Tuesday October 14th 2003
Accounting 1 session 1
This is the first semester of a two semester course in accounting.
Accounting is a set of techniques necessary to manage a firm. It records in some organized way events happening in the firm. And it produces useful summarized information.Therefore, naturally enough, the very first accounting document is some sort of a log book of events in the firm: it is called the journal. To well manage a firm an accounting system is necessary, but it is not sufficient. Managing a firm is a complex matter, that's why managers are usually well paid.
This is not a course to make you into certified accountants. We shall not study the fine techniques CPAs (certified public accountants) learn. But you will learn all the techniques necessary to be a good manager. Most of you will become managers, in large firms or in small firms. You will have professional accountants working for you. However in order to understand the figures they will present to you, and to take correct decisions, you need a good general understanding of accounting. This is the goal of this course.
The first semester is concerned with "general accounting" that - we shall see - is legally required, produces very synthetic documents, is mostly concerned with analyzing the past ("what happened in our firm over the past year...?"), and some of the information of which must be made public. Your clients will have access to it. Your competitors will have access to it.
The second semester is concerned with "cost accounting", also called "managerial accounting", (in French: "comptabilitι analytique") that is not legally required, produces very detailed analyses and documents, is mostly concerned with forecasting the future ("where do we want to go, and how to get there...?") and which is definitely not made public. It produces sensitive information that you do not want your competitors to know, and not even your suppliers or your clients (for example your margins per product). You may give some of it to your banker if it's a condition he puts to lending you more money...
What is a firm?
It is an organization of people, and tools (or equipment, or machines), located in some premises, to produce products and services, and of course to sell them on various markets.
Classification of firms :
It is customary to classify firms into manufacturing firms and service firms, and to distinguish small firms from large firms. Let us list some examples:
A small toy manufacturer
A lawyer office
A real estate agent
A TV repair shop
Note that this classification is crude. Most manufacturing firms also produce services : they sell, sometimes to the public at large. A baker is classified in manufacturing, but it is much a service producer as well. This classification is for convenience to fix ideas, no more.
A detailed example :
a small manufacturer making wooden toys, in particular this funny little toy called in the West a Chinese snake :
I found this toy in France at a small handicraft producer in Burgundy, a guy who had decided to live in the countryside and earn his living making wooden toys that he sold mostly to distributors and occasionally to visitors to his small workshop like me.
The choice of which market we shall try and sell to is an important one. Running a firm selling to wholesalers is different from running a firm selling to the end consumers. The job of the salespeople is not the same. The costs are not the same. The gross margins are not the same either.
Let us imagine and note all the important events from the outset until the end of the first four months of the Chinese snake mfr. (MFR stands for "manufacturer", and "MFG" stands for "manufacturing".)
1) First we need to gather some money, because we shall have plenty of expenses to set up the firm and to launch the production and the selling organisation, before we earn our first euro from sales. We want to start with, say, 50 000 . Usually we will not be able to get this initial money from a bank. So first of all we gather 50 000 from our own savings (10 000 ), from our family, it is called "love money", (20 000 ), and from friends (20 000 ).
2) Secondly we open a bank account and put the 50 000 on the new bank account. We could of course put the money into our own personal bank account we already have, but it would be a bad idea because we would soon mix up personal expenditures from expenditures for the firm. And anyway it is legally mandatory.
3) We need premises. We rent a place and pay right away six months of rent, 5000 .
4) Let us take care of "human resources": we hire two people to work with us. One will be in charge of manufacturing, and one will be in charge of selling. You as the boss will be in charge of the administrative chores, relationships with the authorities, with the bank (you will be the one "having the signature" for the checks), and you will organize the work of the other two people. Each employee including yourself will cost 2000 per month. One of the persons has to be in charge of purchasing. Suppose this is you the boss that will take charge of that too.
5) We need to purchase office equipment: a table, a file cabinet, and a desktop computer. This plus some expenditures for fixtures amounts to 3000 .
6) We are at the end of week one. We purchase a used van, 4000 .
7) We purchase a mechanical saw: 2000 .
8) We purchase raw materials, wood planks, tape and glue: 2000 . Let's keep track of how much money we have spent so far: at the end of the second week we spent 16 000 . We still have 34 000 in the bank account of the firm.
9) The manufacturing employee begins to make toys. The salesperson sets up a selling program, and begins to call potential clients (they are called "prospects").
10) At the end of month one we have to pay salaries, and the charges that go with them (social security, etc.), 6 000 , the telephone line (we also got a telephone) 1000 , and we also spent 1000 in gasoline and hotel expenditures. So we are down to 26 000 at the bank.
11) At the end of the second month we have to pay the same expenditures plus say electricity and maintenance expenses in the workshop: altogether 10 000 . We are down to 16 000 at the bank.
12) We also note that we have wood wastes of 20 percent: that is 80 percent of the wood we purchase ends up in our toys and 20 percent are wastes or rejects.
13) We also note that the manufacturing employee produces 50 toys per day, about 1000 toys per month. And the salesperson visits on average two prospects per day in France.
14) At the end of month 3 a great news: our first sale. Carrefour orders from us 2000 toys. The final price of these toys will be 20 per toy, on Carrefour's shelves. But we sell to Carrefour at the price of 10 per toy: a first sale of 20 000 ! We celebrate in a restaurant, 100 .
15) Carrefour will pay us in 45 days. In the meantime we have a "bill" signed by one of Carrefour's chief purchasers (a piece of paper called an IOU) certifying that we shall get paid in a month and a half.
16) At the end of month 3, we have to pay the usual salaries, 6000 , and various other expenditures 2900 (of course we have a detailed list of these expenses). We ship the 2000 toys to Carrefour. They no longer belong to us.
If we list what the firm has at the end of month 3 we get this: 7000 in the bank, a piece of paper from Carrefour promising a payment of 20 000 in a month and a half, no raw materials left,1000 toys ready for sale, a used van, a mechanical saw, and some office equipment.
17) We purchase raw materials: 1000 . At the end of month 4 we pay the salaries (but the boss decides not to pay his own salary - well it is not really a choice :-) is it ?): 4000 . And we pay various expenditures 1500 . At the bank we are down to 500 . We shall wait until Carrefour's check to purchase more raw materials, and to pay with a delay the boss salary.
18) We receive the check from Carrefour: 20 000 .
And life goes on.
What are the points I want to illustrate with this logbook?
I want to illustrate that we have to keep track of all sorts of pieces of information to run the firm. A central one of course is the amount of money, at any point in time, left in the bank. But we have information about raw materials, about assets, about clients, about productivity of the employees, about expenditures like gasoline, or hotel expenditures etc. All this information has to be monitored. That is the job of the boss.
Some of this information is of a monetary nature. And some of it is not of a monetary nature (for instance the legal contracts signed when we hire people).
Accounting is a set of techniques to organise and present in a useful manner the monetary information recorded in the logbook. The information properly organised and properly presented in a synthetic way is very useful to managers.
In accounting the logbook that records very precisely all the information, on a daily basis, concerning the monetary operations of the firm is called "the journal". The sale of 2000 toys to Carrefour for 20 000 is a monetary information, even though no money is exchanged on the day of the sale. But value is exchanged.
The little example of the foundation and beginning of operations of the toy mfr already touches many of the questions treated in accouting :
We shall study all this in depth during the semester. The example is a simple one, but it is rather realistic. The steps listed correspond reasonably well to what you have to do to start a small wooden toy manufacturing firm. (The only thing unrealistic is that it will take a longer time and much efforts before you sell to Carrefour, but we may very well get clients within three or four month. In late 1992 I founded my third firm, a firm making CD-ROMs, and I got my first sale to FNAC in july 1993. FNAC paid within one week, but only if you granted them a further 3% discount, which I cheerfully accepted...)
First ideas stemming from the toy manufacturer example :
Fundamental principle: never run out of cash. Because if you go very low on cash and put yourself in a situation where you will not be able to pay a forthcoming expense, then you will go bankrupt.
This leads naturally to a second principle: keep constantly track of forthcoming expenses, and keep forecasting as well as you can future cash inflows. This process is called budgeting. By the way do not confuse a sale with a cash inflow.
In this example we saw the difference between several types of expenses: the expenditure to purchase a mechanical saw is of a different nature than the travelling expenses for the month of September. Accounting will treat them differently. Within "current" expenses we also see many differences: the purchase of wood is of a different nature from, for instance, the monthly expenses for telephone, or the salaries. All these will be carefully recorded separately by the accounting system.
Expenditures for equipment like a mechanical saw or a desktop computer or a delivery van are called "capital expenditures" (we shall see in the second half of the session that the etymology of the word "capital" here refers to cattle heads!). These pieces of equipment are tangible and remain within the firm for several years. They become what we call "assets of the firm".
Expenditures like salaries of the month of September or travelling expenses or the monthly rent etc. are not "capital expenditures". These expenditures are of another nature. They correspond to some sort of "consumption", just like when you buy yogurts, or pay your piano teacher, as opposed to when you buy a bicycle. The name used in accounting for these "consumption expenditures" is "revenue expenditures". (The wording may be a bit confusing, but we weren't asked when it was chosen...)
Salaries or rents do not end up as assets of the firm. (Every rule having exceptions we will also meet exceptions, but they are not important to understand accounting at the beginning.)
The sale to the client (in our example it is our first sale, and it is to Carrefour):
After a few months of efforts we win a sale to Carrefour. That is we get an order from Carrefour. We ship the next day, or a few days later, 2000 toys to one of Carrefour's warehouses. On that day we cease being the owner of the toys. The ownership is transferred to Carrefour. In exchange for the toys we do not get money yet. We get an IOU of 20 000 to be paid in 45 days. Technically it can be "a draft at 45 days sight", that is in 45 days we shall receive the money in our bank account, or it can be another way of payment. We don't need to know all the means of payment right now. It is sufficient for the time being to call that an IOU.
This IOU is interesting. It replaced 2000 of the 3000 toys that we had in our firm, waiting to be sold. This IOU is an asset of the firm. It is not money, but it definitely has value. Since Carrefour is a very big firm, very well known, and very trustable, there is no question that our IOU will be transformed into 20 000 in a month and a half. That is because Carrefour is "trustworthy".
The question of trust is central in business.
Whenever we exchange something coming from our firm for something else coming from somebody else we have to make sure that what we will receive has the value we are told. Sometimes there is no question (eg. Carrefour). Sometimes it requires trust (=faith) on our part (eg. a new unknow client wants to buy 1000 toys, receive them in one week and pay in two months.). We may accept or we may not. Usually we require new clients to pay when they first order, and after a while if they appear to be serious we may apply a more flexible "payment policy".
When we trust a potential client, we shall accept for instance an IOU promising a payment in one month or in two months. We shall "extend credit" to the client. "Credere" means "to trust" in Latin. "Credit" will appear again and again in commerce and therefore in accounting.
By the way "commerce" means "exchange", "social intercourse" says my dictionary. This is one of the reasons why doing business is so interesting: not only if we're successful do we make plenty of money :-), but we constantly deal with people and have to evaluate who is trustable and who is not. It is great fun for he who likes human contacts.
Accounting is concerned with the recording of all the events or information of a monetary nature happening in the firm. Managers need to constantly monitor this information to manage correctly their firm. So we say that Accounting is a dashboard of the firm.
It is not the only one. Managers must also monitor plenty of information that is not of a monetary nature : productivity of workers, downtime of equipement, trustworthiness of a client, contracts with salaried people, the quality of the raw materials, worrisome delays in delivery, should we change supplier ? the problems created by changing supplier, the market tastes change, a competitor has a production process with much less waste than us, there will be a surge in demand in the Fall for the Christmas period, how to accomodate this inflated order log? etc.
The second half of this session is devoted to two subjects :
What are the goals of a firm?
This section describes the economic and social environment of a firm in order to prepare us to better understand the goal and techniques of accounting ; it can be skipped in a first reading.
Usually the first idea that comes to mind is: make profit and enrich its owners. That is right. But that's not the whole story.
It also serves a community, supplying products or services. It creates wealth in a community. (Accounting will show us that a firm can create wealth and yet lose money. SNCF creates wealth and yet loses money. This is also possible for private firms, but not forever...)
And very importantly it provides work to some members of the community it serves.
All over the world almost all societies are based on exchange. You get your shelter, you get your food etc. in exchange for something. I am not talking about money yet. What I'm saying is true even in societies functioning without money (we shall study money in the second part of this session).
The only thing most people can offer in exchange for what they need is their work.
Being able to produce work, for any human being, is only a matter of health, skill and time.
Then to participate into society, and its exchange mechanisms, all you need is someone willing to take your work and give you something for that. Of course in modern societies everybody knows that what you get for your work is money. But let us not go too fast. Let's analyse how the "work market" appears.
The exchange mechanisms I'm describing work even without money. In fact we shall see that money appears only after the basic mechanisms of exchange take place.
Since you don't eat work nor clothe yourself with it, you need to transform it into something else. You basically have three options:
1) transform it yourself into the goods you need, like
2) transform it yourself into goods that you will exchange,
3) exchange directly your work itself for things you need.
Option number 3 is the one chosen by most people. They choose to "be employed by somebody else". And in modern societies the exchange described by option 3 is: work for money. (In option number 2 we say that you are "self-employed".) The type of human relationships entailed by option 3 is a vast and deep and interesting subject outside the scope of this course.
The only thing most people have to exchange is their work, and they choose to do that by being employed in a firm. The firm produces goods and services that in turn are what is given in exchange for the work. Firms have owners (private people or states) that receive a part of the goods produced in exchange for what they bring to the firm.
Due to the mechanisms of redistribution of the wealth created, there is a tendency to increase the productivity of the work as much as possible, from the people who wield the power in the firm. That is well and good only to a point. If the firm reduces too much the quantity of work it employs, it will also reduce the "purchasing power" of the members of the community, and in the end shoot its own foot.
Economy is a complex system.
We won't have to understand economic systems very deeply, this is also outside the scope of the course. It is only useful to get a feel for the complex system into which firms take place. This can be illustrated by this sentence of Henry Ford: "I pay my workers well so that they can afford to buy my cars". One can feel that to understand how this principle may be a good principle one must analyze a complex system. We shall not do that. Just remember that firms are elements in complex systems. These systems are social systems to produce and redistribute wealth.
With this in mind we understand better that firms have the goal of producing wealth and of offering work to the members of the community they serve. Money is the tool for exchange in societies. "Maximizing the profit" is a good "common sense" principle, but only to a point.
It is possible to create wealth and lose money, but only for a limited period of time. We shall see that losing money has nothing to do with destroying wealth.
In France at present the legal working time per week is 35 hours.
Since there are 168 hours per week, and we sleep say one-third of the time (56 hours), this leaves 77 hours for other things than work or sleep. These 77 hours are used for all sorts of chores (errands, tending our house, talking to our mother-in-law...) and for leisure. Modern societies leave more and more time for leisure. But they're still fundamentally based on the exchange of work for purchasing means. Let us not confuse the fact that we try and make the work we sell more and more productive, leaving us more leisure time, with a society where we would get the satisfaction of our needs without work.
This may happen in 100 or 200 years. Who knows? Social organizations do evolve. In fact they have evolved tremendously in the past thousand years. But at the moment the production of goods and services consumed by society must come from the work of some people. They receive for their work a good chunk of what is produced. And it is considered a great tragedy to be pushed out of the work market when we are valid. This is the problem of unemployment.
Modern societies are aware of this problem and do protect the unemployed. They also take care of the people that are outside the work market for other reasons, the elderly without means, the kids and the sick. In traditional societies the unemployed were helped by their family and their close community. In fact the notion of unemployment as we understand it today did not really apply.
That the social welfare managed by states leads to a certain amount of social deresponsabilisation, and therefore dysfunctionings of the social and economic system, is a problem that will have to be addressed by governments in the next few decades. I say decades rather than years because it will require profound social evolutions and this cannot be carried out in only a few years. These observations show us that firms, being social units, cannot be viewed outside a political framework, whatever viewpoint we have.
Firms are social units, and as such have legal rights and legal duties.
This course does not purport to suggest that one social system or one political line is better than another. But it stresses that accounting is a set of techniques to manage firms and that to understand accounting well we have to understand well what firms are, and are for, and therefore we have to have some view of how social systems work.
To the question above I would tend to answer that the main objective of the firm is to create wealth. "Maximizing profit" is a good principle that has shown its efficiency in creating wealth. And we shall study it at length, among other aspects of accounting.
To complete your culture about the surroundings of firms you should study the economic history of the 20th-century, the Great Depression, the emergence of the consumer society, and of the welfare society, the great instabilities in the last fourth of the 20th-century, particularly just a few years ago, the "Internet bubble", the advantages and disadvantages of world globalization etc. You should build up an understanding of the issues related to the debate concerning the "35 hours" in France, as well as the role of the government and of the state etc.
In short, in order to benefit most from your studies, aside from listening to the lectures, you should start the habit of reading newspapers, particularly their economic and social pages, at least once a week.
Go to part 2