Brain Dead Simple! Accounting Concepts Susan D. Tiner Brain Dead Simple! Financial Organizing
Cover image of Luca Pacioli from Wiki Commons (http://commons.wikimedia.org/wiki/File:Luca_Pacioli_(Gemaelde).jpeg#file)
Introduction You do not need not need to wade deeply into accounting theory just to understand the basic principles well enough to manage your own personal and small business bookkeeping. The basic principles developed in this document are: • • • • •
the accounting equation the purpose of accounting accounts and balances debits and credits financial statements
The Accounting Equation There is one equation that lies at the heart of the accounting model and it’s called the accounting equation. equation . Most people intuitively understand this equation by thinking about the familiar example of buying a house.
Accounting Equation
Assets
Liabilities
Owner Equity
Assets
Liabilities
Owner Equity
You know intuitively that the equity of your home is its fair market value less the outstanding mortgage amount. Well, that’s the accounting acco unting equation! Look at the first equation shown you’ll see that it’s written just the wa y you typically understand it. In this case, the asset is your home’s fair market value, the t he liability is your outstanding mortgage, and owner equity is the equity you have in your home. This is the wealth you’ve accumulated in your home due to payments reducing the mortgage and market appreciation increasing its fair market value. The first equation makes a lot of sense, but the problem is that this equation is normally written in the second form shown. These two equations are equivalent equations, but b ut you
might not find the second equation quite as intuitive because of the way it’s written. You might wonder why it’s written in a counterintuitive way, and there is a reason for it, but that discussion is beyond the scope of this document. The best way to deal with the unfamiliar form is to convince yourself you can move the parts around and the equation is still true. For example, once you’ve figured out your home equity, however you calculated it in the first place, you must agree a gree that if you take the amount of your home equity and add to it the outstanding mortgage amount, this equals the fair market value of your home. The accounting equation is actually more general than the home example above. Let's generalize to personal finances first, then switch to business entities. Another way of thinking of the above equation, in more generalized form, is the value of all your personal assets (e.g., house, car, furniture) - the balance of all your liabilities (e.g., mortgage, car loan, bills due) = your personal net worth Cleaning this up a bit we have: personal assets - personal liabilities = personal net worth (or personal equity) This is nearly equivalent to the formal accounting equation: assets - liabilities = owner equity In the personal case, the owner is you. In a business entity, the owner might be you or stockholders—but let's hold off on discussing the business case for now.
The Purpose of Accounting The accounting equation: assets - liabilities = owner equity is usually abbreviated A - L = OE In the personal context, consider the following scenarios: sce narios: •
•
•
Assets going down in value, e.g., a decline in housing prices making your home worth less, Savings, i.e., what’s left over after you subtract al l your expenses from your income, Taking out a home equity loan to remodel your house.
As you think of each situation, do you understand how your net worth increases or declines as a result? Double-entry bookkeeping formalizes our intuitive understanding of what happens to our net worth as a result of changes to our assets and liabilities. To put this into an historical context, the Italian monk Luca Pacioli (pictured on the cover) published in 1494 what became bec ame the first widely read description of double-entry bookkeeping. Pacioli himself gave credit for originating the method to Benedetto Cotrugli, who had earlier published a manuscript describing d escribing features of double-entry bookkeeping. Both Pacioli and Cotrugli addressed the needs of the “trader” in determining his financial position. Pacioli's work specifically aimed to give “the trader without delay information as to his assets and liabilities.” At a high level, the purpose of double-entry bookkeeping is to: a) give a business entity an ability to compute its equity position, i.e., the difference between what the entity owns and what the entity owes, and b) give a business entity information on the transactions that affect equ ity—income and expenses. Consider the transaction: •
Assets going down in value, e.g., a decline in housing prices making your home worth less.
Suppose your house, when you bought it, was worth $1,000,000, your mortgage was $800,000, and your equity—in this case the down payment—was $200,000. So you had A = $1,000,000 L = $800,000 OE = $200,000 Since A - L = OE must hold true, let’s see if the above numbers work: $1,000,000 - $800,000 = $200,000 They do! But now your house has gone down in value to $850,000. $850,000 - $800,000 = $50,000 The asset going down in value makes the equity go down by an equal amount. This is the fundamental principle of accounting—the equation A – L = OE must always hold true.
This means that a change in one term must always be balanced by an equal change to another term such that A – L = OE is still true. This balancing of one change with another change of equal amount means that every single transaction creates two changes. This is where the te rm double comes from in double-entry bookkeeping. The practice of accounting is all about abo ut figuring out the equity or net n et worth of individuals and businesses. Accountants examine transactions and fit them into the equation A - L = OE so that the equation stays in balance. Why is it so important to compute net worth? Banks care because they secure loans based on equity. Individuals care, because in order to retire they need to increase net worth over time to the point where it’s possible to live off of the savings. In the case of business entities, e.g., corporations, shareholders care because they want stockholder equity to increase. When accounting is done properly, net worth is calculated accurately. When accounting is manipulated, e.g., Enron, the results are disastrous. In a sense the entire world economy depends on accounting being done properly because faith in financial markets is based on everyone following the same core accounting rules. QuickBooks forces the above equation to hold true. This means if you change a value of one of the terms, you'll have to change the value of another by an equal amount to keep the equation in balance.
Accounts and Balances Before examining more transactions, it’s important to understand accounts. accounts . The elements of the accounting equation are not actually terms but accounts. Accounts are things that have balances that go up and down. There are three types of accounts: 1. assets, 2. liabilities, 3. equities. We've been talking about a house as an asset. If you put your house as an asset into a personal accounting program like Quicken it will have h ave a balance reflecting its current market value. If you were to login to www.zillow.com and see that your house value has gone up, you'd increase the balance of the house account in Quicken. The mortgage is also an account, in this case a liability account. Your net worth is also an account, but you don't change its balance—Quicken changes it automatically based on the balances of all your asset and liability accounts.
Getting back to the example of your house going down in value: A (house value goes down by 150k) – L (mortgage stays the same) = OE (goes down by 150k) $850,000 - $800,000 = $50,000 The balance in the house account is 150k smaller and the OE account balance is also 150k smaller. Now you want to remodel, so you take out a 10k home equity loan. A (stays the same) – L (goes up by 10k for equity loan) = OE (goes down by 10k) $850,000 - $810,000 = $40,000 How does savings affects your net worth. What is savings anyway? Savings is what’s left over from your income after you pay for all of your expenses. ex penses. If the result is positive, you’re a little richer. If it’s negative, you’re a little poorer. When you get paid, your checking account—an asset—goes up and your equity goes up. When you pay a bill or expense, your checking goes down and your equity goes down.
Debits and Credits Just when you got used to the standard form A - L = OE we have to switch it because the form below is the one used on the financial statement called the Balance Sheet and an d it’s also the form that’s best for understanding what’s going on with debits and credits: A = L + OE Now you know that these terms are really accounts, e.g., asset accounts, liab ility accounts and equity accounts. Every time you make the balance of one account go up or down you must make another account go up or down by that same amount to keep the above equation in balance. Double-entry bookkeeping bookk eeping was set up such that the first transaction is defined to be a debit to an account, and the second transaction is defined to be a balancing credit to another account. For every debit there is a matching credit such that the sum of all debits equals the sum of o f all credits. The main accounting equation eq uation stays in balance after every single pair of transactions. The convention is to record the debit first, then the credit.
Let’s take the example of paying a $50 check to a vendor for a telephone bill. The checking account is an asset account (A), typically classified as cash. The vendor bill is recorded in a liability account (L) called accounts payable. accts payable (L) (dr -)
(cr +) 50
350 300
Cash Checking (A) (dr +) 3000
(cr -) 50
2,950
Since cash is an A (asset), it’s on the left side of the equation A = L + OE. The convention for the left side is that debits increase the account balance and credits decrease the balance. For L and OE accounts on the right side of the “=” sign the convention is that credits increase the balance and debits decrease the balance. In our example, accts payable starts with a $350 balance, then you record a debit of $50 of $50 to pay the telephone bill. The color red means the balance is going down. The ‘T’ looking diagram is just that. It’s the way to represent an ac count and it’s called a “T” account because it looks like the letter ‘T’. Notice that debits always go on the left and a nd credits always go on the right regardless of whether they make the account go up or down. So we record the of $50 of $50 to pay the telephone bill and that action makes the accts payable decrease to $300. Now we have to matching a matching credit. In this cash the action of paying the bill makes the checking acct balance go down by $50 $50.. In this case checking has a beginning balance of $3000, then we record a $50 credit and now the balance is $2,950. Going back to A = L + OE we see that it’s still in balance: A (goes down by $50 $50)) = L (goes down by $50 $50)) + OE (doesn’t change) To recap, for every debit there is a matching credit. Suppose you create a table with two columns—one for debits and one for credits, and list one account per row. If you record the debit or credit balance per account the total amount of debits should equal the total amount of credits.
Financial Statements The balance sheet shows asset, liability and equity account balances on a specific date. Dec 15, 07 ASSETS Current Assets Checking/Savings
90,695.84
Accounts Receivable
81,798.70
Other Current Assets
87,869.36
Total Current Assets
260,363.90
Fixed Assets
407,291.13
Other Assets
1,041.85
TOTAL ASSETS
668,696.88 668,696. 88
LIABILITIES & EQUITY Liabilities Current Liabilities Accounts Payable Credit Cards Other Current Liabilities
54,405.04 5,127.62 12,585.62
Total Current Liabilities
72,118.28
Long Term Liabilities
77,447.18
Total Liabilities
149,565.46
Equity
519,131.42
TOTAL LIABILITIES & EQUITY
668,696.88 668,696. 88
The profit and loss (or income) statement shows the net of income less expenses that will increase (or decrease) equity. Oct 1 - Dec 15, 07 Ordinary Income/Expense Income Construction Labor
37,769.25
Materials
69,039.51
Miscellaneous Subcontractors Total Construction
4,560.55 57,207.01 168,576.32
Total Income
168,576.32
Cost of Goods Sold Cost of Goods Sold Total COGS
Gross Profit
8,541.37 8,541.37
160,034.95
Expense Automobile Insurance
712.56
Fuel
231.10
Automobile - Other Total Automobile
Bank Service Charges Freight & Delivery
10.60 954.26
47.50 139.60
Insurance Disability Insurance
300.00
Liability Insurance
2,100.00
Work Comp
1,650.00
Insurance - Other Total Insurance
297.66 4,347.66
Interest Expense Loan Interest
288.05
Interest Expense - Other
651.77
Total Interest Expense
939.82
Job Expenses Equipment Rental Job Materials Permits and Licenses
1,000.00 38,059.07 700.00
Subcontractors
44,166.00
Total Job Expenses
83,925.07
Payroll Expenses
29,513.77
Professional Professional Fees Accounting Total Professional Fees
250.00 250.00
Rent
1,200.00
Repairs Building Repairs Computer Repairs Equipment Repairs Total Repairs
Tools and Machinery
175.00 45.00 0.00 220.00
1,160.00
Utilities Gas and Electric
277.08
Telephone
100.71
Water Total Utilities
Total Expense
Net Ordinary Income
61.85 439.64
123,137.32
36,897.63
Other Income/Expense Other Income Interest Income
93.42
Other Income
37.50
Total Other Income
Net Other Income
Net Income
130.92
130.92
37,028.55
