Accounting

General principles

Note to the reader

• This presentation was given twice, with minor variations– Slides from 3 to 37 correspond to the first time– Slides from 38 to 66 correspond to the second

time

• It may be beneficial to read through all the slides to study in depth the concepts presented

Accounting

• It is a set of procedures to monitor the activity of a firm

• The basic elementary activity of a firm is a TRANSACTION (it is the « atom » of operations)

• A transaction is an EXCHANGE two ways between the firm and the outside world

A transaction : TWO MOVEMENTS

• A transaction is TWO MOVEMENTS• One from the firm to the outside world : goods,

services, value, or money leave the firm• One from the outside world to the firm : goods,

services, value, or money enter the firm• When thinking about a transaction always think

about the two movements, and the two accounts involved

• DOUBLE ENTRY accounting

The DOUBLE « reflex »

• It is not a usual reflex because we are used to our checkbook accounting where we only focus on one account

• We are used to thinking about one account for one transaction (I sell -> Sales account)

• BUT WE MUST DEVELOP THE TWO ACCOUNT REFLEX : I sell -> Sales and Cash, or Sales and a Debtor…

Second most important concept in accounting :

consumption vs durable acquisition• The simplest transactions are purchase of

something :• Always ask the question : « Is it a consumption

(that is, or will be, consumed quickly) or is it a durable acquisition ? »

• For example : – I pay the rent : Consumption– I buy a machine for my mfg process : Durable

acquisition– I buy goods for resale : Consumption (the Purchases

of goods for resale are a consumption ; they will leave the firm quickly)

MOVE

• The purchases MOVE through the firm, as quickly as possible

• They are a consumption of the accounting period (possibly with some adjustments for the end of the year)

• Firms make money through movements of goods

• Nothing drives a shopkeeper more nuts than goods that stay on the shelves

A creditor

• In which situation does creditor to our firm appear ?

• Well : when we buy some things and do not pay with cash or check. In that case the supplier must accept « a promise of payment » from us, that is grant us CREDIT (a creditor is some one who trusts us)

• It is someone to whom we owe money for a while

• The creditors « believe » in us. They must trust us when we say that we shall pay them later

The first two steps

• A transaction is the elementary operation of a firm

• First we record it in plain english into the journal. Don’t hesitate to be wordy in the journal

• Second : POST the transaction into two accounts. That is understand the TWO MOVEMENTS and the two accounts involved and make the TWO ENTRIES

Liquidity

• An asset is liquid if it is easy to exchange• It is easier to exchange a banknote of 10 euros

for a meal, than a IOU of 10 euros (from somebody else) for the meal

• « Liquid » = « easy to exchange »• Cash is the most liquid asset• (good) debtor paper is the next one• Cockoo clocks are next• Machines are last

Entity rule

• One of the fourteen rules of accounting (guidelines on how to proceed when we hesitate)

• One of the Boundary rules subset

• It says : do not confuse the firm with other entities like for instance its owner

• The owner is part of the outside world of the firm

Date of a sale

• It is the date of change of ownership

• It is not the date of signature of the agreement• It is not the date of payment with cash

• Can a sale be paid for a date other than its recording date ? Ans. YES, but something must be given at the date of the sale (an IOU)

• We shall never ship some goods without getting at least a piece of paper acknowledging the receipt (and therefore the debt) from the client

Joe’s company sold goods to Mary’s co

• This is ONE transaction• What are the TWO MOVEMENTS ?

– Goods leave the firm (physically)– In the most favorable case cash enters the firm

• The sales account will get the entry for the first part of the double entry (a credit)

• The cash account will receive the other part (a debit)

• Mary can also pay with a check or with a promise

Legal tenders and IOU’s

• We do not need to record where (or from whom) a cash payment comes from. Because banknotes are LEGAL TENDERS.

• IOU’s are not legal tenders. We could not record who they come from and use a large « DEBTORS account » but we would lose important information to run our firm

• We do not have accounts « cash from Mary », « cash from Scott », etc. But we DO have debtors accounts by name

Mary’s point of view

• The transaction « Joe sold goods to Mary » is also a transaction for Mary’s firm

• Mary(‘s firm) bought some goods from Joe’s

• We are told these goods are for resale. Therefore we debit, in MARY’s ACC SYST, the purchases account

The posting of the transactions from the journal

• Each transaction corresponds to 2 Movements and 2 Accounts

• First transaction (as usual) : « the owner puts money into his firm ».– Money enters the firm– A piece of paper goes from the firm to

Edward’s files (if there were several owners we would call these pieces of paper SHARES, or STOCKS)

Shareholders

• If ten friends decide to found a firm together, each puts 1000 euros into the firm, each becomes a shareholder (or stockholder)

• Here the pieces of paper received by the founders become clearer

• These stocks can be traded on a market called the STOCKMARKET

Edward puts cash into his firm

• Debit the cash account

• Credit the capital account

• None of these are consumption

• None of these accounts are revenue accounts

• We are not yet concerned with consumptions to create sales

Edward’s buys a van on credit from Perkin’s garage

• One transaction : TWO MOVEMENTS– A van arrives in the firm– Edward gives a PROMISE (to pay in a while)

• Debit the van account

• Credit an account recording that we owe money to someone : to PERKIN’s. In order to have a good view of our operations we must record that it is to Perkin’s

Settling Perkin’s account by check

• A transaction : TWO MOVEMENTS

• What leaves the firm ?– Ans. A check

• What enters the firm ?– Ans. We get back the IOU that we had given

Perkin’s

Rents premises. Pays one quarter by check

• One transaction : TWO MOVEMENTS• Something leaves the firm• Something enters the firm• What leaves the firm ?

– Ans. A check (for 1000 euros)

• What « enters » the firm ? (Hint : it is not concrete, it is a consumption)– Ans. « the disposal of the premises for one quarter »

• Credit the bank account• Debit the rent account

Buys goods on credit from Roy Ltd

• A transaction = how many movements ?– Ans. 2 (always)

• What enters the firm ?– Ans. Goods (for resale, otherwise we would call them differently)

• What leaves the firm ?– Ans. An IOU (4000 euros)

• Credit Roy’s account (remember that we open an account named Roy’s for our convenience. Roy doesn’t care… It is not under the responsibility of Roy !)

• Debit the Purchases account

In Roy’s firm…

• In Roy’s firm there is an accounting system.

• In this accounting system Roy opened an account named Edward’s account

• Who is in charge of the writings in this account ?– Ans. Roy !– It is an account Roy created to remember that

Edward owes him money– It’s none of Edward’s business

Back to Edward’s : Pays shop expenses by check

• One transaction : 2 movements• What leaves the firm ?

– Ans. 1500 euros in check

• What enters the firm ?– Ans. Things or services to run the firm– Example : the janitor, the window cleaning liquid, the

new door mat, coffee for the coffee machine, rolls for the cash register

• These are consumptions, they will end up in the P&L account

Posting all the transactions and then balancing the accounts…

• The trial balance is the list of accounts balances

• This is the first step before preparing the P&L and the Balance sheet

• In order to establish the P&L we shall select all the revenue accounts (the consumption accounts and the sales)

Establish the Trial balance

• List all the account balances• Do not mix up the assets accounts and the

creditors accounts– For instance do not mix up the Van account

and Perkin’s garage account– The van account will carry a figure of 3000

euros (that we shall depreciate as we « consume » the van)

– Perkin’s account is settled as soon as we pay what we owe

Revenue and capital accounts

• The TB is the list of all the accounts

• Then we mark off the Revenue accounts to « treat » them into the Profit and Loss account

• Because we want to measure the value created by the operations during the year– And this is the difference between the Sales

and the consumptions

Value creation

• The Sales minus the consumptions gives the value created during the accounting period

• It increased the asset side of the Balance Sheet (in one form or another)

• Therefore the firm owns more, and this new value must belong to someone : the shareholders

• This is why we report the Profit or Loss on the liability of the BS

The trial balance

• Is it balanced ?– Yes, it should be. Otherwise there is a

mistake someplace

• If it is balanced, does it prove there is no mistake ?– No, there could still be mistakes, but they

would compensate each other

The purchases figure

• Figure : 6000 euros• Who did we purchase from ?

– Roy

• Did we pay for all of the goods ?– No, we paid only 500 euros, to appease him (and be

able to order more… )

• If we pay more, this will not change the P&L. The P&L records sales and consumptions, and is not concerned with payment

From the TB on…

• Going from the trial balance to the P&L and BS should be easy

• To establish the P&L we select all the consumptions accounts and the sales, list them, compute the balance…

• The balance of the P&L and all the other accounts go into the balance sheet

Profit and cash

• There is no simple link between profit and cash

• Profit has to do with the difference between sales and costs (of consumption)

• Cash has to do with money flowing in and out

• Since we may sell and not get paid for a while, we may show a profit and yet be short of cash

Multiplier

• In a firm the multiplier is the ratio of sales to purchases (or better COGS)

• For example in a dress shop, we buy a dress 110 euros and sell it 230 euros– Multiplier ? 230/110 = 2,09

• The common multipliers in small shops are between 2,5 and 3

Purchases and match

• In the P&L we want to record exactly the goods (for resale) « consumed »

• If the purchases do not match exactly what was sold, we adjust them a bit (we look at the variation in stocks)

• So it is possible for the purchases not to match exactly the period

• The purpose of adjustment is to get the exact consumptions of the year (a second purpose is to devaluate « overvalued assets »)

Link between accounting and history

• History starts with the first writings

• The first writings were accounting writings

• Therefore accounting is exactly as old as history (about 5000 years)

Recap

• The operations of a firm are just a long series of transactions

• Each transaction is an exchange between the firm and the outside world

• It is TWO SIDED. « There ain’t no free lunch ». If we get something (be it goods, an IOU back, cash) we give something (a promise, money, value)

What is difficult in running a firm…

• It is not accounting for the operations• It is constantly « knowing what keeps the

clients coming » and spend money (more than our costs)

• This requires « STRATEGIC thinking » (understanding our « position » compared to competitors, our strengths and weaknesses), and understanding in particular MARKETING

The first concept is a TRANSACTION

• The very first concept to grasp to understand accounting is a TRANSACTION

• The elementary actions of a firm are transactions : it is an exchange (both ways) between the firm and the outside world

• Exchange of goods, services, value or money

Double entry accounting

• The exchange both ways nature of the transactions is reflected in DOUBLE entry accounting

• In the POSTING process of every transaction TWO accounts receive writings : one is credited and the other one is debited

• Whenever we describe a transaction (even casually) we MUST mention TWO accounts

• « In this world there ain’t no free lunch »

Consumption vs durable acquisition

• A simple transaction is the purchase of something • When we purchase something it is

– Either a consumption– Or a durable acquisition

• I pay a salary : consumption• I pay for the electricity : consumption• I purchase some goods for resale : consumption (most of

them will be resold during the accounting period – perhaps with some adjustment)

• I purchase a file cabinet for my office : acquisition (aka capital expenditure, or investment)

Consumption vs durable acquisition (2)

• Revenue accounts– Rent– Electricity– Raw materials– Salaries– Purchases of goods

for resale– And the sales

• Capital accounts– All the other accounts– And the P&L bottom

line

Consumption and sales

• The consumptions are used to create Sales

• We want the value of the sales to be higher than the value of the consumptions we made

• The difference will be the profit.

• The investments are also made to create sales but they are not consumed quickly

Revenue and capital acc

• The simplest : the consumptions : R

• The sales : R

• Everything else is capital acc : C

• (including the P&L result)

Running a firm : the difficulty

• The difficulty in running a firm is not the accounting

• It is to constantly answer the question : « what makes my clients keep coming ? » and « how to sell them goods with a profit ? »

• To answer this we must have a STRATEGIC understanding of our position, and we must understand MARKETING

A dashboard

• Accounting provides the equivalent of DIALS that give important information about the firm, in order to take decisions

• So we call it the dashboard of the firm

• A manager is a decision maker : power, fun, but loneliness

• A mgr, that is a chief, is also a fireman

• A boss : « the buck stops here »

Personal check book

• Single-entry accounting

• In our check book we do not attach too much importance to the TWO SIDED aspect of exchanges

• We pay and we record the amount and the recipient or what was the expense for (we are rather casual in our personal accounting)

The first step

• Record each …. into the journal :– TRANSACTION

• It is the basic exchange.

• Ecole de commerce : commerce means exchange

Posting

• The second step

• The split of a transaction into two parts (something arriving into the firm, and something leaving the firm), and the recording of that into TWO ACCOUNTS

• Never describe a transaction mentioning only one account

Prudence rule

• When we have a choice as to how to account for a transaction (for instance the dress shop spends money on a bunch of flowers – artificial flowers – to make the shop cheerful)…

• If in doubt choose the way that lowers the profit

Materiality rule

• Do not open too many accounts, to account for insignificant things– (An account for green markers, another for

red markers, etc.– A closing stock of markers…– ….)

Joe’s co sells goods to Mary’s

• The exchange is :– Goods leave Joe’s co– Some kind of payment enters Joe’s co (from

Mary’s)

• Credit Sales acc

• Debit the account corresponding to the payment received (cash, bank, Mary’s)

Joe’s co sells goods to Mary’s

• Viewed from Mary’s co :• The exchange is :

– Goods enter Mary’s co– Some kind of payment leave Mary’s co (and goes to

Joe’s)

• Debit Purchases acc in Mary’s accounting• Credit the account corresponding to the

payment received (cash, bank, Joe’s as a creditor)

A transaction

• When describing a transaction : always mention two accounts

• Always describe the « things » entering, and the « things » leaving

Joe’s co sells goods on credit to Scott & Co

• What leaves Joe’s co ? (physically)– Goods physically leave Joe’s premises (or his

warehouse)

• What enters Joe’s company ? (concretely)– A piece of paper from Scott, – bearing what ? « I owe you 3000 euros, which I’ll pay

in 45 days (for instance) »

• Account credited (in Joe’s acc syst) : Sales• Account debited (in Joe’s acc syst) : Scott’s

account

In Joe’s accounting system…

• There are accounts to record money or value coming in

1. Cash2. Bank3. And various debtors account : when a client gives us a

promise we record this into an account bearing the name of the client

• Why do we distinguish debtors accounts by name ? – Ans. : Because an IOU from Scott may be much more

trustworthy than an IOU from Steven– Secondly we want to monitor how much credit we grant PER

CLIENT• There is no such question with cash : cash has no

smell, and is legal tender

Joe’s settles Perkin’s acc by check

• What leaves Joe’s firm ? – Ans. : a check

• What enters Joe’s firm ? – Ans. : OUR « IOU » BACK ! (we won’t leave it

at Perkin’s, will we ?)

The trial balance

• It is the list of all the accounts balances

• In order to find the Revenue and Capital accounts START with the consumptions (they are the easiest to figure out), continue with the sales : all these will be treated in the Profit & Loss account (put the sales on top, then the purchases, then all the other costs)

• Every else will be treated in the Balance sheet (including the bottom line of the P&L)

The trial balance

• Why does it ought to be balanced ?

• A trial balance, if all the entries have been made correctly, must be balanced (because it is true for the first transaction, and it remains true for any new transaction. Recurrence reasoning)

• The converse is not true : a mistake can appear that does not create an imbalance in the TB (for instance if we add mistakenly same figure on the credit somewhere and on the debit side elsewhere)

Question 16

• « The revenue accounts record the consumptions of the year and the sales »

• Correct ?

– YES

Preparation of the Profit and Loss account

• « Check off » all the Revenue accounts balances, and list them (in an organized way) in the P&l

• Start with the SALES• Then the PURCHASES• And then all the expenses

• Compute the balance (called the bottom line) and report it into the Balance sheet

Objective of the Profit and Loss account

• Measure the VALUE created by the firm over the accounting period (usually one year)

• It is the sales figure minus all the costs (purchases, possibly adjusted, and other consumptions)

• If the sales figure is higher than the costs to produce them, we created value, we made a profit.

The multiplier

• It is the ratio between the Sales and the Purchases

• In a small shop typical figures are 2,5 or 3

• For instance : we buy dresses 50 euros apiece and sell them 125 euros apiece.

• Therefore Gross margin per item = 75 euros• The profit must take into account the other

costs.

Then the Balance sheet (1)

• The asset side : the list of all the « things » the firm owns

• Start with the least liquid on top (« liquid » means easy to exchange)– Fixed assets : van, fixtures, equipment,

machinery– Debtor paper– Bank– Cash

Then the Balance sheet (2)

• The liabilities side : the list of all the « creditors » to whow the firm owes money (including the owners)

• The bottom line of the P&L goes on the liability side of the BS

• The firm cannot have an increase in value w/o owing it to someone

Profit and cash

• It is possible to be cash tight and yet make have made a large profit

• Cash is only one of the form of value entering the firm

• It is the most important one : the only one that does not rely on trust

The first modern book on accounting

• Written by Luca Pacioli around 1495

• In France a guy name Barrême wrote an important book on accounts http://www.histoire.ens.fr/colloques/ecrire/21_03am.html

• The first writings in History, 5000 years ago, where accounting writings.