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 -> Sales account) • BUT WE MUST DEVELOP THE TWO ACCOUNT REFLEX : I sell -> 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. 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

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. 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

14. 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

15. 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

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 Edward’s 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. 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

20. 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

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 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

23. 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

24. 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

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 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)

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 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

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 P&L. The P&L records sales and consumptions, and is not concerned with payment

31. 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

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 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 »)

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 ain’t 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 ain’t 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. 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 vs durable acquisition (2)

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 P&L 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… • ….)