1. Opening:
Accounting defines profit. There are no investment activities without profit. Without profit, there is no capitalism. Therefore, accounting is the foundation of the capitalism.
For profit calculation, we need a robust recording system. The recoding tool is called the double bookkeeping system. Surprisingly, this recording tool never changes more than 500 years in its principle.
This presentation goes through the process how the financial statements, which measure our corporate performance, are generated, and understand the functionality of the double bookkeeping system.
2. Agenda:
Double bookkeeping system. As it called “system”, it is automation and processes enforcement.
Balance Sheet (BS) / Profit Loss statement (PL). These are called financial statements. Financial statements are the outputs of the double bookkeeping system. Therefore, changes on the financial statements will impact on the mechanics of the double bookkeeping system. This is similar to computer system. If output changes, the internal mechanics of the computer system has to change.
These two are linked. Financial statements are the output of the double bookkeeping system.
3. History of Accounting:
A brief history, the first accounting book was written by Luca Pacioli during Renaissance time. Luca is a close friend of Leonardo da Vinci. As the book title indicates, “Summary of arithmetic, geometry, proportion and proportionality”, this is a mathematics book. The reason why the first accounting book was written as mathematics book is, mathematics and bookkeeping were written in the same format, sentences and paragraphs. Sciences were not branched out still.
4. Double Bookkeeping system:
Double bookkeeping system is a great human invention, just like mathematics. This is because double bookkeeping system allows users to do recording, tracking, calculating, reporting and checking without understanding how accounting works, so long as following pre-determined steps and formats. This is an analogy of a computer system. We can use computer system, without understanding how it works.
5. Account Origin (1) :
Let us start with “what is account” to understand the double bookkeeping system. In Ancient Rome, lending money is not accepted moral with citizens, therefore handled by non – citizens. The initial form of bookkeeping was recording “I owe you” and “you owe me”, i.e. debtor and creditor. In this context, accounts are personal names. Debit and Credit have the original meaning of debtor and creditor.
6. Account Origin (2) :
After Industrial revolution, economic activities evolved significantly. Accounts are no more personal, but can be anything. The key observation on this slide is, “profit/loss” account. This is purely conceptual, doing profit calculation. Accounts are detached from the context of debtor/creditor. Debit and Credit simply mean left and right in modern days.
7. Book Structure:
The next few slides are to describe the interface of the double bookkeeping system with a simple example.
Books are just notebooks. Ledger is a book recording financial information, which can have multiple accounts. Ledgers are a part of the double bookkeeping system which means to say it can impact on the outputs i.e. financial statements, whereas Journal and Daybook are not. Journal and Daybook used prior to Ledgers.
8. Journal / Daybook:
The usage of the sales day book is, first, sell products on credit by issuing invoices. Second, record date, invoice No and amount of the transaction. At this stage, The Folio column is blank. Finally, once the transaction information is posted to Sales ledger, fill out the folio to indicate to which ledger being posted. Since Sales ledger is also another notebook, it is important to note which page, in this case, the page fifteen (SL15) for traceability.
9. T-Account (1):
C Knight and D Mike are account names in the Sales Ledger. All the four sales of the previous slide were posted on the left hand side. On the right hand side, there is an entry of Bank $200, indicating C Knight has paid $200 on the Aug 28th.
At the end of the each financial period, we need to close off the balance for reporting. The steps to close off the account are 1, calculate the total amount of each side, 2 calculate the difference between the two sides, and post the difference as balance carried down to balance off. 3 the double lines indicate the amount 300 is “total amount” and the single line is meant to say “account is closed”, 4. Post the balance brought down for the next period.
Account is called “debit balance”, when the balance B/D appears on the left hand side. And account is called “credit balance” when the balance B/D appears on the right hand side. If balance does not appear on the either side, it is called zero balance.
10. T-Account (2):
The total amount of the sales book is posted to the right hand side of the Sales account which is a general ledger account (nominal accounts). The key observation here is the information of the sales book has been posted to two sides left and right. And the total amounts of each side are the same, $500.
11. Posting Rule:
For reporting purpose, we need to close all the accounts, and list up all the outstanding balances periodically. This process is called “Trial balance“. Since the same amount is posted to both left and right side, the total of the debit balances and the total amount of the credit balances are always equal in the double bookkeeping system. This checking can be done with an accounting entry by transferring out all the balances to one account, called “control account”. The balance of this control account should be always zero balance, otherwise posting error. The key observation here is, recording of transactions, tracking of customer payment, and checking the posting accuracy are all done in the same format, i.e. debit and credit. This is the greatness of the double bookkeeping system.
12. Five Accounts (Cycle):
The next few slides are to answer which account and which side. This is determined by the financial statements.
As explained, debit and credit are just left and right. Therefore we need a context to determine which side. The context given is, first, company needs to raise money by borrowing money (liability) or using own money (Equity). Second, spend the money for whatever necessary to maintain a business (Asset). Finally, generate profit by using assets and the profit goes back to equity. The key observation here is, only Asset can have tangible accounts, such as lands and cash. The rest of the four are all conceptual.
13. Which Account (1):
The vertical line, in and out This distinction is linked with cash flow, either associated with in-coming cash flow or associated with out-going cash flow, with an exception of cash itself. The horizontal line, stock and flow are related to each financial period. If we need to retain for the next financial period, that is stock. If not, then flow. Again stock will be retained within the company, flow is not.
14. Which Account (2):
The outputs of the double bookkeeping system are BS and PL. BS is the list of outstanding balance of stock accounts. PL is the list of outstanding balance of flow accounts, and calculating profit. The distinction between B/S and P/L are sometimes arbitrary. An investment company led by ex-chairman of NASDAQ, Bernad Madoff, was collecting money from investors which are supposed to be stock, but distributed as profit to investors.
15. Which Account (3):
Here is the example of account names.
16. Profit Calculation:
The next few slides are to understand profit in detail. Business entities before the industrial revolution are more like a project basis. Once voyage or journey is over, liquidate everything, and the leftover is the profit. On the other hand, the modern business entities do not have the specific end date. Therefore profit has to be allocated across several financial periods. In short, PL accounts have introduced to allocate profit across periods.
17 Accounting Equations (1):
What we have discussed can be summarized into two equations. First, Balance Sheet Accounts, “Asset – Liability = Equity“. In this equation, increase in Asset automatically follows increase in either Equity or Liability to balance, indicating the double bookkeeping system. Equity is owner’s share after returning liabilities.
18. Accounting Equations (2):
Second, Profit / Loss statement, “Income – Expense = Profit”. When we post to PL accounts, we are touching profit.
19. Accounting Equations (3):
Profit is added from the profit and loss statement to the balance sheet every financial year end. In this example, the profit $100 is added, so that Equity is increased by $100, assuming no dividends. The key observation here is, BS and PL are linked via profit.
21. Posting for Allocation (1):
In profit distribution, there are always trade-offs among stakeholders. Say, tax authorities / short term investors would like to recognize profit (i.e. distribution) as soon as possible. Long term investors / debt holder would like to delay the recognition of the profit.
Profit can be manipulated either by deferral or accrual. “deferral “means, cash flow already happened but retained in B/L first , and posted to P/L accounts later. “Accrual” means cash flow has not taken place yet, but posted to P/L first before cash flow.
22. Posting for Allocation (2):
Once cash flow is either deferred or accrued, profit is impacted. And this information is kept in stock accounts i.e. B/S. This slide explains which accounts for which. Take depreciation as an example. A bakery shop purchased an oven for coming 10 years at the price of $100. If we post this $100 as expense in one shot, the short term investors will not have profit. For the sake of fair profit distribution, we post $10 for each year over the 10 years to expense account. In this example, cash outflow already happened. This is the case (A). Next, a bookshop received 2 years subscription fee $240 in advance. So we post $10 for each month over the two years. In this example, cash inflow already happened, but profit was deferred, so case (B). The importance thing here is, the adjustment of profit is accepted for certain justices, such as fair distribution of profits so on.
23. Posting for disclosure:
On top of the justice, fair distribution, there is new trend of a justice, so called “Disclosure”. This is because financial markets are so predominant nowadays. Profit can be up and down based on stock price, without any cash flows. The key understanding here is, profit can change even without cash flow. And this is the reason why cash flow statement has been introduced.
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