Accounting Philosophy, part 1

Hello readers, in this series of posts I will discuss some of the basic foundations of accounting theory. Specifically I will talk about the principles, assumptions and constraints of accounting. From these we can find justification for every rule. Also with the transition from the US GAAP to the International accounting standards (IFRS) which is more so principle based than our current system, I though it would be a good topic to write about.

Assumptions

Let’s start with the assumptions in accounting. As you no doubt already know in life sometimes you just have to assume some facts, which you may not know. Accounting is no different. In order to ‘account’ for something we have to assume that some points are true. In accounting we have four assumptions. They are: Economic entity, Monetary unit, and the Time period assumption.

Economic entity assumption

The economic entity assumption requires that we account for the activities of one distinct and independent enterprise. In other words we need to draw the line between a firm and its owners, employees, vendors, customers etc. To illustrate this consider the following example. Silda owns a consulting business called Silda’s Consulting. The business has a few employees but provides Silda with the means to live on (i.e. its her only job). Every two weeks she pays her employees and draws out some money for her self. In addition to her business she owns a summer home in Milan which she uses only for personal recreation. If you were the accountant for Silda’s Consulting you would need to separate the activities of the firm from the activities of its owner. For example, the mortgage on Silda’s summer home is a personal expense, and should not be an expense of the company, likewise office supplies (for company use) should be expensed through the companies books and not through her personal accounts. This can sometimes be a challenge, some small firms don’t mind paying their personal bills through their company…while that is not necessarily wrong it does create some difficultly in determine the success of the business. In general, we must define what entity we are going to account for before we can account for it.

Monetary unit assumption

This is an easy one! Everything we account for is going to be measured in money. Transactions will be measured in dollars, not some other unit like time. And that only transactions that can be measured in money will be reflected in the accounting records. Some text books give problems where they list a series of events and the student selects which will be accounted for. For example select the one which won’t be accounted for:

A) Purchase of a truck

B) Payment of the electrical bill

C) Death of the company’s president

If you selected C you’ve got a great hold on the monetary unit assumption. The company president’s passing, while tragic, isn’t an event that can be measured in money, while the other two events clearly involve the exchange of money and thus can be measured through that exchange.

Time period assumption

Last but most certainly not least. The time period assumption states that the activities of an entity can be divided into artificial time periods such as months, years, or even accounting cycles. This assumption while simply creates the most headaches for auditors, salespeople and many others affected by an enterprise. Most business operate on a calendar year. In other words, on January 1st they begin a new accounting cycle, and look at the transactions to see how the previous year preformed. This is closely tied to the accounting function of Closing which is the end of the accounting cycle. While well known time measurements such as a year are common accounting cycles some business run their books through a production cycle or a sales cycle. For example, a ship builder who spends 2 years building one ship and only builds one ship at a time, may only close their books after completing the ship. This way they can closely match the economic events to the production of the one ship.

 

Well that concludes assumptions stay tuned for constraints and principles!

The Accounting Cycle

Happy New Year! This year we should all resolve to learn a little bit more about accounting huh?

In today’s entry we’re going to look at the accounting cycle. This is a relatively simple concept, and shouldn’t take long to explain. Some of these concepts will be expanded upon in future entries, but I’ll try to provide concise enough explanations for today’s blog.

The accounting cycle consists of 10 steps, though some textbooks may have fewer or more.

The steps are:

1. Identify the Transaction
2. Analyze the Transaction
3. Record in the Journal
4. Post to the Ledger
5. Create a Trial Balance
6. Make Adjusting Entries
7. Create the Adjusted Trial Balance
8. Create the Financial Statements
9. Make Closing Journal Entries
10. Create the Post-Closing Trial Balance

Taken one at a time

Identify the Transaction: this is the recognition that a transaction has taken place, it usually begins with something we call a Source Document. Simply put a source document is what will identify a transaction has (or is) taking place. Examples of source documents which involve transactions include receipts, invoices (bills), purchase orders, etc.

Analyze the Transaction: Since we have identified a transaction as taking place, for example our boss gave us a receipt, now we have to examine the transaction (receipt) to see what accounts might be involved. For example if the receipt in question was for office supplies and she paid in cash we have all the information we need. The accounts in question are going to be Office Supply Expense, and Cash. Other pieces we have/need are the amount, and the date—all present on the receipt.

Record in the Journal: This is creating the entry from the information we determined above. For more info on this step see my entry on double entry bookkeeping.
Post to the Ledger: This step is deceptively simply. First off the ledger (or general ledger) is simply a record of an individual account. It contains a running total of the individual accounts balance. I’ll go into more detail on ledgers in a future entry, for now just stick with my explanation.

Create the Trial Balance: The trial balance is a report which shows the balance of every account. Since some accounts have Debit balances and others have Credit balances and we have learned that Debits = Credits, the trial balance serves to prove that we are indeed in balance. This step may seem trivial; however it is crucial that we are in balance before we move into the next steps.

Make Adjusting Entries: In this step we are going to make any necessary adjustments to the journal for end of the year/period/accounting cycle etc. These might be overwhelming right now, mostly because I haven’t yet introduced the concept of accrual (vs. cash) accounting. Although a common adjustment would be adding any additional (but unpaid) interest on a loan.

Create the Adjusted Trial Balance: Similar to the first trial balance however this time, we are again checking to ensure we are in balance. Further more from this trial balance we will use it to create the financial statements.

Create the Financial Statements: This process will require its own blog entry however; the basic financial statements are the Income Statement, Balance Sheet, Statement of Cash Flows, and the Statement of Retained Earnings. Together these statements reflect the financial condition and position of the firm.

Make Closing Entries: We the completion of the statements we have to close the temporary (income statement) accounts so that they are ready to record transactions in the next cycle.

Create the Post Closing Trial Balance: Yes, I know by now you don’t want to create another trial balance, but this again is needed to verify that the accounting system is in balance going into the new cycle.

Thanks for your reading, please comment, and tune in for the next blog entry!

Luca Pacioli and Double Entry Bookkeeping

For the better part of the last 800 years accounts have relied on one particular tool. This tool is the double entry bookkeeping methods that Pacioli first wrote about, sometimes he is credited with its discovery but some speculate double entry bookkeeping existed for many years before he wrote about it. Either way Pacioli was the first to document this important system.

If you haven’t please read my discussion of the accounting equation as an understanding will be necessary to grasp the concept of double entry bookkeeping.

So what is double entry bookkeeping (Double Entry)? It’s the method by which we accountants record economic transactions into the company’s general journal.

I’ll go into Journal’s and ledgers and the accounting process in a future post, for now, please accept that a Journal is where double entry bookkeeping entries are made.

Every event recorded in this system has at least 2 entries a Debit (Dr) and a Credit (Cr). I know what you’re thinking; I have a credit card and a debit card! Well you do, but in this context, Debit and Credit only mean Left and Right. As a good friend of mine once told me, when discovering I was becoming an accountant, “Just remember, Debit on the Left, Credit on the Right!” This is a very simple concept, and please don’t try to overcomplicate it, I think many people do, but honestly Debit = Left Credit = Right, that’s all you need to know about them.

Before we can start using this, you need to understand its relationship to the accounting equation.  Accounts are going to have something we call Normal Balance. Normal Balance refers to which side of the journal entry increases the value of the account. Recall the equation Assets = Liabilities +Owners Equity. Assets have a normal balance of Debt, Liabilities have a normal balance of Credit, Owners Equity consists of different types of accounts some with normal debit balance some with normal credit balance, and we will handle those on a case by case basis, but its generally considered to have a normal credit balance.

For now, I’m going to come up with some economic events, which we commonly call transactions, and I’ll show you their effect on the accounting equation, with an emphasis on the debits and credits of it all.  Cash is an asset account with a normal debit balance, and expenses (such as telephone bills) are an owners equity account also with a normal debit balance. Let’s assume Li pays 100 to Spint for his cell phone bill.

Think of the transaction, we’d have to decrease cash by 100, and increase the expense by 100. Cash having a normal balance of debit is decreased through credits, and expense(s) having a normal debit balance are increased through debits! So the entry would be to debit Telephone expense 100, credit Cash by 100. In a Journal it would look like this:


Account                         Dr          Cr
Telephone Expense        100
         Cash                                   100

In a journal Debits typically come first. There are other ways of writing the entry, but in general you need to identify the Debit and the Credit and the affected accounts.

Let’s look at Silda’s paycheck again, She received a paycheck for $5,000. In this case we increase cash by 5,000 and we have to increase revenue (an owners’ equity account) by 5,000. Cash has a normal debit balance and Revenue(it means income) has a normal credit balance. So it would look like this:

Account            Dr            Cr
Cash                5,000
       Revenue                  5,000


Simply huh?! I’ll give you one, and put the answer below. Mike buys a Car for $10,000. Think about it, the car is going to be an asset, and cash is an asset. I’ll give you the entry after the jump

The Accounting Equation

Assets = Liabilities + Owner’s Equity*
*Sometimes called Shareholder’s Equity, or Capital – but nonetheless the same concept
Those 3 pieces are what accounting is all about. Simply put Assets are things you have. For example cash, trucks, inventory, and even non-physical things, like copyrights, trademarks and this mysterious thing called Goodwill (which deserves its own article so I won’t get into it here) are all different kinds of assets. Liabilities are things you owe. For example, your monthly bills (in business we call these Accounts Payable), Car note, personal loans from the bank, and even mortgages, these are all liabilities. Lastly, Owner’s Equity there are probably a few ways to define this, but the most basic way is to say that it consists of what you own of your assets, rather than the part you owe to others. For simplicity, when I use the term Equity I’m referring to Owner’s Equity. Equity also consists of other things are can’t be described as assets or liabilities, I know all this sounds kind of abstract, but let’s work through a couple of examples, I’m not going to get into the actual accounts used, or double-entry bookkeeping, those I’ll save for future lessons.

Remember from high school algebra, equations always have to be balanced. In other words the left side of the equal sign has to be the same as the right side of the equal sign. I’m not a math wizard, so they may be better ways to explain this but just to illustrate this. 2 = 2. 4 = 2 + 2. In both instances the left and right sides of the equation are equal. Just to illustrate what’s wrong. 5 = 2 + 1. This equation is not in balance because 2 + 1 = 3 not 5. Ok, that’s enough math, and I won’t get any deeper with it I promise, just remember the sides have to be balance.

So let’s get back to accounting, I’m going to provide a few examples and we will look at the effect on the accounting equation.
1. Jim buys a car for $10,000 and its 100% financed
        Assets = Liabilities + Owner’s Equity
     $10,000 = $10,000 + 0
Jim now has a car (An Asset) and he owe’s the bank $10,000 for it (A Liability) since the car was 100% financed Jim doesn’t own any of it, that’s why there is 0 equity. Notice how the equation is in balance.\

2. Silda gets paid her monthly paycheck of $5,000.
      Assets = Liabilities + Owner’s Equity
     $5,000 = 0 + $5,000
In this transaction Silda had received cash of $5,000 (an asset). There is no other claim to her paycheck so there is $0 Liability, and since she owns all of her paycheck we have $5,000 equity.

3. With me so far, here’s a tricky one, Rick and Mary have bought a house for $100,000. They put $20,000 down and have a mortgage for the rest ($80,000). Let’s see what this looks like**
        Assets = Liabilities + Owner’s Equity
   $100,000 = $80,000 + $20,000
Yes, it’s in balance. Rick and Mary have a house worth $100,000 (an Asset) they have a mortgage of $80,000 (a liability) however, they own $20,000 of the house they purchased because of the down payment so they have Equity of $20,000.

I’ve introduced you to the basics of the accounting equation. I hope you found this insightful and if you have any questions please comment!

**Ok, so this is a bit more complex then I eluded to, because it assumes that they already had $20,000 in cash and also equity. The end result would still be the same as above but it requires some extra steps to get there. Of course these steps are what accounting is all about, the flows of money and its end state. So I will repeat the example with steps for the cash flows.
   Assets = Liabilities + Owner’s Equity
$20,000 = 0 + $20,000
This is their initial state before they buy the house they have $20,000 in cash and no claim against it, so $20,000 in equity also. For the next few steps I’ll put the signs of movement in ().
         Assets = Liabilities + Owner’s Equity
      $20,000 = 0 + $20,000 Initial State
  (-)$20,000 Paying of $20,000 as a down payment, they are giving up Cash (an Asset)
(+)$100,000 = (+)$80,000 +0 Buying the house they are getting the asset (the house) and a liability  (the        mortgage)
    $100,000 = $80,000 + $20,000 Ending state.
It’s a bit more complex because of the intra-asset transaction with the $20,000 down payment. It might seem that taking away the $20,000 cash unbalances the transaction, but remember these events are happening simultaneously with the purchase of the house.

Expense...Cost....Expenditure the same or not?

In common language the terms expense, expenditure, and cost have similar meanings. For example when renting an apartment you might ask what the monthly utilities cost is or what are the monthly utility expenses? But in business (especially accounting) these terms represent three separate ideas.

Briefly,

• Expense - is the amount of an asset or resource consumed (measured in dollars) the outlay or payment of cash is not necessarily required
  
• Cost - is the amount of an expenditure that would or will be required to obtain or create something, though in the field of Economics it tends to have the meaning of Opportunity cost (which I won't get into here)
  
• Expenditure- refers to the outlay or payment of cash

Now that we have some working definitions lets put it together. To purchase a new car it will cost us $10,000 (Future expenditure required). When I bought the car I created an expenditure of $10,000 (cash outlay). I had to buy 6 months of car insurance, which cost $600 and it had to be paid in advance, requiring a $600 expenditure (future amount to obtain service/ cash paid for services now and in the future). I will expense $100 (1/6 of $600) each month for 6 months (consumption of resource, in this case the paid in advance insurance).

Now you have a rudimentary understanding of the differences bewteen Expense, Cost and Expenditure. There are probably thousands of examples I could provide and if you'd like more or any clarification please comment back!