INTRODUCTION

At the end of the previous chapter, we considered a simple numerical example of a business and used this to illustrate three basic financial statements, which summarise the economic activity of the firm during a period, within the framework of accrual accounting. These were the balance sheet, the profit and loss account, and the flow of funds statement. In this chapter, we shall explore the accounting framework with two objectives. Firstly, we need to understand how transactions can be recorded and ordered systematically in order to prepare the summary statements: the way in which our numerical example was constructed was informal and would have been cumbersome to use if there had been more transactions. Secondly, in understanding how the statements are constructed from individual transactions, we hope to understand more about the properties of the statements and the relationship between them.

THE BALANCE SHEET

The balance sheet is the fundamental accounting statement. This does not necessarily mean that it is the most important statement: that is a matter for users of accounts and many would prefer the profit and loss account if they were allowed to see only one statement. However, the balance sheet is fundamental in that it expresses the basic identity which underlies all double entry accounting.

In the previous chapter, we saw that the balance sheet contained a list of assets on one side (the right-hand side in the UK: the left-hand side in the USA) and liabilities on the other side, together with the proprietor's capital, which provided the balancing item.