Unit 1 · Why Accounting Exists
1-1 What Accounting Is, and Who Uses It
Mariam opens a small bakery in Alexandria. She buys ovens, flour and sugar, and hires two workers. After three months she feels busy — but she does not know whether she is making a profit, whether she owes money, or whether she can expand. She has receipts. She does not have a system.
Guiding question
Why does every successful business depend on accounting? (p.9)
Learning outcome. By the end you can say what accounting is in the book’s own words, name the six people who use it and what each one wants to know, and show with numbers why a business can be full of customers and still be failing.
The definition, and the three questions behind it
Accounting is the process of recording, summarizing, and presenting financial transactions in the form of reports. Learn that sentence — it is the book’s own, and an exam will accept it as it stands.
But a definition is easier to hold on to when you know what it is for. The book says accounting answers three questions, and every single thing you will do this year is one of these three in a different costume:
Question 1
What assets does the business own?
The oven, the flour, the money owed to her.
Question 2
What liabilities does it owe?
The unpaid rent, any loan, any supplier bill.
Question 3
Is it generating a profit?
The one Mariam thought she had answered.
An asset is something the business has that is worth something — cash, an oven, flour in the store, or money a customer still owes it.
A liability is something the business owes to somebody outside it — rent not yet paid, a bank loan, a supplier’s bill.
Profit is what it earned, minus what that earning cost. Notice that the word “cash” does not appear in that sentence. That is not an oversight.
Here is the thing that makes accounting necessary rather than merely tidy. Mariam’s bakery has eight ordinary events in it. Nothing dishonest happens. We are going to add them up twice — once asking “how much money moved?” and once asking “what did she earn, and what did it cost?” — and get two different answers.
Press Play, or step through it one press at a time. Go slowly on step 4.
Step 1 of 6 — Three months in Mariam’s bakery
Eight ordinary things happened. She bought an oven, bought flour, paid two workers, sold bread, sold cakes to a café that has not paid yet, paid most of the rent, and took a little money for herself. Nothing unusual, nothing dishonest.
The eight figures are invented for teaching — the book gives Mariam no numbers at all. What is not invented is the arithmetic: the cash total, the profit total and every line of the bridge are recomputed from the same eight events, and the bridge is checked to close exactly. Keep the book’s own wording for the exam — accounting is the process of recording, summarizing, and presenting financial transactions in the form of reports — and keep this picture for knowing why she could not answer her own question from a shoebox of receipts.
🧮 The same thing worked by hand, one line at a time
- 1
Add up everything that went INTO the drawer: 50,000 from Mariam + 60,000 of bread sold over the counter = 110,000.
Why this step: This is the easy half and it is the half most people stop at. Two events, both of them money arriving. Notice the café’s 9,000 is not here — the café has not paid.
- 2
Add up everything that went OUT: 30,000 oven + 24,000 ingredients + 18,000 wages + 6,000 rent paid + 4,000 Mariam took = 82,000.
Why this step: Again, only what actually left the drawer. The 3,000 of rent she still owes is not here, because she has not handed it over.
Most people slip here: Do not sneak the unpaid rent in. This column is about money that moved, and that 3,000 has not moved.
- 3
Cash in the drawer = 110,000 − 82,000 = 28,000. She started with nothing, so the money went UP by 28,000.
Why this step: And here is where Mariam stops, feels reassured, and gets it wrong. The number is perfectly correct. It is simply the answer to a question she was not really asking.
- 4
Now start again and add up what she EARNED: 60,000 of bread + 9,000 of cakes = 69,000.
Why this step: The cakes count. She baked them, the café took them, they are gone from her shop and the café owes her — the earning is finished. Whether the money has arrived is a separate matter. Her own 50,000 does NOT count, because putting your own money in is not earning it.
Most people slip here: This is the single most common mistake in this whole unit: treating the owner’s own money as though the business had earned it.
- 5
Add up what the earning COST: 24,000 ingredients + 18,000 wages + 9,000 rent for all three months = 51,000.
Why this step: The full 9,000 of rent, not the 6,000 she paid. She used the shop for three months, so three months of rent is a cost of those three months. The oven is not here at all — she still has it, so nothing has been used up. Nor is the 4,000 she took: the bakery did not consume that, Mariam did.
Most people slip here: The oven is the other classic trap. 30,000 left the drawer, and not one pound of it is an expense.
- 6
Profit = 69,000 − 51,000 = 18,000.
Why this step: So she did make a profit — a real one — but 10,000 less than her drawer led her to believe, and for five separate reasons.
- 7
Check the gap closes: 18,000 + 50,000 − 30,000 − 9,000 + 3,000 − 4,000 = 28,000.
Why this step: Start at the profit and walk to the cash: add the money she put in, take off the oven, take off the sale not yet paid for, add back the rent not yet paid, take off what she withdrew. It lands exactly on 28,000 — nothing left over. A system that can show you where every pound of a difference came from is what the word "accounting" actually means.
Most people slip here: If a reconciliation does not close exactly, you have not "nearly" got it. You have got it wrong, and something is still unexplained.
Where the comparison breaks down: A tracker measures something real and just measures too little of it. Cash is worse than incomplete — it can point the wrong way entirely, showing a rise in the very months a business is sliding under.
Mariam is not the only person who will ever open these records. The book lists six users — it calls them stakeholders — and gives each one a reason. The reasons are worth more than the list, because an exam question will describe a situation and ask you which user it is.
One set of records, six readers
Mariam keeps one set of accounts. Six different people will open it, and each of them is looking for something different. Press a person to see what they came for.
The book calls these people stakeholders. They disagree about almost everything — an owner wants profit to look strong, a tax authority wants it declared honestly, a worker just wants the shop open next year. They agree on one thing: the figures have to be trustworthy. That agreement is the whole reason accounting has rules.
Now the book’s question (p.10) — identify the main user
Decide before you press. Getting it wrong here costs nothing and teaches more than getting it right by luck.
1. A bank reviewing a loan request →
2. A shareholder deciding whether to buy shares →
3. The tax authority →
What they all have in common
These six want different things and some of them want opposite things. The book’s point is what happens anyway:
They share a common need: access to relevant financial information. Therefore accounting information must be objective, consistent, and based on established accounting principles. If the information is unclear or manipulated, decisions become unreliable, and the economy may be adversely affected. (p.10)
Read that last clause slowly, because it is doing more work than it looks. It is not saying bad accounts are untidy. It is saying that banks lend, investors invest and people take jobs on the strength of these figures — so when the figures cannot be trusted, the damage does not stop at one bakery.
Accounting does not operate randomly. Because six different readers have to be able to rely on the same figures — and to compare this year against last year, and this bakery against another one — the way things are recorded cannot be each business’s own invention. The book gives four principles.
- Prudence (Conservatism)
- — Exercise caution. Potential losses should be recognised as soon as they are foreseeable, whereas profits should only be recognised when they have been realized. (p.11)
- Matching
- — Expenses must be recognised in the same accounting period as the revenues they help generate, so that profit is measured accurately and fairly. (p.11)
- Consistency
- — Use the same accounting policies and methods across different accounting periods, enabling fair and meaningful comparisons of financial results over time. (p.11)
- Accrual basis
- — Revenues and expenses are recorded when they are earned or incurred, regardless of when cash is received or paid. (p.11)
- Cash basis
- — Financial transactions are recorded only when cash is actually received or paid. (p.12)
Matching — put the cost in the same period as the sale it helped make. Mariam’s three months of rent belong to the three months of bread she sold with it.
Consistency — do it the same way every year. If you change the method you also change the answer, and then nobody can tell whether the business improved or only the bookkeeping did.
Accrual — record it when it happens, not when the money moves. This is the one you already used: the café’s 9,000 counted, and so did the unpaid rent.
🧮 Which principle is each of Mariam’s five awkward rows?
- 1
The café’s 9,000, counted as a sale before any money arrives → the ACCRUAL basis.
Why this step: The earning is complete: the cakes are baked, delivered and gone. Accrual says record it when it is earned, regardless of when the cash comes.
- 2
The full 9,000 of rent counted, though only 6,000 was paid → MATCHING (and accrual).
Why this step: She used three months of shop to make three months of sales. Matching says the cost sits in the same period as the revenue it helped generate; putting only 6,000 in would flatter these three months and punish the next one.
- 3
If the café now looks unlikely to pay, reduce the 9,000 straight away → PRUDENCE.
Why this step: Foreseeable losses go in as soon as they are foreseeable. Note the asymmetry: she may NOT record a sale she merely hopes to make, but she MUST record a loss she merely fears.
Most people slip here: Prudence is not pessimism for its own sake. It is a deliberate lean, because an owner who is deceived by their own optimistic accounts keeps trading until the money is gone.
- 4
Whatever she decides about the café, she must decide the same way next year → CONSISTENCY.
Why this step: If she writes off doubtful customers this year and not next, her profit will move for a reason that has nothing to do with the bakery, and no comparison between the two years means anything.
- 5
The oven (30,000) and her own withdrawal (4,000) are neither revenue nor expense → not a principle at all, a CLASSIFICATION.
Why this step: These two are not judgement calls. The oven is an asset because she still has it; the 4,000 is a reduction of what the business owes her, not a cost of baking. Getting this wrong is not imprudent — it is simply wrong, and Unit 4 has a name for it: an error of principle.
Match each description with the choice that fits it.
A business expects some customers will not pay, so it records a bad debt expense instead of assuming all money will be collected.
A company delivers goods in December but gets paid in January, so it records the revenue in December.
The cost of producing goods is recorded in the same period the goods are sold, not when they were made.
A company uses the same depreciation method every year, allowing financial results to be compared fairly.
Mark each statement ○ if it is true or × if it is false. Decide before you press.
Accounting is mainly a matter of doing arithmetic carefully.
If a business’s cash balance rises over a year, the business made a profit.
Money the owner takes out of the business for herself is an expense of the business.
A sale made on credit is recorded as revenue even before the customer pays.
Prudence means recording expected losses early but waiting until profits are realized.
Buying an oven for 30,000 cash reduces the profit by 30,000.
Exam-style — the three questions accounting answers (p.10)
Using Mariam’s three months, answer the three questions the book says accounting exists to answer. Write your answer before you open the solution.
One of you argues that Mariam should simply watch her cash, because cash is what pays the wages and cash cannot be argued with. The other argues she must measure profit, because cash told her she was 10,000 better off than she was. Swap sides after two minutes. Both positions have something real in them, and noticing what is right about the one you disagree with is exactly the skill the JRE essay at the end of this unit is marked on.
How the real paper is built
The ministry sets half multiple choice and half written answer in every subject. The two halves are not the same skill. In the multiple-choice half you have to spot the wrong options quickly — and the wrong options are built out of the mistakes students really make. In the written half nobody gives you the answer to recognise; you have to produce it, in your own words, with a reason.
Practise both. Being good at one half and weak at the other costs you exactly half the paper.
In a New Context
A friend runs a phone-repair stall. He tells you that business is excellent, because the money in his box has doubled since January. You ask three questions and discover: he put in his own savings in February; he bought a soldering station that he still has; and four customers have collected repaired phones promising to pay “next week”.
Which of these three makes his box look better than his profit, and which makes it look worse? Explain each one in a sentence, and then tell him what he should measure instead.
Lesson Question — Answered
Why does every successful business depend on accounting?
Because the things an owner most needs to know are the things that cannot be seen directly. Mariam could see her customers, her ovens and her cash, and not one of those told her whether the bakery was working. Accounting is the system that turns what happened into figures that answer the three questions — what is owned, what is owed, whether a profit was made — and it does it by agreed rules, so that the same figures also serve the five other people who will need to read them. Without it, as the book puts it, profit would be guesswork, growth would be illusion, and financial success could not be distinguished from temporary cash flow. (p.3)
Keep reading — this lesson marks itself done automatically.