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Accounting

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									 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 loose
  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       • Capital accounts
  – Rent                   – All the other accounts
  – Electricity            – And the P&L bottom
  – Raw materials            line
  – Salaries
  – Purchases of goods
    for resale
  – And the sales
      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
    –     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
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.

								
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