Outline of Accounting

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short version Outline of Accounting

Accounting is old. It was developed in Renaissance Italy at the time of Marco Polo. Most of the terms we use in accounting came from these Venetian merchants.
Accounting is nothing more than "glorified arithmetic."
It is not complicated nor extensive.
When someone tells me he has a degree in accounting, I am as impressed as if he had said he has a degree in arithmetic!
How is it possible to spend four years studying glorified arithmetic? By throwing in some introductory business, law, and management courses, it is possible to turn a week's worth of study into four years.
Non-accountants need not be awed by or intimidated by degreed accountants; however, they may respect accountants who have other skills to add to the "glorified arithmetic."
Accounting is told from the point of view of the business, not from the point of view of the owner.
A business owns itself.
A business owes itself to lenders and its owners.
A business owns assets.
A business has liabilities and capital.
Assets are what the business owns: bank accounts, equipment, buildings, accounts receivable, inventory, and intangibles.
Liabilities are what the business owes to lenders, the government, and a few others: mortgage balances, taxes payable, charge accounts, and so forth.
Capital, also called Equity, is what would be left over if the company sold all its assets, paid off the liabilities, and gave the left-overs to the owner.
The "accounting formula," which is the subject of chapter 1, page 1 of any accounting book expresses the idea that a company owns itself but owes it all to lenders and the owners:
ASSETS = LIABILITIES + CAPITAL
Saying that Capital is what would be left over if a company sold all its assets and paid off the bank loans and charge accounts can be expressed by rearranging the "accounting formula":
ASSETS - LIABILITIES = CAPITAL
Successful business owners and managers look at their businesses this way:
1. The "main deal" is not how much money a company is making.
2. The main deal is how much wealth the company is accumulating.
Income and expenses are only temporary "ideas."
If there is a profit, the assets increase.
1. Bank accounts go up.
2. The business buys more or new equipment.
3. Inventory goes up.
4. Bank loans are paid down or paid off.
If there is a loss, the liabilities increase.
1. The business borrows more money.
2. The business runs up charge accounts it owes.
3. The owners even lend money to the business.
4. Bank balances go down.
The basic unit of accounting is a "transaction."
This seems to be the stumbling block.
This seems to be the critical point where I hear "I don't know what the hey accounting is all about."
After hours of grunt work, the accountant finally figures out this about the business:
Assets = Liabilities + Capital
$150,444.50 = $75,500.75 + $74,943.75
Then you come along and make a sale for $100.00 and deposit it into the bank.
Now, gosh darn it, the equation is no longer in balance. You added $100.00 to the assets so now
$150,544.50 DOES NOT EQUAL $75,500.75 + $74,943.75
The person with the degree in "Glorified Arithmetic" points out that you are not thinking of the sale as a transaction. In his snooty way, he says:
1. You made a sale of $100.00.
2. You deposited the $100.00 in the checking account.
3. You forgot one more thing: the company now owes an additional $100.00 to the owners.
4. So, Doofus, not only did the assets go up $100.00 when you deposited the money in the checking account, but the capital went up $100.00 because the company doesn't get to keep the sales, it owes it to the owner!
  $150,544.50 NOW DOES EQUAL $75,500.75 + $75,043.75
The Italian Renaissance accountants worked out an easy way to know if the transaction was correct. We rarely think about that because QuickBooks checks for us; however, when we enter general journal entries in QuickBooks, then we do have to have the tranaction in balance.
"In balance" means that the debits equal the credits.
Some people think of the debit as a "plus" and the credit as a "minus." I suppose that's OK.
A debit represents what a company owns.
Hopefully one can make the quantum leap to understand that a debit might also be a reduction of what a company owes.
Debits are the amount added to bank accounts, increases in customer charge accounts, increases in the cost of equipment, increases in inventory.
A credit represents what a company owes.
A credit can also be a reduction of what a company owns.
Credits are the amount subtracted from a bank account, decreases in customer charge accounts, increases in loan amounts, decreases in inventory, and increases in amounts owed to the owner.
It really really most assuredly bothers some people that expenses are debits.
One of these people says, "An expense goes out, so an expense should be a minus amount, a credit. I absolutely positively so-help-me-God refuse to understand why an expense is not a credit. So don't even attempt to explain it to me. I refuse to understand if you try to tell me that an expense is a debit."
The credit is the check that decreased the checking account balance. In exchange for that check, the business now has something: paper, electricity, insurance, eight hours' worth of labor, whatever. The key is the word "has."
It might be easier for Mr So-help-me-God to understand why an expense is a debit if instead of electricity he bought a barrel of oil, instead of insurance he bought gold Krugerrands to put in the safe in case emergency money is needed, or buys a slave instead of paying for wages.
The Italians did not use plus and minus signs for debits and credits.
There are two ways to know whether an item is a debit or a credit.

In general journal entries, debits go on the left and credits on the right. Ledger pages are also done this way.
But usually you know whether a balance is a debit or credit balance by the list it is in. If the list is labelled "ASSETS," then the items are all debits.
If the label is "LIABILITIES" or "CAPITAL" or "EQUITY," then the items are credits.
If you see an amount in brackets (instead of a minus sign), it does not mean "minus" or "credit." It means "the opposite of what you would expect to find in this list."
A bracketed amount in the list of Assets is a credit that popped up unexpectedly.
A bracketed amount in the list of Liabilities is a debit that popped up unexpectedly.
If the bank account is overdrawn by $567.30, then the amount will be written as <567.30> and means "this time we actually owe the bank."
If the Taxes Payable was accidentally overpaid by $30.13, that will be shown as <30.13> because it is a debit that appears where usually credits are written.
Shirley has trouble with a check that is paid from one bank account to another.

She starts off with this. The company has a bank account with $70,000, owe the banks $50,000, and capital is $20,000:
$70,000 = $50,000 + $20,000

The company decides to open a new checking account to pay insurance and other annual expenses at the end of the year.
Shirley writes the check for $5,000.00 and calls in an expense called "Insurance Fund" or "Slush Fund" or "Emergency Checking Account."
That is soooooooooooooooo stupid, and she probably has a degree in Advanced Arithmetic.
What is so difficult about debiting a new Bank Account called "City Bank Checking Account"?
Then the first checking account goes down by $5,000 and the new one goes up $5,000. We now have:
$65,000 + $5,000 = $50,000 + $20,000
Shirley also has trouble with paying bank loans. (Shirley is an imaginary person who has a heart of gold but not very smart and very predictable).

She starts off with this. There is $90,000 in all of the bank accounts combined. The company owes banks $50,000 and the owners $20,000.
$90,000 = $50,000 + $20,000

Shirley writes a special check for all principal for $7,000.
She charges it to an Expense called "Loan Payments."
Someone save Shirley from me because I want to strangle her on sight when I see her again!
She should charge the check against the loan balance ending with this equation:
$85,000 = $45,000 + $20,000
Income and expenses are really temporary accounts. They fit into the accounting equation this way:
ASSETS + Income - Expenses = LIABILITIES + CAPITAL
At the end of the year the Income and Expenses accounts actually disappear.
ASSETS (increased by cash from profit) = LIABILITIES + CAPITAL (increased by profit owed to owner)
In ancient times before QuickBooks, on December 31 at midnight, the accountant would actually make general journal entries to change the year-to-date income and expense balances to zero and charge the amounts to Capital. Advanced Arithmetic graduates do not know how to do this now.
QuickBooks actually does this every day, so we can look at a balance sheet any day we want to. It was not always like that.

October 18, 2008