Accounting

1
Accounting

• General principles

2
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

3
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

4
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

5
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 -gt Sales account)
• BUT WE MUST DEVELOP THE TWO ACCOUNT REFLEX I
  sell -gt Sales and Cash, or Sales and a Debtor

6
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)

7
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

8
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

9
The first two steps

• A transaction is the elementary operation of a
  firm
• First we record it in plain english into the
  journal. Dont 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

10
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

11
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

12
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

13
Joes company sold goods to Marys 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

14
Legal tenders and IOUs

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

15
Marys point of view

• The transaction Joe sold goods to Mary is
  also a transaction for Marys firm
• Mary(s firm) bought some goods from Joes
• We are told these goods are for resale. Therefore
  we debit, in MARYs ACC SYST, the purchases
  account

16
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 Edwards
  files (if there were several owners we would call
  these pieces of paper SHARES, or STOCKS)

17
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

18
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

19
Edwards buys a van on credit from Perkins 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 PERKINs. In order to have a good
  view of our operations we must record that it is
  to Perkins

20
Settling Perkins 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
  Perkins

21
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

22
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 Roys account (remember that we open an
  account named Roys for our convenience. Roy
  doesnt care It is not under the responsibility
  of Roy !)
• Debit the Purchases account

23
In Roys firm

• In Roys firm there is an accounting system.
• In this accounting system Roy opened an account
  named Edwards 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
• Its none of Edwards business

24
Back to Edwards 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
  PL account

25
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 PL
  and the Balance sheet
• In order to establish the PL we shall select all
  the revenue accounts (the consumption accounts
  and the sales)

26
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
  Perkins garage account
• The van account will carry a figure of 3000 euros
  (that we shall depreciate as we consume the
  van)
• Perkins account is settled as soon as we pay
  what we owe

27
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

28
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

29
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

30
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 PL. The
  PL records sales and consumptions, and is not
  concerned with payment

31
From the TB on

• Going from the trial balance to the PL and BS
  should be easy
• To establish the PL we select all the
  consumptions accounts and the sales, list them,
  compute the balance
• The balance of the PL and all the other accounts
  go into the balance sheet

32
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

33
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

34
Purchases and match

• In the PL 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 )

35
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)

36
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 aint no free lunch .
  If we get something (be it goods, an IOU back,
  cash) we give something (a promise, money, value)

37
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

38
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

39
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 aint no free lunch

40
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)

41
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 PL bottom line

42
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

43
Revenue and capital acc

• The simplest the consumptions R
• The sales R
• Everything else is capital acc C
• (including the PL result)

44
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

45
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

46
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)

47
The first step

• Record each . into the journal
• TRANSACTION
• It is the basic exchange.
• Ecole de commerce commerce means exchange

48
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

49
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

50
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
• .)

51
Joes co sells goods to Marys

• The exchange is
• Goods leave Joes co
• Some kind of payment enters Joes co (from
  Marys)
• Credit Sales acc
• Debit the account corresponding to the payment
  received (cash, bank, Marys)

52
Joes co sells goods to Marys

• Viewed from Marys co
• The exchange is
• Goods enter Marys co
• Some kind of payment leave Marys co (and goes to
  Joes)
• Debit Purchases acc in Marys accounting
• Credit the account corresponding to the payment
  received (cash, bank, Joes as a creditor)

53
A transaction

• When describing a transaction always mention
  two accounts
• Always describe the things entering, and the
  things leaving

54
Joes co sells goods on credit to Scott Co

• What leaves Joes co ? (physically)
• Goods physically leave Joes premises (or his
  warehouse)
• What enters Joes company ? (concretely)
• A piece of paper from Scott,
• bearing what ? I owe you 3000 euros, which Ill
  pay in 45 days (for instance)
• Account credited (in Joes acc syst) Sales
• Account debited (in Joes acc syst) Scotts
  account

55
In Joes accounting system

• There are accounts to record money or value
  coming in
• Cash
• Bank
• 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

56
Joes settles Perkins acc by check

• What leaves Joes firm ?
• Ans. a check
• What enters Joes firm ?
• Ans. OUR IOU BACK ! (we wont leave it at
  Perkins, will we ?)

57
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 PL)

58
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)

59
Question 16

• The revenue accounts record the consumptions of
  the year and the sales
• Correct ?
• YES

60
Preparation of the Profit and Loss account

• Check off all the Revenue accounts balances,
  and list them (in an organized way) in the Pl
• 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

61
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.

62
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.

63
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

64
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 PL goes on the liability
  side of the BS
• The firm cannot have an increase in value w/o
  owing it to someone

65
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

66
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/colloq
  ues/ecrire/21_03am.html
• The first writings in History, 5000 years ago,
  where accounting writings.