Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Fundamentals of Financial Accounting

Rafał Grabowski

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 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Contents
Introduction ........................................................................................................................................... 4
CHAPTER I Business Environment and Accounting ................................................................................. 5
I.1 Information as a Basis of Wise Decisions about Allocation of Resources ........................... 5
I.2 The General Concept of Accounting.................................................................................... 7
I.2.1 The Definition and Types of Accounting ............................................................................. 7
I.2.2 The Monetary Unit Assumption (Principle) ......................................................................... 9
I.2.3 The Balance Method ........................................................................................................... 9
I.2.4 The Entity Assumption (Principle) ..................................................................................... 12
I.3 Summary............................................................................................................................ 14
I.4 Exercises ............................................................................................................................ 15
CHAPTER II Balance Sheet: the Concept and Recognizing of Assets, Liabilities and Owners’ Equity ... 18
II.1 The General Concept of Financial Statements .................................................................. 18
II.2 The General Concept of a Balance Sheet .......................................................................... 19
II.3 Recognition Criteria of Assets ........................................................................................... 22
II.4 Recognition Criteria of Owners’ Equity and Liabilities ...................................................... 25
II.5 The Actual Layout of a Balance Sheet in Accordance with the Accounting Act ................ 27
II.6 Summary............................................................................................................................ 31
II.7 Exercises ............................................................................................................................ 31
CHAPTER III Business Transactions within the Accounting System (part I)........................................... 37
III.1 Business Transactions and Their Influence on the Financial Position of an Entity ........... 37
III.2 Measurement of business transactions ............................................................................ 41
III.3 Documentation of business transactions .......................................................................... 42
III.4 Recording of business transactions ................................................................................... 44
III.5 Summary............................................................................................................................ 62
III.6 Exercises ............................................................................................................................ 63
CHAPTER IV Profit and Loss Account ..................................................................................................... 67
IV.1 The General Concept of Profit (Loss), Revenues, and Expenses ....................................... 67
IV.2 Recognition and measurement of revenues and expenses .............................................. 70
IV.3 The Division of Income ...................................................................................................... 78
IV.4 Summary............................................................................................................................ 80
IV.5 Exercises ............................................................................................................................ 82
CHAPTER V Business Transactions within the Accounting System (part II) .......................................... 89
V.1 Recording Revenues and Expenses ................................................................................... 89
V.2 Transferring Revenues and Expenses to the “Net Profit (Loss)” Account ......................... 94

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V.3 Summary............................................................................................................................ 97
V.4 Exercises ............................................................................................................................ 97

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Introduction
This manual is designed for students who are starting to learn (study) accounting. It
contains a description of the key issues that are discussed during the course "Accounting".
However, it should be noted that the manual cannot be considered as an alternative to the
lectures - it may be treated only as an addition to the lectures. The manual describes the
theory. However, it also contains examples and exercises that are helpful in understanding
described issues.
This manual was written as a part of the project “Young Teachers Prepare a
Management Course in English” implemented at the Warsaw School of Economics.
Therefore, I offer thanks to all those who initiated and pursued this project.

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CHAPTER I
Business Environment and Accounting

I.1 Information as a Basis of Wise Decisions about Allocation of

Resources
Within the world that we live in, we have to take into consideration an economic
aspect of almost every decision that affects our resources. For example, on a personal level we
have to consider whether we can afford to buy an apartment or a car, or to accept a job and a
salary offered to us. To make wise decisions we need information that enables us to choose
the best solutions. An economic aspect in the decision making process is necessary because:
1. the amount of resources that we possess is limited; and
2. we need these resources to exist and grow.
At a business level we may say the same. Every business entity (also called just an
entity or a company) has its own core business. Hospitals provide health care, car
manufacturers provide vehicles, and so on. In other words, every entity is established to
provide specific products and/or services to its customers. But to do so, to provide those
products and/or services, to exist and grow, entities need resources which are limited. And
that is why to run a company, to sustain its existence and growth, internal managers (also
called internal stakeholders or internal users of information) also have to take into
consideration an economic aspect of their decisions. For example, they may have to decide on
prices, payment terms, salaries, sales, terms and conditions of contracts for the supply of
goods and services. To do so, to make wise business decisions, they need appropriate
information.
However, economic information about a business entity is also needed by others than
just internal managers. This is because no entity is run in isolation. In fact, every company is
run within its own environment. There is no doubt that others (called external stakeholders
or external users of information) within this environment also need information about an
entity. This information is especially needed by others for the purpose of deciding whether
and how to deal with an entity.
There are several principal external stakeholders:
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1. current and prospective investors (for example, shareholders in the case of joint-stock
companies);
2. lenders;
3. suppliers;
4. customers;
5. government and regulatory agencies.
Current investors need information about an entity in order to decide whether to
continue investing in it or not. They also need information to assess the board of directors,
who are responsible for adding value to an entity. Prospective investors, similarly to current
investors, need information in order to decide whether to invest their money in an entity or
not.
Lenders, for example banks, also need information about an entity. The main question
is about the credit capacity of an entity - whether it is and will be able to repay a loan and pay
interest. So, lenders need to decide whether to lend money and to determine the terms of a
loan (for example the value of a loan, repayment date, interest rate, security that is needed,
etc). They also need information to evaluate changes in the credit capacity during the
repayment period.
Suppliers sell goods, raw materials and services to a business entity. They need
information in order to decide whether it is reasonable to sell these goods or services on
credit. The information is needed also, because it helps suppliers predict future demand for
goods and services that they provide.
Customers also need information about an entity. Usually when we do everyday
shopping we are not interested in the financial situation of a supplier or a producer of goods
and services that we buy. However, sometimes when we buy very expensive goods, for
example an apartment or a plot of land, we wonder whether the supplier (the entity) is able to
fulfil its obligations.
Unlike external stakeholders mentioned above (investors, lenders, customers,
suppliers), government and regulatory agencies do not need information mainly for the
purpose of deciding whether and how to deal with a business entity. They need information
primarily for the purpose of performing their roles that were established by law. For example,

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in Poland there is Central Statistical Office which is responsible for collecting and publishing
statistics (also financial statistics) related to the Polish economy, society, and population.
As we may conclude, appropriate information is crucial to make wise decisions that
affect resources. This statement is related to the personal and business level. In this book the
attention will be paid on the business level. The rest of the book is devoted to fundamentals of
the system that provides financial information about a business entity. This system is called
accounting.

I.2 The General Concept of Accounting

I.2.1 The Definition and Types of Accounting

Accounting is a system designed to collect, accumulate, process and communicate

economic information about a business entity. The most important function of this system is
communication. To do so accounting uses specific terms. These terms enable people to
communicate about financial aspects of business entities, and that is why accounting is often
called “the language of business”.
In theory accounting is divided into: financial accounting and managerial
(management) accounting. There are several features that constitute the basis of the
distinction between financial and managerial accounting. The three most commonly used are:
the sort of users of accounting information, the range of rules that should be applied, and the
period of time that the type of accounting focuses on (tense).
Financial accounting is aimed to satisfy information needs of external stakeholders.
To ensure that they will obtain appropriate information, financial accounting is heavily
regulated within the law or within the generally accepted standards. In accordance with these
regulations business entities must prepare and publish specific reports which are called
financial statements. Financial statements are focused primarily on the past. Generally, they
inform about resources, liabilities, and owners’ equity as at a specific point in time, but also
about past performance obtained during a specific period of time.
Information that is generated within a financial accounting system is not only used by
external stakeholders, but also by internal managers. However, the latter need also other
information that is provided by managerial accounting.

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Managerial (management) accounting is focused on the information needs of

internal managers. In this case information is provided in the form of reports which are not
regulated within the law or within the generally accepted standards. The guidelines for
preparers of reports are: knowledge and managers’ preferences. Managerial accounting, as
opposed to financial accounting, is primarily focused on the future. It is because managers
need information not only to evaluate past performances, but also to predict and make
decisions on the basis of these predictions.
The division of accounting into financial accounting and managerial accounting is the
most often. However, it must be emphasized that within the literature there are a lot of
dissertations devoted to the so-called tax accounting which is concentrated on assessment of
taxes, especially on income tax and value-added tax (VAT). Similar to the financial
accounting, tax accounting is heavily regulated and focused on the past. Although usually tax
accounting is regulated separately from financial accounting, to some extent financial
accounting regulations and tax provisions are similar, but there are also many differences.
Managerial accounting and tax accounting are beyond the scope of this book. This
book is devoted to the fundamentals of financial accounting and includes theoretical
explanations of the fundamentals, but also description, how these fundamentals are regulated.
This follows from the fact that in reality all accountants and users of financial accounting
information should know theory, but also accounting regulations that must be applied.
Generally, the basic set of accounting regulations in Poland is the Accounting Act of
29 September 1994. The Act regulate, among other things, how to keep the books of
accounts and how to prepare financial statements. Entities which must apply the Act are
specified in article 2. Some of them must keep the books of accounts and prepare financial
statements in accordance with the Accounting Act. However, there are also others who must
keep the books of accounts in accordance with the Accounting Act, but prepare financial
statements in accordance with the International Accounting Standards/International
Financial Reporting Standards (IAS/IFRS). The text in this book refers only to the
Accounting Act.

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I.2.2 The Monetary Unit Assumption (Principle)

Accounting is a system designed to collect, accumulate, process, and communicate

economic information about a business entity. To use an accounting system and information
generated by it, it is necessary to know “the rules” of accounting. Within this chapter three of
them are described:
1. the monetary unit assumption / principle;
2. the balance method;
3. the accounting entity assumption / principle.
The monetary unit assumption, also called the monetary unit principle, assumes
that the monetary unit is a common denominator, which is used within each accounting
system in order to collect, accumulate, process, and communicate information about an entity.
Usually the sort of monetary unit which should be used within an accounting system depends
on a country, where a business entity is located. For example, business entities that are located
in Poland must use PLN as the monetary unit within their accounting systems.
For accountants the first and most important characteristic included in an accounting
system is a value expressed in terms of money. Within a system of accounting other features
matter only when they influence the value expressed in terms of money. It means that
although other characteristics may be very interesting (a colour, a shape, an usefulness, an
attractiveness, a taste, a size, etc.) they have nothing to do with accounting if they don’t
matter for the value expressed in terms of money. For example, it is not accounting’s
responsibility to collect, accumulate, process, and communicate information about
architectural styles of buildings that were acquired by an entity. However it is accounting’s
responsibility to collect, accumulate, process and communicate information about the value of
those buildings. Does it mean that in this case architectural styles do not matter for
accountants? This is not entirely true. The architectural styles will matter if they influence the
value of the buildings.

I.2.3 The Balance Method

Another basic and very important “rule” is the balance method. This method may be
illustrated by a saying “every coin has two sides”. It requires us to describe an entity in a
special way – from two points of view.

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From the first point of view we should describe an entity in terms of resources and
their value. In other words we should answer the following question: what groups of resources
does our entity control (possess1) and what is the value of each particular group of these
resources? By answering this question we indicate assets.
From the second point of view we should describe an entity in terms of sources of
assets funding. In other words we should answer the following question: what sources of
assets funding are there and how much (what value expressed in terms of money) was funded
by each group of these sources? By answering that question we may indicate two main groups
of sources: liabilities and owners’ equity (to be explained later).

Exhibit I.1 A business entity viewed by applying the balance method

A business entity

Assets Liabilities and owners’ equity

(resources) (sources of assets funding)

Since each penny has its source of funding, we may conclude that the total value of
assets is always equal to the total value of sources of assets’ funding (liabilities + owners’
equity). This statement is called accounting equation and is written as follows:

Assets = Liabilities + Owners’ Equity.

In accordance with the Accounting Act assets are “resources of a reliably estimated
value controlled by an entity, resulting from the past events, and causing in the future the
inflow of economic benefits to the entity”. Examples of assets are: cash, raw materials,
equipment, plants (manufactures), etc.
1
Within a financial accounting system ”control” means almost the same as “possess”. There is one exception in
the case of capital lease. This issue is beyond the scope of this book, so at this stage you may assume that
“control” means the same as “possess”.

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Liabilities are defined in the Accounting Act as “entity’s obligations arising from the
past events to provide goods, or services of a reliably estimated value, and which will involve
the use of existing or future assets of the entity”. The obligations, that are called liabilities,
may be fulfilled by making payments, supplying goods or providing services. The way that an
entity will fulfil its obligations will depend on the terms of the agreement. For example, if our
entity buys raw materials on credit than it usually has to pay its liabilities by cash or by a bank
transfer. In another situation it may occur that our entity’s customer will pay in advance. In
this case, our entity will probably be obligated to provide specific goods or services to its
customer.
Liabilities constitute first sort of sources of assets funding. The second is owners’
equity. Within the Accounting Act owners’ equity is defined indirectly. It is only written that
“net assets mean assets of an entity net of its liabilities, equal in their amount to the entity’s
equity”. Transforming accounting equation we may write it as follows:

Net Assets = Assets – Liabilities = Owners’ Equity

However, the question about the meaning of owners’ equity still remains.
Owners’ equity is also source of assets funding. There are several situations in which
owners’ equity arises. For each business entity the first situation (as regards to chronology)
when owners’ equity arises is the establishment of this entity. The owners’ equity that arises
under such circumstances is called share capital. Owners, who establish a business entity,
contribute to their entity (insert in their entity) resources: money, equipment, tracks, and so
on. Thus, on the one hand such an entity obtains resources (assets), but on the other hand a
sort of the entity’s obligation to its owners arises. This obligation is called initial capital and is
very distinct from liabilities - there is not due date. It does not mean that this obligation must
be fulfilled on demand. Quite the opposite, there are only a few and specific situations
(circumstances) when this obligation must be fulfilled. And that is why there is a saying that
owners’ equity is the safest source of assets funding.

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Example I.1 The application of the balance method

Assume that Mr. X and Mr. Y decided to establish a company Z. On 1 of March they
wrote an agreement according to which they should contribute (invest) to the company:
 Mr. X –building worth PLN 80 000.00; and
 Mr. Y – PLN 70 000.00 cash.
They contributed to the company the building and cash on the same day (1 March). On 2
March the company obtained a credit (PLN 10 000.00), so the bank transferred money into
the entity’s account.
On the basis of these assumptions we may – using balance method – describe the
entity as follows.
1. Balance sheet as at 1 March
Assets Value Liabilities and owners’ equity Value
Buildings 80 000.00 Owners’ equity 150 000.00

Cash 70 000.00 Liabilities 0.00

Total assets 150 000,00 Total liabilities and owners’ equity 150 000,00

2. Balance sheet as at 2 March

Assets Value Liabilities and owners’ equity Value
Buildings 80 000.00 Owners’ equity 150 000.00

Cash 80 000.00 Liabilities 10 000.00

Total assets 160 000.00 Total liabilities and owners’ equity 160 000.00

The report that includes assets, liabilities, and owners’ equity is called balance sheet
and will be described in detail in the next chapter.

I.2.4 The Entity Assumption (Principle)

The third and the last rule that is included in this chapter is the accounting entity
assumption (also called accounting entity principle). This assumption holds that within the
accounting system of particular entity this entity must be viewed separately from her owners
and other companies. It means that within the financial accounting system of a particular
entity we should include only:
1. assets of this entity and transactions that affect them (assets);
2. liabilities of this entity and transactions that affect them (liabilities);

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3. equity of this entity and transactions that affect it (equity);

4. other information that must be included within financial statements prepared by this entity
in accordance with accounting regulations.
All these assets, equity, liabilities and other information must be viewed from the entity’s
point of view.
“If this assumption were not made, personal economic activities of the owners (e.g.
purchase of a home, the payment of a child’s college tuition) would be merged with the
transactions of their business, thus combining the affairs of two separate and distinct units.
The resulting financial statements constructed to report the business’s financial health and
profitability, therefore, would not be meaningful.
The entity assumption also notes that a firm should be viewed aside and apart from
other firms. Imagine the difficulty of performing a detailed analysis of the computer industry
if the operations of IBM could not be distinguished from those of Apple. These are two
separate units and their activities must be accounted for accordingly. The entity thus requires
the establishment of segregated accounting systems and individual sets of financial records
for each business enterprise”.

Example I.2 The application of the entity assumption (principle)

Assume that Mr. X and Mr. Y decided to establish a joint-stock company Z. On 3
April they wrote an agreement according to which they should on 4 April contribute to the
company:
 Mr. X – two trucks worth PLN 300 000.00 and PLN 100 000.00 cash;
 Mr. Y – PLN 300 000.00 cash.
According to the agreement each of them should obtain shares:
 Mr. X – 400 shares (each worth PLN 1 000.00);
 Mr. Y – 300 shares (each worth PLN 1 000.00).
However, on 3 April Mr. Y had only PLN 200 000.00, so he borrowed PLN 100 000.00 from
a bank L. After that, on 4 April Mr. X and Mr. Y contributed to the company the trucks and
money.

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On the basis of these assumptions we may – using the balance method and the
accounting entity principle – prepare a balance sheet of the joint-stock company Z as at
4 April.
Assets Value Liabilities and owners’ equity Value
Trucks 300 000.00 Owners’ equity 700 000.00

Cash 400 000.00 Liabilities 0.00

Total assets 700 000.00 Total liabilities and owners’ equity 700 000.00

Assets of the entity Z amounted to PLN 700 000.00 and consist of trucks (PLN
300 000.00) and cash (PLN 400 000.00). Owners’ equity includes only initial capital and
amounted to PLN 700 000.00. Liabilities of the entity Z amounted to PLN 0.00 – that is
because of the accounting entity assumption. In accordance with the accounting entity
assumption PLN 100 000.00 that was borrowed by Mr. Y is not the entity’s loan. This is Mr.
Y’s loan and liability.

I.3 Summary
Within the world that we live in, we have to take into account an economic aspect of
almost every decision that affects our resources. In order to make wise decisions we need
information. This statement is appropriate at a personal level, but also at a business level. At a
business level information is needed by internal stakeholders (internal managers), but also by
external stakeholders (investors, lenders, suppliers, customers, government and regulatory
agencies).
A system that is designed to collect, accumulate, process, and communicate
information about a business entity is called accounting. In theory accounting is primarily
divided into financial accounting and managerial (management) accounting. However, there
are a lot of dissertations devoted to the so-called tax accounting. Therefore we may say that
tax accounting constitutes the third type of accounting.
Managerial accounting and tax accounting are beyond the scope of this book which is
devoted only to financial accounting. Financial accounting is focused primarily on
information needs of external stakeholders. To ensure that they (external stakeholders) obtain
appropriate information, financial accounting is heavily regulated within the law and within

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the generally accepted standards. The main set of accounting regulation in Poland is the
Accounting Act.
To use an accounting system and information generated by it, it is necessary to know
“the rules” of accounting. Within this chapter three of them were described:
4. the monetary unit assumption / principle;
5. the balance method;
6. the accounting entity assumption / principle.

I.4 Exercises

Exercise I.1 The application of the entity assumption (principle)

Assume that Mr. Johnson and Mr. Smith decided to establish a company J&S Ltd. On
2 May they wrote an agreement according to which they should on 5 May contribute to the
company:
 Mr. Johnson – a building worth PLN 300 000.00 and PLN 150 000.00 cash;
 Mr. Smith – machines worth PLN 200 000.00 and PLN 250 000.00 cash.
According to the agreement each of them should obtain shares:
 Mr. X – 450 shares (each worth PLN 1 000.00);
 Mr. Y – 450 shares (each worth PLN 1 000.00).
However, on 2 May Mr. Johnson had only PLN 50 000.00, and Mr. Smith had only PLN
100 000.00. So they borrowed:
 Mr Johnson - PLN 150 000.00 from a bank X; he decide to spend PLN 50 000.00 on a
new car;
 Mr. Smith – PLN 150 000.00 from a bank Y.
After that, on 5 May Mr. Johnson and Mr. Smith contributed to the company resources.
Required
Describe the company J&S Ltd. Using the balance method and the accounting entity method.
Assets Value Liabilities and owners’ equity Value

Total assets Total liabilities and owners’ equity

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Exercise I.2 Multiple Choice Questions

1. Internal users of information (the so-called internal stakeholders) include:
a) Customers
b) Suppliers
c) Managers
d) Lenders
e) Investors
2. The type of accounting that is primarily focused on information needs of internal
stakeholders is:
a) Financial accounting
b) Managerial (management) accounting
c) Tax accounting
d) Fraud accounting
3. External stakeholders include:
a) Government and regulatory agencies
b) Suppliers
c) Customers
d) Internal managers
4. The principle that requires every business entity to be accounted distinctly and separately
from other entities and its owners is known as:
a) The balance method
b) The monetary unit assumption
c) The accounting entity assumption
d) The matching principle
5. The difference between a business entity’s assets and its liabilities is also called:
a) Owners’ equity
b) Net assets
c) Total assets
d) Total liabilities and equity

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6. Creditor’s claims on a company’s assets are called:

a) Liabilities
b) Net assets
c) Owners’ equity
d) Total assets
7. The accounting equation may be written as follows:
a) Assets + Liabilities = Owners’ equity
b) Assets + Owners’ equity = Liabilities
c) Owners’ equity + Liabilities = Assets
d) Assets – Liabilities = Owners’ equity
8. Which statement about assets is true?
a) Assets are resources controlled by an entity.
b) Assets are expected to provide economic benefits in the future.
c) Assets are obligations to provide goods or services to other entities.
d) Assets are sources of resources funding.
9. If owners’ equity of an entity increased by PLN 20 000.00 during the period of time, and
liabilities decreased by PLN 12 000.00 during the same period, the value of assets of the
entity:
a) Increased by PLN 8 000.00
b) Decreased by PLN 8 000.00
c) Increased by PLN 32 000.00
d) Decreased by PLN 32 000.00
10. The main set of accounting regulations in Poland is included in:
a) The Accounting Act
b) The International Accounting Standards
c) The International Financial Reporting Standards
d) The Commercial Code

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