General accounting
II. 7. First principles
Video
The little toy manufacturer example teaches us some first general principles.
Cash: do not run out of cash
We have cash in the till, on premises, and the equivalent of cash at the bank.
If we run out of cash (lumping together cash on premises and at the bank),
- we shall not be able to buy what we need,
- or to pay an invoice which comes due.
In the first case, if we cannot get credit from suppliers, we will have to slow the firm's activity down, and possibly layoff people temporarilly.
In the second case, if we cannot postpone further a bill due, technically we are defaulting. And we enter into what's called bankruptcy.
Notice that it is illegal to request credit from your employees, that is to ask them that they be paid with a delay after the end of the month when their salaries are due.
When bankruptcy is triggered, a court will decide
- either to force the creditors to wait more because the firm ought to be given a second chance – that is to "freeze" the firm's debts –, and to set up a schedule of refunding (all or part of what is due) delayed in time,
- or to liquidate the firm, and pay partially the creditors with whatever money can be gotten from liquidation.
Liquidation processes are handled by administrators who oftentimes are corrupt, and keep for themselves or friends or strawmen whatever equipment or inventory of value remain in the firm. For instance, when a firm which sold textile machinery all over the world is liquidated, the inventory of spare parts (and the machines to make them) have a high value because clients are captive, and spare parts can be sold to them for a highly profitable price. Liquidation administrators and the top management of the failed firm may discreetly buy this stock at a firesale price and set up a spare part firm for their own benefit.
Usually a new firm does not have access to credit, and banks will not at first lend it money.
In order to get credit, we must first of all show, during the first few months of operations, that we are serious, that the firm is viable and "creditworthy".
Planning and budgeting. The first principle – enjoining us never to run out of cash – leads to the second principle: constantly forecast as well as you can future revenues and future cash inflows. We saw that a sale does not mean an immediate cash inflow.
And plan future expenditures and cash outflows.
So that you don't go "negative" at the bank. The expression "to be negative at the bank" is not the standard way to say that we are overdrawn at the bank. We shall learn soon the standard wordings.
New unknown clients: Symetrically, extend credit to clients only when they have proved their creditworthiness.
Carrefour is creditworthy.
A new unknown client, who wants to receive 1000 toys tomorrow and pay in 2 months, is not. Usually you will require the client to pay cash (or by cheques) its first orders. And after a few orders, shipments and payments, if they went well, you may begin to extend credit.
Credit: The word credit pervades the business world. It comes from the latin word credere which means to trust.
Business is fundamentally related to credit: we keep exchanging things for other things (sometimes IOU's) so we must have confidence in the value of what we receive (particularly when we receive promises).
Modern money: Modern money is paper money with legal tender status within its currency zone.
It evolved slowly from bills of exchange used by merchants at big medieval trade fairs in the XIIth century and after.
It began to play an important role in the XVIIIth century when banks began to issue large quantities of notes (receipts for deposits of precious metals) that could be used as means of payment. A financier by the name of John Law (1671-1729) even advocated that the money of a community ought to be only made of slips of paper ("guaranteed" by various things). It is a long and most interesting story, because at the beginning of the XXIst century we are still in the throes of trying to apply Law's ideas and build a satisfactory world monetary system.
In most countries paper money acquired its legal tender status in the XIXth century, when one bank was selected to play the role of central bank, and its "banknotes" were granted the official status of money.
What is the meaning of legal tender status? Answer: in the eurozone, if I owe you 5€, you cannot refuse my 5€ banknote which I give you to extinguish my debt to you, although it is just a piece of paper...
Private money: IOUs and bonds issued by firms can be seen as "private money".
IOUs are promises to pay for a purchase in a few days or weeks. They don't generate interest. The term "IOU" is an play on words with "I owe you".
Bonds are contracts linking ("binding") the lender and the borrower. The borrower is also called the issuer, because it "issues" the bond. A third name of the borrower is the "seller". The contract specifes according to which schedule the borrower will refund the lender (interest and principal). The lender is also called the buyer or investor or bondholder.
Recap :
borrower = issuer = seller
lender = investor = buyer = bondholder
An IOU or a bond is signed by its issuer. It is a promise.
Concerning more specifically an IOU, you may or may not accept it, depending on how much trust you have in the client who wants to pay you only in a while.
Promises by states and governments: Not only firms issue IOU's, also municipalities, states and governments.
In the latter case, we talk of "government bonds". A bond is a contract linking a lender and a borrower: the borrower promises, by contract, to pay back (interest and principal) the loan of money it received from the lender, according the a certain schedule.
Government bonds can be issued in the currency of the governement's country or in other currencies.
The case of the United States: Since the 1970's the US have a big trade deficit with the rest of the world. In the mid 2000's it reaches $2 billion per day!
They pay this trade deficit with dollars. To some extent, this trade deficit is natural because, the dollar being "the world money", the world needs dollars and therefore "buys" them from the US with goods and services. It is the Triffin paradox foreseen by Robert Triffin (1911-1993) in the 60's. As of 2010, the quantity of dollars circulating outside the US is estimated at $500 billions.
But, since the US have another deficit - the federal budget deficit (the two deficits are called the US twin deficits) - they buy back some of the dollars they first paid with, replacing them with government bonds. This was not foreseen by Triffin. Furthermore at the end of his career he was a staunch supporter of a unique European currency for all of Europe, although in 2011 we are witnessing the beginning of the collapse of the euro. The author thinks that the proper system in each country comprises (at least) two currencies.
The world financial tensions created by the large issue, from the richest country on earth, of government bonds which end up in the central banks of other countries is a source of concern for the future of the world financial system. It may be one of the causes of the appearance of new non-national currencies, managed by more reliable outfits than governments.
The financial and monetary tensions created by large scale issuance, by the largest and most powerful country on Earth (the United States, as of 2016), of bonds which end up in the reserves of central banks of other countries around the world is a source of concern about the future of the world monetary and financial system. It will be one of the causes of appearance of new moneys, managed by private entities, transnational and more reliable than States.
It is only mentioned here to illustrate the concept of credit which plays such a central role in business and in accounting.
