Financial Accounting: Why Profit Is Not Cash
A tour of financial accounting, from the accounting equation and double entry to accruals, the three financial statements and the IFRS framework.
Try 3 questions
1. A bakery in Lima borrows 10,000 from a bank. How does the accounting equation change?
- Liabilities rise and equity falls by 10,000
- Assets and equity both rise by 10,000
- Assets and liabilities both rise by 10,000
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Answer: Assets and liabilities both rise by 10,000
The cash received is an asset, and the obligation to repay it is a liability of the same amount; equity is untouched because borrowing is not income.
2. If a company's liabilities are larger than its assets, what is its equity?
- Zero, since equity cannot be negative
- Positive, since owners invested capital
- Negative, a deficit for the owners
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Answer: Negative, a deficit for the owners
Equity is simply assets minus liabilities, so when liabilities exceed assets the result is a negative balance, often called a shareholders' deficit.
3. A company pays a supplier 2,000 it already owed for past purchases. What happens to the accounting equation?
- Assets and liabilities each fall by 2,000
- Expenses rise and equity falls by 2,000
- Assets fall and equity falls by 2,000
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Answer: Assets and liabilities each fall by 2,000
The expense was recognized when the goods were received; paying the debt later just swaps cash for the payable, shrinking both sides equally.
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