Accountancy/Principles of Accounting

Accounting Operations: Credit & Debit

Accounting approaches the world of economic transactions from the viewpoint of Capital Transformation. Accounting books record the source of the Capital and the form it takes after passing through a company's productive & administrative mechanism. Since Accounting wants to capture these two pieces of information (whence the Capital comes - to what it is transformed), it needs two operations - and Accounting has indeed two and two only operations: Credit & Debit. Traditionally we always say "Debit & Credit" and we always put "Debits" to the "left" (of a page) and "Credits" to the "right" (of a page). But causally speaking, the act which the operation "Credit" captures comes first: because Credit shows the source of the Capital, while Debit shows to what the capital has been transformed before. That's why "A Debit must always equal the corresponding Credit".

Suppose now that the company's Board of Directors, after receiving the cash from the shareholders, decides to spend it in order to buy new productive equipment, striking a deal with a supplier to pay him or her after 60 days from purchasing the equipment. In order to reflect this transaction we need to record two different Accounting Entries.

A) The purchasing of the equipment under 60 days credit terms. Here, since we are buying "on credit", the supplier essentially supplies us with Capital (for 60 days). So we will Credit the Suppliers Account in order to show that we initially are buying the equipment using the suppliers capital, and we will Debit a Fixed Assets account (with equal amount) in order to show that we transformed this capital into Equipment.

B) The cash payment for the equipment after 60 days. Here Accounting sees that capital available to us in the form of Cash (the initial shareholders capital increase in cash), is transformed into Capital returned to supplier. So we will Credit our Bank Account (to show whence capital comes), and we will Debit the Suppliers Account to show to what we have transformed this capital (into Capital Returned to the Supplier).

For each transaction, the sum of credits equals the sum of debits

The difficulty is the exercise of correct categorization of which accounts to debit, which to credit, and by what amounts.

The first categorization of accounts is whether the account is an asset account, liability account, equity account, income or expense account, cash account

In general, debits increase the left side, and credits increase the right side (of the equation : assets= liabilities + equity).

Hence, debits increase asset accounts, credits increase liability accounts, credits increase equity accounts. Income can be thought as increasing equity, so credits increase income accounts. Expenses decrease equity, so it is the opposite of Income, so debits increase expense accounts.

(After a while, it becomes almost automatic to record an expense as a debit to an expense account, and a credit to an asset account (cash), or a credit to a liability account (payable); a sale as as a debit to cash, or a debit to accounts receivable, and a credit to sales account; a inventory purchase as a debit to inventory, and a credit to cash, or a credit to accounts payable ; a loan as a debit to cash in bank, and a credit to bank loan account (liability).

It is also customary, that debits are written down first, then credits, when recording initially in chronological order in the general journal).

Once these are gotten used to by practice, there may be also a need to think of contra-accounts, such as contra-asset accounts such as accumulated depreciation, or contra-equity accounts such as Recovered Bad Debts previously written off.

Forms of Capital

As the above example indicated, "capital" in the world of Accounting, can take many forms. We can state the following all-encompassing definition: Any debt of a company, with or without interest, that is not paid in cash or otherwise settled, at the moment it is recorded in the Accounting Books, becomes capital given to the company.

Essentially then, "capital given to a company" is the amount that the company must return to its creditors. And we record as "capital" even temporarily unpaid debt. For example, suppose that from the payroll of a certain month, you have deducted from the employees' salary a payroll tax that you should pay to the State. If this payment, according to the relevant laws, must be executed three months after the month to which it originates, then for these three months, the state has given to you an amount of capital equal to the Payroll tax amount.

So what are we actually seeing in a Balance Sheet?

In a Balance Sheet we have three main headlines: Assets, Liabilities, Owner's Equity (aka Equity). In many countries, Assets are shown in the left of the page, while Owners' Equity to the top right and Liabilities to the lower right.

Now, it is a fundamental Accounting rule that "Assets = Owners' Equity + Liabilities". But why?

...If we use the "Capital Transformation" approach, we can understand why: "Assets" are of course what the word Assets means. But at the same time they show to us to what the company has transformed the capital given to it by... whom?

a) The Shareholders ("Owner's Equity"), and b) Everybody Else (Liabilities). In Equity we see the amount that is to be returned to the Shareholders, after all Assets are liquidated and all Liabilities are paid in full. In that sense, "Owners' Equity" is also a liability for the company: A company does not own anything - it owes all of its Assets to somebody, Third Parties or its Shareholders. A company is a separate entity from its owners.

In Liabilities, we see the amounts that the company owes to third parties - Suppliers, Banks, Internal Revenue Service, etc. At the same time they show to us "whence the capital came".

So the right side of a Balance Sheet shows how much capital and from whom the company has managed to get at the specific moment of the balance sheet (from third parties-"Liabilities" or from its own shareholders-"Equity"). On the left side of the Balance Sheet, we see to what the company has transformed this capital-"Assets". Again, we are talking about the same capital, the same quantity. So the "right side" (Equity + Liabilities) must equal the "left side" (Assets).

Alternative views of accountancy principles

Accountancy may have been an elaboration of an accidental discovery, much like the tale Archimedes and the bathtub discovery of water volume displacement equals floating object volume. Some idly rich mathematicians found that assets equals liabilities plus equities.

The official story is that accountancy was first systematically expounded by Luca Pacioli in the Renaissance, who in a section of a mathematical book he is generally thought to have written, describes the Venetian method, or double entry accounting.

Double entry accounting maintains the assertion or constraint that assets = liabilities + equity. It gives rise to the concept of periodic trial balances, where the equation is checked at the end of a period. There is also a concept of closing entries, where in addition to the more permanent account types of asset accounts, liability accounts, and equity accounts, there are temporary operational income accounts and expense accounts, which are updated ideally throughout a period of operation, or as a minimum, before the end of a reporting period with journalised historical data, and closed off, i.e. the result of income minus expenses is added to equity, and the temporary income and expense accounts made to have zero balances for the next reporting period.

There is also the concept of accrual vs cash accounting: cash accounting requires an entry whenever cash is exchanged, so doesn't record borrowings or loans, and therefore isn't very sufficient, whereas accrual accounting makes a recording whenever an enforceable or highly probable obligation arises for the future movement of cash to an entity (receivables, a subtype of asset), or out of an entity (liabilities) occur.

Because there are transactions that are accrued, they record an obligation, later transactions are needed to record when obligations are met. Some obligations gradually are met over time, so are calculated according to the amount of time that has expired since the last calculation was made and recorded, and these fall under the category of adjusting entries. Examples of end of period adjusting entries include the recording depreciation, usage of prepaid expenses such as insurance, rent, the performance of services paid in advance by customers (unearned revenue fulfillment). End of period adjusting entries are made before the closing entries that closes off temporary income and expense accounts and updates equity.

There are other uses of adjusting entries, such as in adjusting entries for subsequent periods. These occur because end of period deadlines may be straddled by the periods for which prepayments exist, or periods for which current liabilities fall due, and because these are only partially accounted for in the end of period adjusting entries.

Illustrative example of role of adjusting entries

Pay day is fortnightly and last falls on June 23 for the last accounting period, so on 30 June, a end of period adjusting entry is made to salaries payable for the employee Joe who earns $2000 per fortnight, and an entry is made to salaries payable for $1000, or 7 days of 14 days. Closing entries then close off the salary expense account to zero balance, as profit is calculated as sum of income minus sum of expenses and added to equity (owner capital), and any owner drawings are subtracted from capital. Then pay day occurs on 7 July in the next period, but instead of debiting $2000 from salary expense as usual, $1000 is debited from salary payable (which removes the previous recorded liability), and $1000 is debited to salary expense, (the other side of the double entry is a credit of $2000 to the cash-in-bank asset account, which is unchanged from the normal entry). This non-regular apportioning of an entry to account for end of period adjustments is termed adjusting entries for subsequent periods. As a side note, this irregularity of entry can be avoided by making preempting adjusting entries at the beginning of a period, which are quite artificial : these are called reversing entries.

In the previous example, the opening reversing entry would be a debit to salary payable of $1000 and a credit of salary expense of $1000, leaving the salary expense account in the situation of being $1000 in credit (if there is only Joe on the payroll) since the salary expense account was cleared to zero with a closing entry from the last period (this situation seems artificial because expense accounts are normally in debit). However, this allows the normal pay day entry on the 7th July for $2000 dr to salary expense, to leave the salary expense account in the correct $1000 DR balance, given the other $1000 had been previously accounted for in the previous period (it was recorded as the end of period accrued adjusting entry to salary expense mentioned at the start of the example ; even though there had been no exchange of cash at the time, the work had been done and therefore owed).

Basic financial statements from the adjusted trial balance

The usefulness of double entry accounting is that the equation assets equals liabilities plus equities should always hold after each double entry, and can be done once after adjusting entries are made, called an adjusted trial balance. From the adjusted trial balance, 3 different parts can be used to produce 3 basic reporting statements, the income statement, the statement of change of equities and the ending balance sheet.

Each statement depends on the previous statement. The income statement is a summary of the temporary income and expenses accounts, and states a profit. The profit is shown in the statement of change of equity, where beginning capital amount is added to the profit from the period, any drawings amount subtracted, and the ending capital amount is determined.

Thirdly, the balance sheet shows the ending amounts of the permanent accounts (excluding income and expense accounts, which have been closed off), with the ending capital from the statement of change of equity as the capital stated in the equity section. It will show that the sum of the asset accounts less the sum of the liabilities, is equal to the ending capital (equity).

Why financial statements, or why accountancy ?

Another view of accountancy principles is existential justification. When isn't it necessary to practice accountancy ? Some people feel accountancy is mainly of benefit when a certain threshold of money is involved,and there is use of other people's money. It is those other parties that need to be accounted to. Otherwise, accountancy becomes an exercise of not letting oneself defraud oneself unwittingly.

If a need for accountancy exists, what qualities make it sufficient ?

If it is given that a need exists for accountancy - e.g. some hotshot is playing with some retiree's lifetimes earnings, and could lose it to some undeserving employee of a merchant bank who spends it on cocaine and a collection of porsches, it may be useful to name what qualities might make the results of doing accountancy useful.

4 memorable qualities might be understandable, relevant, reliable, and comparable.

Financial statements should be understandable:usually they are, because there is almost a standard format for statements of income, change in equity, balance sheet, and cash flow. Even so, it is still common practice that these understandable items aren't analysed by spruikers of investing opportunities in a standard way.

Even if the statements are understandable, they could suffer from being irrelevant or unreliable.

Relevance / materiality means if something is included or excluded from financial statements, it can affect the economic decisions of investors if the opposite was true. Including immaterial stuff can paint a too rosy picture, and excluding material stuff can be hiding big problems.

Reliability sounds like relevance, and it begs the question as to whether something can be relevant and unreliable, but it appears to mean that one should not take the accrual principle too far. Examples of accrual in action, is the allowance for bad debts, and provisions for contigent liabilities. As an example of something unreliable is making a recording of an asset some financial product backed by subprime mortgage parcels. Another, which might also lack relevance, is having a major controlling shareholding in a company financed by margin lending, and this amount of equity included in the previous balance sheet. The major shareholder is a separate accounting entity, so doesn't have to reveal his liabilities in the balance sheet, but the amount stated as shareholder equity is in hindsight, unreliable, after a margin call is made.

Another example of unreliable accounting, is having an accumulated provisions for the possibility of fire account as a cash account reserved in theory for the provision, instead of buying prepaid insurance for a specific amount, as the latter is more reliable because there is documentation, a provisioned amount is certain and it is probable that it sufficiently provides for the contingency.

Finally, comparability means that accounting is done similar enough to other companies to make comparisons, as well being able to compare the accounts between different accounting periods of the same company, because enough information is given when policy changes are made, e.g. to the type of accounting made for inventory.