Financial Position of an Individual
How much is a person worth financially? How much are you worth financially? How would you be able to find this out? Take a look at the following example of how an accountant determines how much a person or a company is worth.
Meet Clara Chow. Clara’s dream is to start her own business but first she needs to go to her bank for a loan to help her get started.
She would like to borrow $20,000. The assistance bank manager sits down with Clara and works out her net worth.
Clara’s net worth 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 all assets
First, she lists the items that Clara owns:
Items Clara Chow owns
| Cash | 4 000 |
|---|---|
| Investments | 9 000 |
| Furniture and equipment | 20 000 |
| Automobile | 25 000 |
| Total Assets | $58 000 |
In accounting, items owned are called assets. Clara has assets totalling $58 000.
Step 2: Calculate all liabilities
Next, the amounts that Clara owes to others (creditors) are listed. Items owed are called liabilities.
Items Clara Chow owes to creditors
| Credit Card Debt | 1 500 |
| Automobile Loan | 15 000 |
| Total Liabilities | $16 500 |
Clara has liabilities of $16 500.
Step 3: Subtract total liabilities (established in Step 2) from total assets (established in Step 1)
The final step in calculating a person’s net worth is to subtract their liabilities from their equity. Clara’s personal equity or her “personal net worth” is determined by making the following calculation:
Value of Items Owned (assets) – Total Owed to Creditors (liabilities) = Personal Net Worth
This calculation is also known as the fundamental accounting equation.
Fundamental Accounting Equation
Equity or Net Worth = Assets – Liabilities
Clara’s Equity is calculated by subtracting Assets from Liabilities or E = A – L.
$58 000 – $16 500 = $41 500
This calculation shows that Clara’s net worth is $41 500. This is what she would be worth if all her debts were paid.
In accounting, personal equity is the term describing a person’s net worth. Equity means a claim on assets. Clara’s personal equity or net worth is $41 500. Even though she has assets of $58 000, her claim on those assets is only $41 500.
Because there is a substantial difference between Clara’s assets and her liabilities with the assets being larger, the bank decides to give Clara the loan she needs to start her business.
If her liabilities exceeded her assets, the bank would probably not give her a loan. The banks always confirm that there are enough assets to repay the loan if necessary.
Try It!
Now it’s your turn. Imagine you would like to launch your own internet startup company. Though you don’t need to purchase any equipment, you would like some funding for advertising and research. Before you go to the bank, you want to sort your personal finances and find your net worth.
Use the three steps as we did with Clara above to launch your own imaginary startup company.
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 business to government, and from mom-and-pop stores to not-for-profit organizations.
The main reason why 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 accounting for 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 for all companies. Also, the Harmonized Sales Tax (HST) needs to be recorded and paid 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.
Definitions
Accounting is the overall recording, controlling, analyzing, and interpreting of the information in the accounting system. Accountants and others use the information to make decisions about the business and how it operates.
Bookkeeping is the first part of the accounting process; that is, the recording of information in the accounting records (books) of the business. The recording may be done manually or using a computer. The books of the business include journals and ledger accounts. A journal is a book (or computer file) in which business transactions are first recorded. Ledger accounts are records of the assets, liabilities, and equity.
Users and Amount of Accounting Information
Individuals and groups both inside and outside the business use accounting information. Accounting information is presented in the company’s financial accounting documents. These documents include:
- Income statement
- Balance sheet
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.
Banks 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 traded on the stock exchange whereas the ASPE standards apply to businesses that do not have a public listing. (You will get an overview of different types of business ownership in the next activity).
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.
Try It!
Answer these questions based on what you have read in “About the AcSB.”
How does the AcSB benefit users of accounting?
“develop and maintain Canadian accounting standards to support informed economic decision making by financial statement users through maintaining a framework that provides a basis for high-quality information about financial performance reported by Canadian private sector entities”
The AcSB lists four objectives. Select one and explain in your own words:
Answers will vary
How does the AcSB work with CPA?
Even though the CPA funds the AcSB with resources, they work at arm’s length of each other to remain independent.
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.
Thinking back to Clara and her dream of starting a business, imagine that she has received funding from the bank and is already in her first year of business. She has taken accounting in high school just like you, and luckily is able to do her own bookkeeping and accounting. Now consider all the users of the accounting information above.
Create and complete a table like this one to explain how each user would utilize Clara’s accounting information?
| User of Clara’s accounting information | How they would use the information to make a decision |
| Owner | |
| Manager | |
| Creditors | |
| Investors | |
| Government |