to 2500 BCE (before common era). Here is an ancient Mesopotamian (Sumerian) stone carving with cuneiform from this time period.

So what is accounting? Although the first thing that comes to mind is counting and tracking money, it is way more than just that.

Accounting is a widely used practice in almost all types of organizations, ranging from big businesses to government, and from small, family run businesses to not-for-profit organizations.

An important reason many businesses exist—whether they be large corporations or small ones—is to make a profit. Other types of organizations may have different needs, such as ensuring that they are covering costs, or reporting of their finances to interested parties. Every organization, regardless of its purpose, will need to record the financial transactions that it makes with other parties. Once these have been recorded, the organization will want to compile reports reflecting this financial information so that internal and external parties who are interested can have access to it.

To run a business, managers need financial information so that they can plan where the business is going (budgeting) and assess whether they have met their goals. Accountants use the information to control expenses, report on income targets, and generally measure the business’s efficiency.

Accounting information is used mainly for decision making. A company’s accounting system, whether it is electronic or manual, provides the necessary information. The accounting system is used to:

• record the day-to-day financial activities of the business
• summarize and report information in the form of financial statements
• analyze and interpret the information for decision-making

All businesses are required by law to keep accounting records. Canada Revenue Agency (CRA) requires income tax returns to be filed for all companies. Also, the Harmonized Sales Tax (HST) collected needs to be recorded and paid back to the government on a quarterly basis.

Most companies will produce the following:

• Income statement
• Balance sheet
• An auditor or accountant’s report or letter
• A director’s report

An auditor is an external person who verifies that the accounts have been compiled in a way that complies with the requirements of International Financial Reporting Standards (IFRS) which are set by the Canadian Accounting Standards Board (AcSB). We will look at these standards later in this unit.

Difference Between Accounting and Bookkeeping

The terms “accounting” and “bookkeeping” are sometimes used interchangeably. However, there is a difference.

Accounting Information and Users

Individuals and groups both inside and outside the business use accounting information. Accounting information is presented in the company’s financial accounting documents. Some of the documents included are:

• Income Statement (summary of businesses revenue and expenses and shows the net income or net loss of a business for a given fiscal period)
• Balance Sheet (statement showing the financial position of a business on a certain date)

They will be discussed in more detail later on in this unit. These documents are very useful when seeking financial information on a business, and are used by owners, managers, banks, potential investors, and accountants. They all use the same information for different reasons. Among other analyses, owners use the balance sheet to establish the size of their stake in the business and the amount of debt.

Financial institutions examine the balance sheet to determine the financial strength of the business and to determine its ability to pay its debts. Potential investors review the balance sheet for signs of financial weakness in the business, and accountants look to the balance sheet to examine levels of efficiency in the business.

Standards for the Accounting Profession

All the users of accounting information rely on the same accounting records, but for different reasons. These users make decisions based on the information financial records provide. For this reason, it is important that there are strict standards and guidelines for recording transactions and compiling accounting information.

In the past, these rules and guidelines were contained in the Generally Accepted Accounting Principles (GAAPs). GAAPs were applied consistently by all accountants for all businesses, making the accounting information meaningful and comparable by those who understand how accounting information is compiled. In Canada, the Canadian Institute of Chartered Accountants (CICA) published a handbook containing these principles. CPA Canada was established by CICA and CMA Canada in January 2013. It now supports Canadian provincial accounting bodies under the unified CPA banner.

In 2011, the Canadian GAAP have been replaced by either the International Financial Reporting Standards (IFRS) or the Accounting Standards for Private Enterprises (ASPE) set by the Accounting Standards Board (AcSB) of Canada. IFRS are standards for businesses that are publicly listed and have stocks that are traded on a public stock exchange whereas the ASPE standards apply to private businesses that do not have a public listing and therefore do not have stocks traded on a stock exchange. (You will get an overview of different types of business ownership in the next activity).

Further changes occurred in the accounting industry when in 2013 Chartered CPA Canada was established by CICA and CMA Canada. In order to reduce confusion in the accounting industry the three previously existing accounting designations (CA) Chartered Accountant, (CGA) Certified General Accountant and (CMA) Certified Management Accountant, that each had different educational and work experience requirements for certification, united under a single designation known as Chartered Professional Accountants.

Professional accountants need to create financial statements that strictly follow these standards and as a result must have strong familiarity with them. Throughout this course, you will come across the standards “in action” as they apply to different accounting statements and functions.

Learn about the AcSB

Take a moment to fully understand the AcSB and its purpose as an organization. Read “About the AcSB” and then answer the questions that follow. (Opens in new window)

Excellent! You are aware that there is a need for accounting standards, and that standards exist to guide accountants in preparing their financial records. Throughout units 2, 3 and 4, you will come across various accounting standards and how they related to accounting procedures. You will learn how to perform accounting functions thinking like an accountant! While working through this course, you will need one other tool to help you keep organized. You will need a “notebook”. This may be an actual pen and paper notebook where you can take notes or, you may choose to have a digital “notebook” or a file. This is a personal decision, but it is important that you do have a place for notes. Be sure to add a title to each set of rough notes with the learning activity title and number.

Let's get back to thinking about Clara and her dream of starting a business. Imagine that she has received funding from her financial institution and is already in her first year of business. She has taken accounting in high school just like you, and luckily, has been able to do her own bookkeeping. Since her business is doing very well she is considering expansion but is worried that her skills in accounting may not be enough. She is thinking about hiring an accountant to help her but is not sure. Let's help Clara by giving her some advice.

Create and complete a table like this one to explain how each user would utilize Clara’s accounting information?