Chapter 5: Accounting

Producing information had provided satisfaction that day on my mission as I typed that report. But the next semester I put down my computer books, and basically forgot the topic as I took an introductory accounting class. These courses seemed to have no dependence upon understanding computers. Yet the steps involved were similarly systematic, as I learned about basic bookkeeping, the systematic procedures of accounting.

The following year I entered the accounting program and began my indoctrination into a very old system of information gathering and reporting. Modern accounting is said to have begun with Luca Pacioli documenting double-entry bookkeeping methods in 1494 AD1, only two years after America was discovered, and long before the invention of computers. I found the integration of all the steps very interesting, how this approach resulted in information that could be useful and actionable, yet from so many small seemingly disconnected parts.

The Balance Sheet

Financial statements enable understanding a person’s or organization’s finances. To simplify our discussion, let’s focus our discussion on a single family’s finances. Imagine your family has never tracked their finances. You have kept the receipts and records for things, but you have never added them up. One day you receive notice from a lender that you have not paid some bill. With this motivation, you immediately go to someone for financial counseling.

The first thing the counselor will want to understand is whether you own more than you owe others. The financial concept that answers this question is net worth. What is owned or legitimate claims upon other people’s things are called assets. Financial obligations or potential obligations are called liabilities. Net worth is the difference between assets and liabilities.

The credit counselor will want to categorize, or make a listing of, your assets and liabilities. But even for individuals, listing everything—the couch, the chair, the pen, each type of stock, each credit card, etc. would be very tedious. So groups of similar things are created.

The balance sheet the counselor makes will list

  • Assets: Things you own
  • Less Liabilities: Things you owe
  • Equals Net Worth (for individuals) or Owner’s Equity (for a company)
ExampleBalanceSheet
Figure 1. Example Balance Sheet

The Income Statement

Balance sheet measures financial position at one moment in time, for example, the morning you went to visit the counselor. Knowing where you are may help alleviate the immediate fear of being bankrupt, but it doesn’t help you predict if you will soon be bankrupt. The income statement measures activity over time, or the change between two balance sheets. It helps understand if you are headed to bankruptcy.

When you were born you had no assets or liabilities. So the balance sheet was very, very simple. An income statement that covers your entire life from the day you were born until you went to the credit counselor will start with what you have earned in all your jobs, gifts you have received, interest on that savings bond grandma bought for you. All these are added up as individual sub-categories under the heading of Revenue.

Everything you spend for things you consume are called expenses, for example, tickets to a movie, the bag of chips for a snack, the payment of your phone bill. Certain payments you make are not expenses; they are an investment in an asset. Even though you pay someone to buy a savings bond, you haven’t consumed anything; there is value in the thing you bought that you could exchange for something else.

There is a bit of balancing in making these category decisions. You might not consume something immediately, like the food in your kitchen cabinets. Yet because the value of the food is so low, and diminishes quickly as the food is eaten or spoils, it is easier to call it an expense when purchased rather than when consumed. The number of days of rent on a storage unit you have consumed since the last rental check is similar; called an accrued expense.2

So, in the end, the income statement the counselor makes will list

  • Revenue: What you earned
  • Less Expenses: What you consumed
  • Equals Net Income or Net Loss
ExampleIncomeStatement
Figure 2. Example Income Statement

Income statements show changes in balance sheets. The “bottom line” of the income statement is often the most important point. Insolvency (more liabilities than assets), as summarized on the balance sheet, is best predicted by expenses being greater than revenues as shown on the income statement. But financial reporting begins with the balance sheet because measuring things at a point in time is easier than calculating the change over time.

This relationship highlights the difference between transactions and balances. You are probably familiar with many of these concepts from simply looking at your checking or savings account statement. On those statements, there is usually a section that says what the balance was at the beginning and end of the month, similar to the balance sheet. There is another section that shows each deposit and withdrawal. These would be included in the income statement. If you add or subtract each of these, they explain the change between the beginning and ending balance.

The Accounting Cycle

Creating these reports once, figuring out one’s financial position, is very different from doing this on an ongoing basis. To produce financial statements time and time again, one needs to understand the accounting cycle.

StepsinAccountingCycle
Figure 3. Steps in Accounting Cycle

Execute Business Events

Business events are things like making purchases, earning money, reconciling bank accounts. These are not accounting, per se, but rather the real work of life

Journal Entries

Your accountant would have asked that you provide pay stubs for every pay period, and receipts for every purchase you made. Then she would take these and create journal entries. For example, if you paid for gas with your credit card, she would turn that one receipt into two rows in a notebook that might look like this:

ExampleJournalEntry
Figure 4. Example Journal Entry

These two rows are called a journal entry. The accountant would have recorded the Journal Entry ID on the receipt, to show it has been recorded and provide a way to trace the expense into the notebook. They would make similar entries in the notebook for all receipts and pay stubs.

Why two rows? Because bookkeeping, the process of accounting, is based upon the accounting equation. The basis of the Balance Sheet is:

  • Assets = Liabilities + Owner’s Equity

The Income Statement uses this equation:

  • Net Income = Revenue – Expenses

These equations and recording two rows for everything keeps the system “in balance”. It allows bookkeeping to check for errors in recording the information.

If we remove time periods from the equation, or in other words assume that we only produce one Income Statement covering one’s entire life, then Owner’s Equity = Net Income. Then we can combine the balance sheet and income statement equations:

Assets = Liabilities + (Revenue – Expenses)

Accounting can actually be done without the use of debits and credits, and many modern systems only use the terms to mean positive and negative.

We can use basic algebra to manipulate the accounting equation.

Assets = Liabilities + (Revenue – Expenses)

To be:

Assets – Liabilities – Revenues + Expenses = 0

You’ll remember again from basic algebra that you can do anything you like to an equality, such as the accounting equations listed above, as long as you (1) do the same thing to both sides of the equation, or (2) the net result of what you do to one side equals zero. All journal entries have a minimum of two entries to hold to that rule. The effect of the two entries equal zero, one affecting an expense and one a liability for example.

A debit or credit, then, simply indicates if something is positive or negative relative to the natural account sign in the last equation. Cash has a natural debit or positive balance; it is an asset you want to have. A loan has a natural negative sign, or a credit balance, because it is a liability. Debits and credits are completely unnecessary if the users of the financial statements were happy having loans and revenues and even owner’s equity reflected as negative numbers. Yes, because of the accounting equation, unfortunately the natural sign for revenues is negative and expenses are positive.

We’ll assume our little family example here includes fifty-five rows in 14 different journal entries shown at the end of this chapter.

Chart of Accounts

The accountant determined which categories to track by referring to the chart of accounts. It lists the account number and name, like Cash, and next to it is noted if this is an asset, liability, equity, revenue or expense account.3

SampleChartofAccounts
Figure 5. Sample Chart of Accounts

Accounts are defined for anything you want to see on the financial statement. You could ask the accountant to make accounts for each bank account and each type of stock you had if you wanted. You could in fact make accounts for stock you hoped to someday own. But accounts with no journal entries against them will not show up on the financial statements. This chart of accounts is a little bit like the index; what you will be interested in seeing later is decided beforehand. Journal entries can only be made against these set of accounts.

Accounts, organizations, cost centers, and other reference data can often be expressed as hierarchies. Our simple account hierarchy could be depicted this way.

FnHierarchyofAccounts

Also note—and this is important—that the chart of accounts has to be established before the first journal entry is recorded for which we want to report results. Everything you want to report on must be decided in advance. Accounts can be changed over time, but seeing historical data at a finer level of detail, for example each individual stock held rather than the lump sum in the investments account, wouldn’t be possible from the accounting system records4.

General Ledger

The notebook in which the accountant wrote the journal entries is called the General Journal. Periodically, she will “post” them to the General Ledger. Let’s clarify what we mean by the word post.

A ledger is a summary of journals; in our example the ledger contains only one row for cash. It is a running total of the balance, similar to maintaining a balance in your check register. We would update the corresponding General Ledger account for each account on every row in the General Journal.

For example, the following are the entries that affect the credit card payable account. These are like the individual checks on your checking account statement.

CreditCardPayableentriesforApril
Figure 6. Credit Card Payable Entries for April

The following shows the changes in the general ledger credit card payable balance if these entries are posted on the date of the entry. In other words, this shows the balance for the checking account after each “check” is cashed.

CreditCardPayableAccountGLBalances
Figure 7. General Ledger Balances for Credit Card Payable

The General Ledger is the ledger that summarizes the results for a company or a significant portion of a company like a division.

Trial Balance

When we want to make a financial statement, first we would list the last row for each account, the current balance, on another sheet of paper. This is called a trial balance. We can test if everything has been recorded correctly by adding up all the balances. The debits should equal the credits; the positive numbers should equal the negative numbers; thus the name trial balance. The accounting equation should also be in balance. If the numbers don’t add up we did something wrong. This little step checks our process and gives us all the numbers needed to produce financial statements.5

SampleTrialBalance
Figure 8. Sample Trial Balance

Producing the financial statements is a process of pulling each row off the trial balance in order by the account number, and putting them onto another sheet of paper, then using the accounting equations for totals on the balance sheet and income statement.6

Closing Entries

We’ve assumed thus far only one period in our financial reports. We made only one income statement covering your entire life. However, using shorter time periods for the income statement will help to more accurately predict what the future will be. We add an additional step when we want to end one Income Statement period and start another. The income statement accounts are “closed” for the prior period so that the income statement stops accumulating prior activity and shows activity from here forward.7

SampleClosingEntries
Figure 9. Sample Closing Entries

The closing entries record the “transfer” of the money from the Income Statement equation to Balance Sheet equation. The following shows the trial balance before and after posting these entries.

TrialBalancesafterClosingEntries
Figure 10. Trial Balances after Closing Entries

Recording of new journal entries for May can go on without interruption while the trial balance and financial reports for April are being constructed.

The following fifty five rows make up the journal entries for the sample financial statements, including the closing entries.

FnFullJournalEntries

This little process, outlined by Luca Pacioli and honed over half a millennium, now is remarkable. Continually doing these steps enables creating financial statements whenever desired. It is nearly mechanical, and perfectly suited to be automated by computers. The output from this process is a paper with words and numbers on it, something perfectly suited as output from a computer. And when this process was put into computers, it wasn’t changed at all; the computer simply substituted for the ledger paper. I am amazed that it is such a remarkably enduring information gathering and reporting framework.

Nine months later I ducked as one of my accounting professors expressed his displeasure at the durability of that little system.

 

1 John R. Alexander, The History of Accounting, Association of Chartered Accountants in the US (ACAUS), http://www.acaus.org/acc_his.html Accessed May 2006. Also Anita Sawyer Hollander, Eric L. Denna, J. Owen Cherrington, Accounting, Information Technology, and Business Solutions, 2nd ed. (© McGraw-Hill Companies Inc.: 2000) 80 – 81, and A. Crosby, The Measure of Reality: Quantification and Western Society 1250 – 1600, (Melbourne, Australia: Cambridge University Press, 1997), 202 and 208.  See also www.ledgerlearning.com series on historical accounting, beginning with this blog entry:  What can one learn from Historical Bookkeeping?
2 Alternatively, we can record an asset and estimate consumption. Purchasing a car is a good example. The declining value of the car is called depreciation. It is that portion of the car you “consumed” over time. One could calculate the potential sales price car for at the end of each year and record an expense. But consumption of a car isn’t really that precise of an activity to record on your income statement. It is usually easier to guess at the expected life of the car, divide the cost of the car by that number, and say you consumed that much each year you had it. Other examples of time-based consumption (earnings can also be estimated for that matter) include calculating how much of your storage unit you have consumed from the date you normally make the payment (say the 15th of the month) to the end of the month. These sorts of calculations are called “accrued” expenses (or revenue).
3 The chart of accounts might also note whether an account had a natural debit or credit sign. This would be used to interpret the journal entries if the sign wasn’t used to indicate positive and negatives. It also might be used to multiply revenues and expenses by -1 for presentation on the reports so they are more intuitive.
4 Notice that on our chart of accounts the account numbers mirrors the hierarchy of accounts. Our journal entries use only accounts at level 3. The other levels are used to categorize lower level accounts. So even within account, there are more meanings than just one. The level one and two accounts show up on the financial statements. In a more sophisticated financial system, these amounts can be calculated, making production of the financial statements even easier.
5 Note that this step does not check that everything was recorded. We could have lost receipts, and not made journal entries. Things may be in balance, but not necessarily accurate or complete.
6 Alternatively if the hierarchy is used which contains levels for each of the subtotals on the financial statements, then even the subtotals are calculated and presented as rows of data in the reporting process.
7 Thinking back to the accounting equations, making closing entries is simply making the revenue and expense accounts zero, and making the increase or decrease in equity permanent. There are two ways to do this depending on what our accountant wants to do with the General Ledger notebook for the new income statement period: does she plan to use the same General Ledger notebook she used last period, or start a brand new notebook? The most common way is use the same notebook, to keep the balance sheet totals running. In this case, the trial balance amounts for all income statement accounts are negated and made journal entries, and an entry for the net income made to net worth. That way, when the journals are posted to the General Ledger for the next period, the balance sheet amounts aren’t changed—the cash balance from the last day of the month is the same as the first day of the next month—but the income statement amounts are not; income statement accounts start with a balance of zero.