Accounting is Not a Mystery: Long Version


Accounting is Practical

Accounting is clarity. It is meant to understand and measure your business. Accounting as we know and use it was more-or-less invented by the merchants of Venice, Italy during the Renaissance. Marco Polo and his family used the same accounting that we use today. It is like arithmetic, not differential calculus.

I like to demonstrate the clarity of accounting by using it to solve a popular puzzle. This is the puzzle:

  1. Three salesmen check into a motel room. Each pays the concierge $10, a total of $30.
  2. Later the concierge realizes that the room should only be $25.
  3. He gives $5 to the bellhop and tells him to divide it as a refund to the three salesmen.
  4. The bellhop decides to keep $2 and give each of the salesmen $1.
  5. So the three salesmen each paid $9 and the bellhop pocketed $2.
  6. Three times $9 plus $2 is only $29. What happened to the missing $1?
Solve it using the clean thinking of accounting.

Three salesmen each have $10.

3 x $10 = $30.

They pay it to the concierge.

$30

The concierge gives $5 to the bellhop.

$25 + $5 = $30.

The bellhop gives $1 to each of the three salesmen and keeps $2.

$25 + $2 +$1 + $1 +$1 = $30.

I like to make this point that accounting is clarity before moving on.

ASSETS

Imagine that you own a business that you are looking at it from across the street one morning before it opens for business. Ask yourself, "What is it that this business has? The answer will start with the things you can see:

  1. Land
  2. Building
  3. Fixtures
  4. Equipment
  5. Inventory (also called "Stock in Trade")
  6. You also know that the business has
    1. checking account(s)
    2. savings account(s)
    3. cash for making change

All of these things that the business has are called its "Assets."

There is a particular order in which we arrange Assets. Rather than smallest to largest, we start with the easiest to spend and build up to the more difficult to spend:

  1. Current Assets
    1. Cash
    2. Checking Account
    3. Savings Accounts
    4. Accounts Receivable
    5. Inventory (We consider Inventory to be current because it is fairly easy to convert to cash by selling it.)
  2. Fixed Assets
    1. Furniture & Fixtures
    2. Machinery
    3. Buildings
    4. Land
  3. Other Assets
    1. Goodwill
    2. miscellaneous "left-overs" that do not seem to fit in the categories above.

LIABILITIES & CAPITAL

The business may have these Assets, but it does not own them. Instead it owes the Assets to:

  1. The banks and other creditors and
  2. the owners.

Amounts owed to the banks and other creditors are called the business' "Liabilities." Liabilities are ordered more-or-less according to how soon the business must pay them:
  1. Current Liabilities
    1. Accounts Payable [usually 30 to 60 days]
    2. Trade Notes Payable [usually 6 months to one year]
  2. Long-Term Liabilities. These are usually called "Mortgage Notes Payable."

Any amount left over after subtracting the Liabilities from the Assets is called the "Capital." To make the meaning clearer, it is also called "Owner's Equity."Capital is usually further divided into:

Capital, the amount of money that the owner(s) originally invested. The dollar amount usually remains unchanged through the years.

  • Retained Earnings, the amount of accumulated profit that the business owes to the owner.

  • Distributions, the amount of the Retained Earnings that the owner(s) actually remove.

    The obvious formula is:

    ASSETS - LIABILITIES = CAPITAL


    But this is traditionally written in this form:

    ASSETS = LIABILITIES + CAPITAL

    The Busy-ness of Accounting


    Now imagine that in is the end of the day. You know that during the day sales were $1,000 but of that amount, expenses of $400 were paid. So the amount of profit remaining at the end of the day is $600. The business has the $600 by depositing it in the checking account but the business naturally owes the same money to the owner. Both sides of the equation go up by $600:
    (Assets + $600) = Liabilities + (Capital + $600)
    DEBITS and CREDIT

    The busiest accounting activity for most businesses is checking the change each day in this equation by keeping records of daily Sales and Expenses. During this activity, we hear and use the terms "debit" and "credit." By "international agreement," we follow these rules:


    1. We consider Assets to be "plus" amounts and Liabilities and Capital to be "minus" amounts.
    2. We call the "plus" amounts "Debits" and the "minus" amounts "Credits."
    3. We write the Debits in the left column and the Credits in the right column.
    4. We abbreviate Debit as "DR" and Credit as "CR." There is no "r" in "Debit," but the two "r's" look balanced. In recent times, some banks use the abbreviations "DE" and "CR." That might make more sense, but it is like spelling words like "nite" and "thru."
    The Meaning of Brackets

    "Brackets" are written either as parentheses or the lesser-than and greater-than sign. We normally think of brackets as meaning "minus." That is not what brackets mean. Instead they mean "the opposite of what you would normally expect to have here." For example:

    You may see a list of Current Assets listed in this fashion: 

    	Checking Account First Bank		$3,700.25
	Checking Account Omnibus Bank		$2,483.40
	Checking Account American Bank		$954.43
	Savings Account First Bank		$4,305.07
     
     

    The Checking Account at American Bank is overdrawn. In this case the brackets do in fact mean "minus."

    But you may also see a list of Current Liabilities in this fashion:

    	Sales Tax Payable			$1,705.00
	Payroll Tax Payable			$3,607.23
	Credit Card Payable		        $1,304.04
	Trade Accounts Payable			$2,607.32

    The word "payable" clues you that these are Liabilities. We already said that it is universally agreed that Liabilities are considered "minus" amounts that we call Credits. The list above tells you that somehow you overpaid your credit card balance. The figure is in brackets to show you that it is the opposite of what you would normally find here. In this case the brackets mean "plus." Just remember that brackets mean "opposite."

    Your Left or Mine?

    We debit deposits to our checking account and credit checks. But banks call deposits "credits" and charges "debits," or something like that. It is confusing, but it should not be. Two people are facing each other. One says, "I think we should face left to see the sunrise." The other person asks, "Your left or mine?" The answer is "Mine." Both turn and face the same direction without either complaining, "Whew! That left-and-right thing sure is complicated!"

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