Finance with a review of accounting

Rules of accounting

A digression on phenomena that are predictable, but without date

How to get paid?
In the first half of this lecture, I briefly recalled the history of firms. Modern industrial firms are no more than two centuries old. We talked a little bit about money and value. There is a lot more to say on this topic. A big problem, particularly when we trade with foreign countries, is "how to get paid ?" It is as simple as that. You have barrels of petrol, or cars, or whatever; you ship them to, say, India; what to accept in payment? You need to receive something which will have value, and - more than that - which will keep value, and which you can use whenever you want to purchase other things.

The relative movements of currencies
This problem of value, in international commerce, is the problem of currencies, and the way they are related to one another. The movements between the euro and the dollar, for instance, have been fairly big. When the euro was introduced in 1999, it was worth around $1.20. Then, it went down, over the next three years, to about 80 cents of a dollar. Then it climbed back up, and, in early 2005, it reached $1.30, a more than 60% climb. We will learn what explains these wide movements, and what to expect in the future. I believe the euro will continue to go up with respect to the dollar, among other reasons because there are too many dollars and US TBills out there. But it is one thing to anticipate that it will go up; it is another thing to know when.

Phenomena predictable, but without date
This phenomenon is fairly common. Often we know that something will happen, but we don't know when. And, when it happens, the actual immediate causes are of little relevance. This is the case with snow avalanches, with earthquakes, with some social disruptions, but also with stock market bubble collapse, and with certain currency readjustments. In fact, focusing on the immediate causes instead of on the general conditions is a mistake. In particular, trying to eliminate all the possible immediate causes, in order to avoid the phenomenon is an error. It is impossible. And if we don't work on the deep structural causes, we will not be able to avoid the phenomenon, even though we cannot predict its date of arrival.

Accounting is the process of organising monetary information

A transaction: the "atom of activity" of a firm
The elementary activity of a firm is the transaction: a double movement of value; some value leaves the firm and some value enters the firm. Even small firms may record dozens of transactions every day.

Two movements of value
Value can be money, securities, promises, goods, services, electricity purchased, insurance, having premises at our disposal, labor, etc.. A transaction may involve no money at all: for instance, a sale of goods on credit involves no money. Yet it is an exchange of value of a monetary nature.

Simply a big organizing process
Accounting is nothing more than the process of recording and organising the monetary information about transactions. They come in a raw form in the journal. But the journal is not handy to see quickly how the firm is doing, and to help take the proper decisions in the large process of value creation.

Extracting meaning from organizing information
Organising information is something we do very often. For instance, it is what we do in our mailing software when we classify incoming mails into various folders instead of keeping them into one large "incoming mail" folder. The same is true with mails sent out.

Double-entry (double-movement) recording
In accounting the organising is a little more involved, because of the double-entry recording, and also because the posting process into accounts is only half of the work. The purpose of accounting is to produce a useful dashboard to pilot the process of value creation. It is done in two steps:

• Step 1: posting. Posting is the process of recording each journal entry into two accounts.
• Step 2: preparing synthetic documents (essentially the Income Statement and the Balance Sheet, prepared from the Trial Balance covering a given period).

The Trial Balance is simply the list of all the account balances. Some accounts record movements of value between two dates, t₁ and t₂. Some accounts record movements of value from the beginning of the firm. Then, the Trial Balance is itself treated to produce the Income Statement and the Balance Sheet. In standard accounting, some "year end adjustements" must be made on the Trial Balance to go to the two final documents.

The Income Statement is a film between t₁ and t₂
The Income Statement describes the activity of the firm between two dates, t₁ and t₂, usually the beginning and the end of the calendar year. There is no such thing as "an income statement at date t".

The Balance Sheet is a snapshot at date t
The Balance Sheet can be established at any date we want. It is a snapshot of the Assets and Liabilities of the firm at any given date. Usually we establish it at the end of every year (which is also the beginning of the next one).

Double-entry accounting requires a bit of practice
Double-entry accounting requires a bit of pratice before the deep logic of the process becomes clear. At first we tend to think that many recordings "should be the other way around". Why money arriving in the firm leads to a debit in the account recording this money? Why a sale is recorded as a credit in the Sales account? Why, when we have money in the bank, our bank account is in debit (in our books; and it is in credit in the bank's books)? Etc.

Very powerful method to monitor and run a firm
Accounting produces a set of documents that are unbelievably powerful to manage a firm.

It's fundamental to master accounting to understand finance
Since Finance is concern with the process of value creation, and Accounting is concerned with the recording of movements of value, it is fundamental to be at ease with Accounting in order to understand Finance.

Rules of accounting

Accountants are very tidy people
Accountants are very tidy people. They used to have a beautiful handwriting, because they made their additions by hand. They tend to be nitpicky; it is not a fault, on the contrary, it is necessary in order to be a good accountant. They often dislike the ball park approximations with which consultants are used to work. Standard commercial accounting softwares are built in such a way that an entry, once made, cannot be erased. In accounting we don't erase mistakes, we correct them by making another entry. The reason is that accounting wants to record information, not to delete it.

The accounting system is one of the tools to manage the firm.
There are many other tools which are necessary to managers: production reports, sales reports, reports on human resources, information on product and production technology, on competition, etc.

In order for the accounting system to be useful, and to produce useful synthetic documents, some rules must be followed. They are classified into three categories:

1. Boundary rules
2. Measurement rules
3. Ethical rules

1. Boundary rules

1.1 Entity rule: distinguish clearly what concerns the firm and what does not. Do not mix up transactions concerning the firm and transactions, for instance, concerning the owners, or other agents. The vacations of the boss should not be an expenditure of the firm. Do not overlook transactions concerning the firm (example of the rent overlooked by the owner of "Les Editions Entente").

1.2 Periodicity rule: establish the final documents on regular basis, usually at the end of every year. Stick to the same period. The period is usually 12 month long, because most firms have activities with a seasonal pattern, and if we used, say, periods of 9 months, two successive periods would not be comparable.

1.3 Going concern: record all transactions with the assumption that the firm will exist forever. There are economic activities which are not firms, and which are not going concerns, they are projects with a beginning and an end. Building a bridge is such a project which is not a going concern.

1.4 Quantitative rule: record only quantifiable information (in monetary terms) in the accounting system. For instance, a sale for $100 to a new client, which opens nice perspectives of development, will be treated in the same way as a sale for $100 to a small unimportant client. The strategic value of the new client is a useful piece of information, but is not of an accounting nature. Another example: if we buy two identical machines, with the same cost, and one works better than the other, this piece of information will not get recorded in the accounting system. Skills of workers are not recorded in the accounting system.

2. Measurement rules

2.1 Money measurment: everything is recorded in monetary units, and with the same monetary unit. In the first example of the toy manufacturer, before going into accounting, I explained that, at the end of month three, the assets of the firm were 7000 €, plus an IOU for 20 000 €, plus 1000 toys ready, plus some other assets. "1000 toys" is not an accounting information; it must be measured in euros. There are accounting techniques to evaluate stocks, particularly for manufacturing firms. Multinational firms must present a balance sheet in one currency, not several. Currency movements are a big problem for multinational firms. Sometime a growth of 10% achieved by an overseas subsidiary can wiped out by a depreciation in the local currency in which it deals. Often we read in annual reports sentences like this: "The loss last year was 7%, half of which is due to currency variations". There are some ways to try and protect oneself against currency movements. It is called hedging. It belongs to the field of options and futures. We shall talk about this later.

2.2 Historic costs: assets are recorded in the accounts at their value when they were purchased. Usually this record will not be changed in the books, even if the value of the asset has changed. The typical example is the case of a firm that bought land many years ago, recorded it at its value at the time of purchase, and now the land is worth much more. We do not make a change in the books to take into account this appreciation. This rule has the drawback of making the balance sheet not quite representative of the reality of actual values. This is true of financial assets too: even though their value varies a lot, they are usually not changed in the books. As a result, balance sheets often contain "potential capital gains" - or losses. (There are new rules, called IFRS, which, under some circumstances, enable you to increase historic values.) Even though the historic cost rule says "do not change values", if we know that some asset has lost a lot of its value, in that case another rule (the prudence rule) says "record now the potential loss".

2.3 Realisation rule: it is an important rule, it concerns the date of a transaction (and therefore to which accounting period it belongs). It says: the date of a transaction is the date of change of ownership of the goods sold, or bought. Usually the date of change of ownership is the shipment date. But there are exceptions, when the change of ownership takes place only when the goods are actually paid. It has an important legal consequence in the case of bankruptcy: what does not belong to the firm in banruptcy, even if it is on its premises, will not be included in the liquidation procedures, but will return to its owner.

2.4 Matching rule: again, an important rule. In establishing the Income Statement for the period [t₁, t₂] record only sales and expenditures that correspond to that period. If, the 1st of December, we pay for three month of forthcoming rent, and the accounting period is the calendar year, only a third of this expenditure should be counted into the current period.

2.5 Dual aspect: it simply says that a transaction involves two accounts, one will be debited, and one will be credited. It is the technical translation of the fact that a transaction is made of two movements of value, one leaving the firm, and one entering the firm.

2.6 Materiality rule: we create different accounts to distinguish expenditures or assets or liabilities of a different nature, but we don't create new accounts for insignificant things, we treat them as a lump quantity. For instance, we may have an account called "Stationery", but we will not have separate accounts for pens of different colors. In the same spirit, we don't create a new folder for every new incoming e-mail, otherwise we would have as many folders as e-mails, and the whole classification process would become meaningless.

3. Ethical rules

3.1 Prudence rule: surprisingly enough there are transactions where we have a choice of how to record them (this is the case, for instance, of making provisions). The rule says: when you have a choice between several recording methods, choose the one that minimizes the profit. That way we are prudent. (It is one of the reason of the historic costs rule.) It is easy to be overly optimistic with one's accounts and show a profit that is misleading. And then, after a while, we run into trouble - usually lack of cash.

3.2 Consistency rule: when you have adopted one accounting way to treat such and such transaction, stick to the same way in the subsequent periods. It is important, because one of the functions of the accounting system is to show the evolution of the firm from one year to the next. If we change the accounting procedures, we end up with figures which are no longer comparable. This rule applies, in particular, to depreciation calculations; if we selected a linear depreciation over 5 year for our new cars, we must stick to the same depreciation calculations for future cars we acquire.

3.3 Objectivity rule: don't introduce personal bias in keeping your accounts. If you have a set of procedures to make provision for bad clients, don't say "this one, even though it falls in the category that is provisioned at 25%, we will not provision, because it is a friend of mine..." or "because I feel he will recover..." Be objective.

3.4 Relevance rule: put only relevant information in the accounting documents and their accompanying appendices.

These rules are all fairly natural. They are designed to make the accounting documents as useful as possible.

Exercises

Use the mini_accouting.xls software to check that you know how to post transactions and what is the effect of various transactions on the final documents.

Establish a Trial Balance from a sequence of transactions recorded in the Journal.

Example:

Journal

Trial Balance

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