Financial accounting: practice questions with explanations

1What financial accounting does

Financial accounting records everything a business does with money and reports it to outsiders: shareholders, banks, tax authorities. In the EU, listed companies follow the International Financial Reporting Standards (IFRS).

The results are summed up in three main statements:

• The balance sheet (statement of financial position) shows what the company owns and owes at one moment, for example on 31 December.
• The income statement shows revenue, expenses and profit over a period, for example one year. Revenue − expenses = profit (net income).
• The cash flow statement shows cash coming in and going out over the period, split into operating, investing and financing activities.

Think of the balance sheet as a photo and the income statement as a film of the year.

2The accounting equation

Everything a company owns was paid for either with borrowed money or with the owners’ money. This gives the basic equation:

• Assets: what the company owns or controls. Current assets are used or turned into cash within a year: cash, inventory, accounts receivable (money customers owe for sales on credit). Non-current assets last longer: land, buildings, machines.
• Liabilities: what the company owes. Current liabilities, such as accounts payable to suppliers, are due within a year. Non-current liabilities, such as a long-term bank loan, are due later.
• Equity: the owners’ share. It includes share capital and retained earnings, the profits kept in the business and not paid out as dividends.

Every transaction keeps the equation in balance. This is why double-entry bookkeeping records every transaction in at least two accounts, as a debit and an equal credit.

Assets and expenses increase with a debit. Liabilities, equity and income increase with a credit. Example: buying a machine for €5000 cash debits machines (asset up) and credits cash (asset down).

3Accruals: when income and costs count

Under the accrual basis, revenue is recorded when it is earned and expenses when they are incurred, not when cash moves. Expenses are matched to the revenue and the period they belong to (the matching principle).

This creates four kinds of balance at the year end:

• A prepaid expense (prepayment): you paid for something that belongs to next year, such as insurance. It is an asset until it is used.
• An accrued expense (accrual): you used something this year but have not paid yet, such as December electricity. It is a liability.
• Deferred revenue: a customer paid in advance for a service you deliver next year. It is a liability, because you still owe the service.
• An accrued income: you earned revenue but have not been paid yet. It is an asset (a receivable).

Depreciation works the same way. A machine’s cost is spread as an expense over the years it is used, while no cash moves in those years.

This is why profit and cash are different. A profitable company can still run out of cash when its money is tied up in inventory and unpaid customer invoices.

4Reasoning through a case

Most questions describe a transaction and ask how it is recorded. Work through it in four steps:

1. Name the concept: which account, which principle (accruals, prudence, double entry)?
2. Ask which period the transaction belongs to, regardless of when cash moves.
3. Split the amount: the part used this period is an expense or income; the rest is an asset or a liability on the balance sheet.
4. Check that both sides of the accounting equation still balance.

5Common mistakes

• Treating profit as cash. Profit is measured on the accrual basis; cash can be very different.
• Recording a payment as an expense when it belongs to next year. It is a prepayment, an asset.
• Calling customer prepayments revenue. Until the service is delivered, they are a liability.
• Recording dividends as an expense. They are paid out of profit and reduce retained earnings in equity.
• Thinking retained earnings are a pile of cash. They are profits kept in the business, which may be invested in assets.
• Mixing up receivables (customers owe you, an asset) and payables (you owe suppliers, a liability).

6How exam questions look

All questions are multiple choice, with four options.

• Easy: key terms and facts. The accounting equation, the three statements, what counts as an asset or a liability.
• Medium: applying the concepts. Record a transaction, a year-end accrual or prepayment, or calculate a ratio, a depreciation charge or a break-even point.
• Hard: cases and analysis. IFRS rules (revenue, leases, impairment, provisions), group accounts, costing decisions and reading the story behind the figures.

For any transaction, ask which period it belongs to and check that the accounting equation still balances.