RECORDING FINANCIAL TRANSACTIONS 31
2 Profit is not the same as cash flow. Although there has been a profit of £1,000,
the bank balance has reduced by £34,000 (from £50,000 to £16,000).
3 Most of the cash has gone into the new equipment (£25,000), but some has gone
into working capital (again, this is covered in Chapter 6).Working capitalis the
investment in assets (less liabilities) that continually revolve in and out of the
bank, comprising debtors, inventory, creditors and the bank balance itself (in
this case £32,000 less £6, 000 =£26,000).
The distinction between profit, cash flow and capital investment – the purchase of
assets – is a crucial one for accounting. Whether a payment is treated as an expense
(which affects profit) or as a Balance Sheet item (calledcapitalizingthe expense,
and therefore not affecting profit) is important, as it can have a significant impact
on profit, which is one of the main measures of business performance.
Both the Profit and Loss account and the Balance Sheet are described in more
detail in Chapter 6. In financial reporting, as Chapter 6 will show, there are strict
requirements for the content and presentation of these financial statements. One
of these requirements is that the reports (produced from the ledger accounts) are
based on line items.Line itemsare the generic types of assets, liabilities, income
and expenses that are common to all businesses. This is an important requirement
as all businesses are required to report their expenses using the same accounts,
such as rent, salaries, advertising, vehicle running costs etc. While this may not
appear to be significant, it does cause a problem when a business is trying to
make decisions based on cost information, because cost information is needed for
products and services, rather than for line items.
Principles and limitations of accounting.......................
There are some basic accounting principles that are generally accepted by the
accounting profession as being essential for recording and reporting financial
information. These are as follows.
Accounting entity
Financial reports are produced for the business, independent of the owners – the
business and its owners are separate entities. This is particularly important for
owner-managed businesses where the personal finance of the owner must be
separated from the business finances. The problem caused by the entity principle
is that complex organizational structures are not always clearly identifiable as an
‘entity’. The treatment by Enron of joint-venture vehicles that were not part of the
Enron group for financial reporting purposes enabled ‘off-Balance Sheet’ financing
that was a cause of that company’s collapse.
Accounting period
Financial information is produced for a financial year. The period is arbitrary and
has no relationship with business cycles. Businesses typically end their financial