Role of Financial Accounting

Relationship Between Levels and Flows

Levels and flows are related. For example, if your salary during a given period of time exceeds your per- sonal expenses, you add to the level of your wealth. To illustrate, assume that as of December 31, 2011, you had the following personal asset:

Cash in checking account $6,000

The $6,000 is the beginning level of your personal asset. During 2012 you earned $40,000 and had personal expenses of $38,000. These are your flows. You deposit the $40,000 in your checking account, and you write checks for $38,000. Therefore, as of December 31, 2012, you had the following personal asset:

Cash in checking account $8,000

The level of your asset increased by $2,000 as a result of the net inflow of resources, i.e., your net income. Since you had a beginning level of $6,000 and net income of $2,000, you had an ending level of $8,000.

The Nature of an Account

The above activities describe the nature of an account. All of financial accounting uses this basic building block. Everything that appears on a set of financial statements is derived from an organization’s accounts, and each account behaves in exactly the same way. Specifically:

• It has a beginning level, called the beginning balance.
• It is increased with inflows and decreased with outflows.
• It has an ending level, called the ending balance.

To illustrate, the behavior of your checking account was as follows:

• Beginning Balance     $6,000
• Inflows                        $40,000          
  Outflows                     (38,000)
  Ending Balance           $8,000.00

The Entity Concept : You may decide to be an investor in your own company This happens all the time. When it does, accountants must distinguish between two entities: you as an individual and your company. Your company may be a sole proprietorship, a partnership, or a corporation. As a sole proprietorship, there is only one owner (and investor)—you. Regardless, of the form chosen, the entity concept holds that, for accounting purposes, the company is a separate entity from its owners. As such, if you decide to form a corporation (by far, the most common business form), you as an individual can invest in or lend money to your corporation. If you do this, the accountants treat you and your corporation as separate entities, and keep separate accounting records for each

Toys FR’ Kids, or TFK. The goal will be to help you understand how a variety of economic events affects the financial status of TFK. Let’s begin with some of the steps you would take to create your new entity. First, since you have raised only $20,000 of the $53,000 that is required to get started, you must find some additional cash.

Let’s assume that you convince a friend to invest $20,000, and a bank to lend you the remaining $13,000 on a one-year note (or loan) at an interest rate of 10 percent (per year). On January 2, 2012, having completed the necessary legal work to form the corporation, you put the $53,000 into a bank account in the name of the corpo- ration, Toys FR’ Kids.

So far, TFK has purchased no toys for resale, has sold nothing, and has no employees. But it does have $53,000 in cash in a bank account. This $53,000 was received from both investors (totalling $40,000) and lenders ($13,000). For financial accounting purposes, the entity must be able to reflect its status as of January 2, 2012. This is the purpose of the balance sheet.