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CHAPTER 1: A WAY OF VIEWING BUSINESS

Reality leaves a lot to the imagination.

John Lennon

I hate cameras. They are so much more sure than I am about everything.

John Steinbeck

In this chapter, you will have the chance to ask yourself, what actually is accounting? Is accounting a game, where we can just manipulate and move around accounting numbers to get the results we want? Or is accounting perhaps about using a computer software package to manage a firm’s ‘accounts’, whatever that might mean? You can google ‘Accounting software packages in Australia and NZ’ to find a long list of packages people use, particularly in small to medium size businesses, such as MYOB (‘Mind Your Own Business’), Xero, or ReckonOne. Is this what accounting is about? Recording a whole lot of transactions of a business, like a memory aid? At least such a task has been made easier with the use of computers.

We will look at why and how aspects of the economic and business realities of firms are captured and recorded into a firm’s accounts. Now a firm’s accounts are not themselves the economic and business realities of firms. Accounting is also not like a corporate camera taking precise photos of what is going on. Rather, each firm experiences its own economic and business realities quite independently of what gets recorded in its accounts. But some aspects, or elements, of what is going on in a firm are recorded in its accounts in certain ways. We will look at why these particular realities get captured and recorded in the way they do. Understanding this will help us as we seek to learn how to use a firm’s accounts to engage with and connect to a firm’s economic and business realities; that is, to know what is really going on in a business.

Accounting is supposed to help us connect to reality, to what is actually going on in a firm; and in this chapter we can start to ask ourselves whether or not we think accounting can really help us to do this. We will look at some of the key ideas and concepts underlying the complex way we have developed of accounting for business activities. And we will see that underlying accounting is a particular way of viewing business; a way of imagining business. Accounting is, at the end of the day, a model. Not a fashion model, or a model plane, but a business model. It is a model, or simplification, of each firm’s economic and business realities. It is an abstraction of all the complex activities of a firm. If we are to consider whether we think accounting can help or hinder us to better connect to what is really going on in a firm, we first need to understand the business model underlying accounting; and to ask ourselves whether or not we think it is a powerful or useful way of viewing a business. Before we do this, let us first look at what business reality is.

1.1 It is all about reality

First you must understand how numbers changed reality. Some people think numbers merely reflect reality... but we believe that numbers create reality.

The Accountant Troll, teaching Dilbert how to be an accountant

Accounting is about using information to help us connect to the business realities of a firm. It is about

understanding reality. Accounting is about understanding the realities of business: what is really going on in a

firm. Or is it? This is the question you will be able to reflect on in this chapter and throughout this book. It is a

key issue you will find you keep coming back to as you develop your capacity to use and make sense of

accounting information. It is a great journey to go on; and a very important one for anyone with a serious

interest in business, whether working in, running or investing in businesses.

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Business is a fascinating and wonderful world to work and live in. Business is about creating value: substantial, real, actual value. Value is a word to describe things that matter to us, that we care about, that mean something to us. Business is about serving people’s real needs and desires, in a world and human society where we constantly construct and develop and change our views of value, of what is important, of what we need, of where we want to go in life. Business is where we can make a difference; and not just in our own lives and in the lives of those close to us, but in the lives of many, many people (most of whom we may never meet or know personally). As in all things in life, we can make a difference for the better, or for the worse.

In Australia, New Zealand and many other countries of the world, a lot of economic activity is conducted by people operating in firms that are interacting with other people and firms in markets; in all sorts of markets. We are surrounded by markets everywhere, in which we are exchanging value between each other. Indeed, firms are constantly creating and exchanging value with other firms and with individuals through various markets: input markets (with suppliers and employees), product markets (with customers) and in capital markets (with equity and debt investors). A firm also has interactions with government (through taxation and a wide range of government regulations and services) and with the wider community. Now a firm can create value, and it can also destroy value, through its business activities, just as we can in our personal relationships and in our individual activities each day. Creating or destroying value: this is the challenge before us each day in business. How do we run our businesses to create value for ourselves and others, rather than destroy value? How can we determine the value of businesses we might want to invest in, based on their capacity to create value in the future? In this book you will have the opportunity to consider the role accounting might have to help or perhaps hinder us in creating value in business and in our investing activities.

There are people with accounting qualifications everywhere in business. About half of the directors of listed companies in Australia and New Zealand have accounting backgrounds of some sort; as do about half of the managing directors of these listed companies. For example, the managing director of Ryman Healthcare in New Zealand (a company we will be looking at quite a bit in this book) is Simon Challies, a qualified chartered accountant who was previously the chief financial officer of Ryman Healthcare. People with accounting qualifications, and most importantly an understanding of how to use accounting to connect with the economic and business realities of firms, are everywhere in business. I wonder why this might be? Might there be something important for me to connect to with the business discipline of accounting if I want to be successful in business? Maybe, or maybe not. People have a range of views about this. These are questions you can ask yourself as we have a look at accounting in this book.

Quite a few years ago I was at a Christmas function at a friend’s house. I had submitted my PhD thesis on accounting education the day before, and this was one of the topics of conversation during the party that day. A senior New Zealand politician was at the party and he told me he has an accounting degree (as well as other qualifications). As we discussed my PhD I could see he fully understood the issues I was researching: how to support students studying accounting at university to not just look at accounting numbers (such as ‘profit’) as being some sort of ‘answer’ or reality themselves but to see we use accounting information to seek to engage with what is really going on in a business. You see, something funny can easily happen as we study accounting and focus on ‘the numbers’. We can subtly start to feel the numbers are the answer, rather than the business reality the numbers seek to represent.

Firms can do many different things and be a range of different sizes. In fact, they seem to be all over the place in terms of what they do and the types of businesses they are. Business reality for firms is a very diverse and fast-moving world. This is the world accounting seeks to help us engage with and better understand. Firms can be involved in providing services to customers, retailing products, or manufacturing products (that is, actually making physical goods that they sell to their customers). In reality, many businesses can mix up in different ways providing services, retailing products and manufacturing products. For example, a hairdresser may sell hairdressing services and also sell hair products; a restaurant may sell meals it manufactures from raw ingredients, as well as provide great table service and the experience of a great night out.

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Businesses are everywhere

I am writing this chapter in Yeppoon, a small coastal town in Central Queensland near Rockhampton. I have just had a short walk around the area, and businesses I saw include a dentist, Icon Dental Group, and right next door The Coffee Club, a cafe with a great spot just near the beach. Nearby is Elders Real Estate, Yeppoon Car Wash, and Sullivan Nicolaides Pathology (which provides medical services). There is also David Eaddy & Co (solicitors), Johnson & Tennent (chartered accountants), CEADS (Capricorn Engineering & Drafting Services), Yeppoon Medical Centre, Betta Electrical Yeppoon (electrical retailer), Marsden Tavern (retails alcohol and provides various entertainment services), Young’s Coaches (the local bus company), Sandy’s Cafe, Subway, Rip Curl (clothing & swimwear retailer), Sleepzone (beds and bedding retailer), Woody’s Foodworks Yeppoon (supermarket), Paintplace Yeppoon (paint retailer), Yeppoon Tattoo Studio (tattoo services), Tanby Roses Florist (retails flowers and manufactures flower arrangements), Tai Ho Indian Restaurant, James Street Medical Centre and Centrelink Yeppoon (a government agency providing social welfare payments).

Other businesses I saw were Dollars and Sense (discount variety store), Sail Inn Motel (sells accommodation services), Office National Express (retails office supplies), Happy Sun Chinese Restaurant, S.M. Weston Optometrist (sells eye services and retails spectacles), Yeppoon Health & Fitness Centre (gym services), Pacific Hotel, Wavelengths (hairdresser), Megalomania (bar and bistro), Jaques Coastal Meats (butcher), Video Ezy, St Ursula’s College (a private school that sells education services), Wendy’s (ice cream/cafe), Coles (supermarket), Ian Weigh Toyota (car dealer), Regals Dental (another dentist), Blue Dolphin Caravan Park, Shell (petrol station), Seaside pools (builder of pools), Yeppoon Self Storage, Flexihire (equipment hire and sales), Wot A Sign (sign makers, printer & website designer), Central Queensland Sailmakers (retails, installs and manufactures yacht sails, shade sales, marine upholstery), Yeppoon Veterinary Surgery, Yeppoon Kitchens (manufactures and installs kitchens), Firewood2Furniture (manufactures custom built timber furniture) and Trevor’s Trim & Upholstery (retails, installs and manufactures shade sales, blinds, marine & household upholstery). I took a few photos of these businesses which are included in Figure 1-1 below.

There were also many, many other businesses just a short walk from where I am living at Yeppoon. For example, there are many hairdressers in Yeppoon besides Wavelengths, other butchers besides Jacques Coast Meats and a number of gyms/fitness centres. There are businesses everywhere we look; everywhere. There are small businesses, and large businesses. There are organisations run by government (such as Centrelink), and businesses owned by private people. Some privately owned businesses are run and owned by one or two people (such as S.M. Weston Optometrist), others are large businesses owned by thousands of shareholders and with large numbers of staff (such as Coles). Some businesses provide services (such as CEADS: Capricorn Engineering & Drafting Services); others are retailers and sell products such as meat (Jacques Coastal Meats) or cars (Ian Weigh Toyota); and others are manufacturers and make various goods (such as Firewood2Furniture, maker of custom built timber furniture).

All these businesses which I saw on my short walk around Yeppoon would keep accounts. That is right; every single one of them. Why would they do this? They would employ accountants. Some might have whole departments of accountants (such as Coles and Centrelink) and others (such as smaller firms like Marsden Tavern) might employ the services of an external accountant, either a part-time accountant who might come in say a few days a month, or the services of an accounting firm (such as perhaps Johnson & Tennent, chartered accountants in Yeppoon). The owners of these businesses would also spend quite a bit of time ‘keeping the books’ themselves, no doubt, recording transactions of their firms in their accounts. If you were currently running, or were an owner, or was thinking of purchasing any of these businesses you would find various accounting information coming your way. What would you do with this accounting information? What would this accounting information look like and what would it be for? And what sense do you think you could possibly make of it?

Types of businesses

Besides doing a wide range of activities, which we can broadly think of as service, retail or manufacturing, businesses can also be organised in different ways. A small business with just one owner, who also runs the business, may be organised as a sole trader that has no separate legal status apart from its owner (for

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Figure 4-1: Some businesses in Yeppoon, Queensland

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example, Tanby Roses Florist may use this structure). Most businesses in Australia and New Zealand (and in most countries of the world) are small businesses run as sole traders. Where there is more than one owner the business may be run as a partnership (such as perhaps David Eaddy & Co, solicitors). These groups of owners pool their resources and share in the firm’s profits and losses. The relationship between the owners (called partners) is usually set out in a partnership agreement. This helps make the relationship between the partners clear.

As those of us who may have gone flatting with others know, disputes and problems can arise between flatmates as we live together. It is the same with a business. Once there is more than one owner, disputes and problems can arise between the owners. It is for this reason there is usually a written partnership agreement to help the partners sort out disputes they might have over time. Businesses can also be organised as a company. Unlike sole traders and partnerships, companies are their own separate legal entity, separate to the owners, and have to comply with the Corporations Act in Australia. Coles is a company with more than 100,000 employees and over 11 million customer transactions each week. It is wholly owned by a large Australian listed company, Wesfarmers Ltd (you can click on the link to see how Coles fits into Wesfarmers).

Businesses can also be organised as a trust. A trust is a relationship where a trustee (which can be a person or a company, but not a partnership) carries on a business for the benefit of certain beneficiaries (people who will benefit from the business and who are its effective owners). Trusts would have a trust deed which sets out the relationship between the beneficiaries and also with the trustee. Now a trust can only conduct business through a trustee. It is likely some of the businesses I saw as I walked around Yeppoon have a trust somewhere in their ownership structure.

In this book, we are considering how accounting information may or may not be useful to help us better understand the economic and business realities of firms. Can accounting make it easier, or more difficult, to engage with and understand what is really going on in a firm? This is a question you can ask yourself while you read this book. As you think about and study the essentials of what accounting is, think about this question. There are many people in business and in our capital markets who have a range of opinions about this.

Along with this book, you will be using a spreadsheet designed to support you to analyse your own listed company. As we have the chance to experience for ourselves what it is like to use accounting information to help us make sense of and understand what is really going on in our firm, we can start to form our own judgements and opinions about the role of accounting in business; and in particular, whether accounting information can help, or perhaps hinder, us to better engage with and understand what is really going on in a firm. In this section, we have seen that business reality is all around us, including even in Yeppoon, Queensland. Indeed, there are a lot of businesses everywhere we look. We have seen that accounting is supposed to, but possibly may or may not, help us connect to and better understand this reality. In the next section, we will see that accounting starts with keeping records about what is going on in a firm.

1.2 Keeping records

You have to know accounting. It’s the language of practical business life. It was a very useful thing to deliver to civilization. I’ve heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double entry bookkeeping was a hell of an invention.

Charlie Munger

In this section we will discuss the importance and necessity of first recording things a firm does, and in particular its transactions with various parties, before a firm’s accounts can be of any use to anyone. Basically, unless things a firm does are first recorded and included in a firm’s accounting system in some way, then a firm’s accounts can give us no guidance or help in understanding its economic and business realities. A range of different people have genuine interests in the operations of firms. These might include managers of a firm, equity investors, debt investors, employees, customers, suppliers, the government and the general

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community. Also, firms can be commercial enterprises, not for profit entities or public sector entities. What we will look at about accounting can apply to any type of firm, although we will focus on commercial enterprises. Regardless of the type of firm, or who might have a genuine interest in gaining insights into the economic and business realities of a firm, the question we can reflect on is whether a firm’s accounts may help or perhaps hinder us in gaining these insights.

Luca Pacioli

In the first instance, a firm’s accounts come from the transactions and other economic events someone has recorded in a firm’s accounting system. A way of recording these transactions has developed over a long period of time. It is called double-entry bookkeeping or double-entry accounting. Luca Pacioli (c. 1445–1517) (pronounced pot-choh-lee), an Italian mathematician and Franciscan monk, published the Summa de arithmetica, geometrica, proportioni et proportionalita in 1494. It is a summary of the mathematical knowledge of the time (which we see today as quite elementary arithmetic, geometry and algebra) and included bookkeeping as one of five topics covered. Its section on bookkeeping is the first published book describing double-entry accounting, a method of accounting that was being used by merchants in Venice during the Italian Renaissance. His system included most of the aspects of accounting as we know it today.

Although Luca Pacioli is usually referred to as the ‘Father of Accounting’ he did not invent the system of double-entry accounting. He was simply the first to describe it in a published book. Double-entry accounting has probably been going on much earlier than Luca Pacioli’s time in the late 15th century. For example, ‘the partners Francesco di Marco da Prata and Domenica di Cambio drew up a detailed statement of assets and liabilities on August 30, 1389, quite in the modern manner’ (Foulke, 1968, p. 4). Why did accounting for a firm’s economic and business realities develop in the way it did? Surely it would have been easier to simply enter in transactions once rather than twice as occurs in double-entry accounting. Why make it so hard on ourselves? Also, as we will see in Section 1.3 below, once a transaction is entered in twice they are then re-entered again and manipulated in various ways. At first sight, this seems like a lot double handling. At second and third look, it also seems like a lot of double handling.

We build on the past

History unfolds itself by strange and unpredictable paths. We have little control over the future; and none at all over the past.

Winston Churchill

When we are present in each moment, the past gently rolls up behind us and the future slowly unravels before us.

Richard Levy

To understand how accounting is the way it is we need to remember we were not born into a world with a big blank page in front of us. Many, many people have lived before us. The first civilizations of people sprung up in a number of parts of the world about 5,500 years ago. Our societies, our cultures, the ‘way-we-do-things’ have developed over many generations, with each generation starting with what the previous generation had left it with. Our generation is no different.

One of the things I enjoy is playing musical instruments, especially the piano. I would play the piano for hours every day, given the chance. When I went to university, PCs were only just starting to make an appearance; typewriters were still everywhere. In my first year at university I quickly discovered that in my Law degree I needed to hand in a lot of typed assignments. This would involve me paying someone to type my assignments for me. It also meant I had to complete my assignments a few days before the deadline to give my typist time to type them. So over the summer holidays at the end of my first year at university I taught myself to touch-type. It took me 8 hours followed by a lot of practice. This was the most valuable and useful 8 hours I have ever spent in my life (and the most boring).

Because I had played musical instruments over the years, and in particular the piano, the flexibility of my

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fingers was very good. All I needed to do was memorise where the keys were on the keyboard and practice it a bit so I could type accurately, and I was away. I found I could quickly type as fast as I could write, so I could hand in my Law assignments without paying for a typist and I also did not need to have them written a few days in advance of deadlines. But as I learnt how to type I quickly realised the keys for the letters often used together in words in English were a long way apart from each other on the keyboard. This actually makes typing more difficult and less intuitive. The layout of the keyboard did not seem to make any sense to me at all. It seemed to me it would be a lot easier to type if the letters commonly used together in words were near each other rather than a long way apart on the keyboard. And, in fact, it would.

So what gives? Why is the keyboard on our computer designed the way it is? The reason is that the keyboard we use with our computers was first designed for typewriters. The most common English keyboard layout is called QWERTY. Have a look sometime at the first six letters on your keyboard’s top first row of letters and you will see why it is called QWERTY. Christopher Sholes invented this keyboard in the 1860s and it first appeared in Remington typewriters in 1874. Christopher Sholes was a newspaper editor who lived in Milwaukee, Wisconsin (just north of Chicago) in the US. He first set up the keys on his typewriters in alphabetical order. The second row of letters on the keyboard (namely, ASDFGHJKL) seems to be a remnant of Christopher Sholes’ first alphabetical layout that he replaced with the QWERTY layout.

Now typewriters had a ribbon of ink onto which individual letters in raised metal at the end of an arm were hit in sequence. Christopher Sholes noticed that as the operators of his typewriters started typing faster the metal arms that held each letter and which struck the paper started to hit each other and get tangled up. He found that typing worked much better if the arms of the letters that were commonly used together in words were well apart. Otherwise, the arms could tend to get caught up with each other as they moved onto and off the ribbon. You have probably noticed that computers do not have these metal arms moving up and down as we type on our computers. So why do we use the keyboard with our computers that was designed for use with typewriters? The reason is simple. It would be very difficult to retrain everyone in the world who can already type to type in a different way, compared to the reasonably limited benefits for people who cannot type yet to make it easier for them to learn to touch-type in the first place.

It is the same with some terms we use in our word processing on computers, such as ‘cut and paste’ when we delete something from one part of our document and put it somewhere else. When things were done on paper we literally cut out a piece of text and pasted it with glue or sticky tape onto another part of our document. This is the same with double-entry accounting. The process belongs to the world of the past. Yet we are caught up in that past and it constrains and leads us forwards as we participate in the digital age. So today computers do a lot of the steps of double-entry accounting for us. But we need to understand how these things work because our whole accounting system is built on these ideas. If there is nothing else you remember from reading this chapter, you should remember that ideas are powerful. If we had computers to keep the records of businesses a thousand years ago we may well have gone about accounting very differently, perhaps using quite different ideas. But we did not.

As we will see later, the key thing to remember about double-entry accounting is that it is a system of recording transactions of a firm in such a way as to ensure the relationship between the different elements of the business model that underpins accounting is kept intact. Accounting is based on a particular model or way of looking at business. It is a powerful way of looking at a firm’s economic and business realities. We will look at this business model in Sections 1.3 and 1.4 below. A deep understanding by us of this way of looking at business could challenge the way we view business reality from a perception of business based on commonly-held misconceptions about how business works to a view based on a deep understanding of the powerful ideas and concepts of accounting. These ideas pervade the way accounting is carried out. These ideas were developed from a time way before computers, before the printing press, indeed when quills and paper were ‘hi-tech’.

Bookkeeping without books

With the growing availability of computers since the 1960s, progressively firms’ accounts have moved into a

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digital form. Various accounting software packages have been developed, sometimes tailored to the specific needs of a firm; other times, firms use general packages that they can adapt and use for their own purposes. Some commonly used general accounting software packages that many small to medium size firms use in Australia and New Zealand (and, indeed, in many other countries) are MYOB (‘Mind Your Own Business’), Xero and Quicken/Quickbooks. Other accounting software packages have names such as Pastel, emPOWER, Sage, SoEasy, Cashbook and MoneyWorks. Spreadsheet packages such as Excel are also widely used to record and manipulate and manage data. In my own private equity business I managed the bookkeeping of the firm myself for a number of years using MYOB. It was a straightforward process. I often recorded transactions on the day they occurred or at the end of the week on a Friday or Saturday afternoon. As the business had only a small number of transactions, it was easy to manage the bookkeeping myself. I then used a firm of accountants to complete my firm’s financial statements and tax returns based on the information captured in the accounting package. Slightly larger businesses may often employ someone to complete the bookkeeping each week or each month on a part-time basis. Larger firms will usually employ full-time staff to enter data and to ensure the bookkeeping processes are being correctly followed.

The first decade of the 21st century is often called the ‘digital decade’. Quite quickly everything was converted to digital formats that are readily able to be communicated between computers anywhere in the world though a growing web of wireless and cable interconnections. In almost all cases, except perhaps for a few small businesses, everyone’s accounting record-keeping or bookkeeping is being done digitally or electronically. So the ‘books’ of the past have gone. Bookkeeping is now almost always done without any ‘books’. Bookkeeping is now a redundant word; it would be better called ‘record keeping’, or even better ‘capturing what is going on’.

We have seen that the systematic recording of transactions and economic events of a firm (which we call bookkeeping even though the paper books have largely disappeared and been digitised) is essential to accounting. Without it there would be no record of the economic and business activities of a firm in a firm’s accounting system. We have also seen that the way these activities of firms are recorded by way of double-entry accounting is an historical ‘accident’. It made sense in the days of quills and paper. Yet it frames the way we record transactions today. And more importantly, the whole way of looking at business, that is the business model, underpinning accounting remains the same in our digital age. This way of looking at business, which we will look at in the rest of this chapter, has proved to be a powerful way of looking at the economic and business realities of firms for many years. You may possibly find it a powerful way for you to look at business as well. In studying accounting there are a few key things we need to understand. We will now look at some of these in the next section.

1.3 Two sides to everything

There is a great difference between knowing and understanding: you can know a lot about something and not really understand it.

Charles F. Kettering

There are a few key ideas underlying accounting that you need to understand. You do not need to simply memorise them and be able to reproduce them (perhaps in an exam at university) and then forget about them. You actually need to understand them. You need to personally engage and connect with these ideas. You need to connect these key ideas about business that underpin accounting with your prior knowledge and previous experience. In other words, these are ideas and concepts you need to make sense of for yourself. No-one else can do this for you; you have to do it for yourself. This section is designed to support you to do this. Take the time to reflect on the ideas and concepts discussed in this section. Think about them and search for what they mean to you. In fact, these ideas and concepts could potentially transform the way you look at what business is all about. But before we do this, let us first look at the issue of confidence. How confident are we?

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Confidence and learning

We need a degree of confidence to learn ... actively. To think for myself and to make my own sense and understanding, I need to think my response and opinions matter; and that I can think about why I think something to be true, and be open to discussing this and perhaps changing my mind in the light of new evidence. Here are a couple of short videos on confidence:

Skill of Self-Confidence (over 6 million views).

And if you can ‘fake’ confidence, you’ve got it made; or at least it can be a first step to developing confidence:

Body Language and Confidence (over 31 million views).

So focus on learning for understanding, your own understanding, what you think (and why), rather than simply reproducing ‘clear-cut facts’ from someone else. And as we start to do this, let us first look at journals and ledgers which are the key ‘building-blocks’ of accounting.

Journals and ledgers

Accounting uses two types of books: journals and ledgers. A journal contains the daily transactions of a firm, such as its sales to customers, purchases from suppliers and many other types of transactions and economic events of a firm that keep happening in a constant stream each day. These are entered into a firm’s journals as they occur each day. The English word journal comes from the French word ‘jour’ (or day) which was derived from the original Latin word diurnalis, meaning daily. Also, the word ‘journalist’ has been used for those who write for newspapers since the late 1600s, referring originally to those who wrote for newspapers which were published daily.

So the journal is a great long list of transactions recorded as they occur each day. The ledger contains these same transactions but arranged not in the order in which they occur each day but in individual accounts, being various types of assets, liabilities, equity, revenue and expenses. The word ledger means something that lies down or is laid down, having been adapted from the Dutch word logger. It originally referred to a book that usually stayed in one place because it was heavy and difficult to move and was also constantly being used. So a ledger basically means a book lying permanently in one place. The ledgers are at the heart of a firm’s accounting system. It is where a firm’s key accounting information lies. In this sense, ledger now refers to the data that lies permanently in one place in our computer.

The bookkeeper (or accounting clerk) enters a firm’s transactions into the journals, transfers them (or posts them) to the ledgers (which is usually done automatically by computers these days) and looks after a firm’s financial records or ‘books’ up to the trial balance stage. The trial balance is a worksheet where the balances of each of the ledgers (one for each account) are listed in two columns (debits and credits). The total of each column in the trial balance should be the same (or, in other words, should balance). It is called a trial balance because it is a tool to help detect errors in the accounts: a ‘trial’ or ‘initial’ attempt to balance the accounts in the ledger and this gives us an opportunity to fix up any errors that have caused the various ledger accounts to not balance. However, there are many potential data entry errors in the accounts that would not be picked up by a trial balance: for example, simply transposing (or swapping) a debit and credit entry for a transaction or posting a journal entry to the wrong ledger account.

The bookkeeper (or accounting clerk) brings the books to the trial balance stage. An accountant would prepare the financial statements using the trial balance and ledgers prepared by the bookkeeper. In the days when bookkeeping involved physical paper books, transactions were first entered into the journal and then carefully posted (or transferred) into the ledger. With the widespread use of computers, transactions are now entered only once and they are automatically (and digitally) posted in the various accounts in a firm’s ledger. Indeed, the words ‘journal’ and ‘ledger’ are being used less and less as we no longer see bookkeeping as involving keeping a daily journal or journals of various transactions and a separate series of accounts for a range of different aspects of a firm’s business. We are now recording transactions digitally into a series of accounts and we can look at this ‘raw data’ in all sorts of different ways. Nevertheless, financial records are entered into a firm’s accounts based on a number of key ideas and concepts (including the ideas of journals and ledgers) that

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influence the way we view these transactions and thus the economic and business realities of the firms they represent.

Proprietorship

In accounting, not only do we record the same transaction twice into two different types of ‘books’; that is, first into the journal and then into the ledger. Also, and much more importantly, we recognise that every transaction of a firm has a dual aspect, just as a coin has two sides (heads and tails) or there are two sides to a piece of paper or, usually, two sides to any argument. The key idea underlying double-entry accounting is an awareness of a proprietor or owner of a firm who is separate and distinct from the firm itself. This is the entity concept in accounting where the activities of a firm are kept completely separate from those of the firm’s owners. Subsequently, this idea has been reflected in our legal system as we have created companies that have a separate legal identity and existence to that of their owners. However, this entity concept in accounting applies to any type of firm (including sole traders and partnerships) regardless of whether the particular type of firm involved has a separate legal identity from its owners or not.

The realisation that a firm can be seen to be separate from the proprietors or owners of a firm introduces a duality (or a ‘two-sided’ nature) to all transactions of a firm. This is because all transactions involving a firm will affect not only the firm itself but also the wealth or interests of the firm’s proprietors or owners as well. This is true of each and every transaction or economic event affecting a firm. That’s right, every single one. Double-entry accounting simply reflects this view or way of looking at business reality. As we will see, for every transaction of a firm there will always be two opposite and equal components: the heads and tails of every transaction, if you like. These two sides or aspects to every transaction are called debits and credits.

The word ‘debit’ comes from the Latin word ‘debere’ which means ‘to owe’. Indeed, the related Latin word ‘debitum’ means ‘debt’. The word ‘credit’ comes from the Latin word ‘credere’ which means ‘to believe’ or ‘to entrust’. The practice has developed to put debits on the left-hand side and credits on the right-hand side of a ledger account. For all their capacity today, computers still have no idea about their left or right. For this reason, computers use positive numbers for debits and negative numbers for credits. So as we include items in our various ledger accounts we do not refer to increasing or decreasing an account. Rather, we refer to ‘debiting’ or ‘crediting’ an account which will each result in either increases or decreases in accounts depending on the type of account being debited or credited.

The underlying duality of transactions as a result of the proprietorship or entity concept can be seen when we debit an asset account to record an increase in an asset of a firm. We debit an asset account because when a firm receives an asset it owes an obligation to its equity owners to manage that asset well and provide a return on it for their benefit. This is a firm’s obligation to its owners. It is what it ‘owes’ its equity owners. There is the sense that a firm is obligated to its owners for its assets which it must have gained from them. Also, when we increase either an equity or liability account we credit the equity or liability account. We do this because equity investors (or in the case of liabilities, debt investors) have entrusted a firm with something of value to them. They have only done this because they believe in the firm.

Trust underpins all of business. We saw the importance of this in the global financial crisis (GFC) in 2008. When banks stopped trusting each other because they could not assess the risks in each other’s businesses they stopped lending to each other. As a result, the whole financial and economic system seriously faltered affecting billions of people world-wide (including you and me). Double entry accounting is based on the mutual obligations that exist between a firm and those who entrust resources to the firm (principally its equity owners). In this way, each transaction has two-sides to it, a duality, a balance; indeed, a trust relationship that underpins all of business. For trust to exist in business we need someone to trust, who will be obligated to us in equal measure to our trust. An effect of this duality of all transactions will be that there will always be an equilibrium or balance between these two aspects of debits and credits of every transaction or economic event of a firm.

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Accounting equation

The idea that the equity owners of firms are separate to the firm itself is expressed in the fundamental accounting equation that we will see underpins all accounting:

Equity = Assets - Liabilities

What this relationship means is that if the assets of a firm are increased then the equity interests of the owners of a firm are also increased; and if the liabilities of a firm are increased, the equity interests of the owners of a firm are reduced. Or more precisely, if the difference between a firm’s assets and liabilities are increased then the equity interests of the owners of a firm are increased; and if they are decreased, the equity interests of the owners of a firm are decreased. This is simply a model or way of viewing the world of business. It is a simplification of all the complexity and diversity of business.

This fundamental accounting equation is often expressed as:

Assets = Equity + Liabilities

The idea of proprietorship and of a firm being a separate entity to its owners leads to all transactions of a firm having two aspects to them. This duality has the effect of preserving the fundamental accounting equation throughout a firm’s accounts. The way of looking at transactions or other economic events of firms is consistent with the business model (or way of viewing business reality) embedded in the discipline of accounting. This business model is neatly summarised and expressed as the fundamental accounting equation. In this way, as we record transactions and other economic events in the accounts of a firm each will fit neatly into and support our overall business model or view of the firm.

Double-entry accounting is not a method simply designed as a check on the mechanical accuracy of the entry of transactions into a firm’s accounts. That is a commonly-held misconception about accounting. Rather, the ability to use the fact that the debits and credits of a firm’s transactions should always balance to check the accuracy of data entry into a firm’s accounts is a by-product of double-entry accounting, not the reason for it. Instead, double-entry accounting is a way of looking at business. As it has turned out it is a very powerful way of looking at business reality. This is why the ideas and concepts of accounting have become so pervasive and central to the way we understand business for centuries, right up to the 21st century. And though you may not yet know this, it is the reason why you are finding yourself studying accounting (and reading this book) today.

We can see that, at its heart, double entry accounting is a way of looking at business. It is a way of perceiving and making sense of the economic and business realities of firms. A key idea underlying this view of business is that the owners of a firm are completely distinct and separate from the firm they own. This means a firm is ‘debited’ with assets because it owes an obligation to its equity investors for all the assets it controls and which are the means of generating future value to repay that obligation. It also means a firm is ‘credited’ with equity and liabilities because someone outside the firm has entrusted the firm with resources, believing the firm will repay them in the future.

In this section we have seen there are two key ‘books’ in accounting, namely journals and ledgers; and that in our digital age these two separate sets of books rarely exist. We have also seen the key ideas of proprietorship and of the fundamental accounting equation that together underpin accounting. These central ideas of accounting reflect a way of viewing the economic and business realities of firms. In turn, this view of reality underpins the way transactions are recorded in a firm’s accounts. Accounting records and measures the economic and business realities of a firm in a way that reflects a particular view of business. It is a powerful way of viewing business but is not the only way we can view business. Understanding accounting can be a powerful way to transform the way we actually see and think about the day-to-day realities of business. This is possibly why so many people who end up running our businesses as chief executive officers, as other senior managers or as directors know at least something about accounting.

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1.4 Five elements of accounting

It is a little known fact that truth cannot be memorised.

Barry Long

The key ideas underlying accounting of proprietorship and the entity concept of a firm leads us to view a firm as having five key elements: Assets, Liabilities, Equity, Revenue and Expenses. Assets are those aspects of a firm we expect will provide future economic benefits to a firm; that is we expect will add value to a firm in the future. For example, Coffee Supreme (a coffee business based in Wellington in New Zealand with operations throughout New Zealand and in Melbourne, Australia) owns a number of small silver delivery vans. These delivery vans are assets because they are expected to provide future economic benefits to Coffee Supreme by transporting its products to customers (who are mainly coffee shops) in the future.

Liabilities are those aspects of a firm we expect will use up future economic benefits of a firm; that is we expect will take away value from a firm in the future. For example, Coffee Supreme may have promised to pay $50,000 in two months to a firm in Brazil that has recently supplied it with raw coffee beans. This is a liability because we expect this will involve using up future economic benefits of Coffee Supreme, with $50,000 moving out of Coffee Supreme’s bank account in two months.

Equity is often referred to as a ‘left over’ concept: what is ‘left over’ for the owners of a firm after liabilities are deducted from assets. However, the concept of Equity is grounded in the concept of proprietorship and of a firm being a separate entity to its owners. It is the ‘other side of the coin’ to a firm’s assets and liabilities. Assets and liabilities represent the value of a firm. Equity represents the value of the interest of its owners in the firm. Based on our view of business reality underlying accounting, Equity will always equal Assets less Liabilities as summarised and expressed in our fundamental accounting equation. Equity is not in essence a residual item. Equity has its own conceptual ‘reality’ in our view of the economic and business realities of a firm that informs the discipline of accounting. It is because Equity does have its own separate conceptual ‘reality’ in the way we view business in accounting, that all transactions of a firm conceptually have a dual nature, affecting both its Equity and also its Assets and Liabilities.

Measure of value

Assets, Liabilities and Equity are the three elements that provide a measure of the value of a firm and of the interests of its equity owners, or in other words the financial position of a firm (and of its equity owners) at a given point in time. Value is a central concept in all of our lives and we have a wide range of opinions and views about what is important, or valuable, or worthwhile in life. So accounting enters right into this issue of what we value in business. Indeed, accounting seeks to put a precise dollar figure on the value of a firm; or at least to give us information to help us make our own estimates or judgements of value. This is useful in business (well, actually essential) because all firms transact with others in markets using dollars to measure the value being exchanged.

Firms transact in product markets with customers, in input markets with suppliers and in capital markets with equity and debt investors. All exchanges of value between a firm and other participants in these markets are made in precise dollar terms. For this reason, quantifying value into hard, harsh monetary terms is unavoidable in our market-based economy. If nothing else, it focuses our minds sharply on what is of value in our lives, and in particular in our business lives and experiences. The view of the value of a firm in a firm’s accounts is built up from each and every one of the transactions recorded in its accounts. This is where the value of a firm as expressed in its assets and liabilities (and also the value of the interests of a firm’s equity investors as expressed in its equity) come from. They do not come from anywhere else.

Changes in value

A firm’s value is changing day-by-day and moment-by-moment as a result of its business activities and of changes in the markets in which it operates and in the world around it. As anyone who has been involved in business knows, firms never stay still. Business is always ‘on the move’. The realities of business are always

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shifting and changing and affecting the value of a firm (and the value of the interests of its equity investors) at different points in time. The value of a firm, as expressed and measured by a firm’s assets and liabilities, is constantly ‘on the move’ and changing. In the dual nature of our view of business reality, the value of the interests of equity investors in a firm is also constantly changing. Indeed, the two are inextricably linked: the value of a firm and the value of the interests of equity investors in a firm.

Revenue and expenses

Now we come to something important about the way we view business reality in accounting. We usually do not keep adjusting our firm’s equity day-by-day or moment-by-moment for changes in the value of a firm. Instead, what we do is have temporary accounts of Revenue and Expenses to hold the various additions or reductions in our equity. Every so often, perhaps monthly, six-monthly or yearly, we empty out these temporary Revenue and Expense accounts and calculate the net effect of our firm’s transactions for a period on the value of the interests of our equity investors in a firm. We call this a firm’s ‘profit’ if there is an increase in value and a ‘loss’ if there is a decrease in value. We then transfer this profit or loss to a firm’s equity at the end of a period. We then start the next period with zero amounts in our Revenue and Expenses accounts.

Revenue are additions to equity as a result of increases to assets or reductions in liabilities of a firm (but not those changes to assets and liabilities that relate to transactions between a firm and its equity owners). For example, revenue would include sales by Coffee Supreme of fresh roasted coffee to Chocolate Dayz Cafe, a café at Days Bay on Wellington harbour in New Zealand. If Chocolate Dayz Café paid for this coffee in cash then this would increase an asset (that is, cash) of Coffee Supreme by the same amount. Revenue would not include an increase in cash (an asset) if shareholders in Coffee Supreme paid cash to the company to buy new shares in the company. Rather, in such a case equity would be changed immediately.

Expenses are reductions to equity as a result of decreases to assets or increases in liabilities of a firm (but not those changes to assets and liabilities relating to transactions between a firm and its equity owners). For example, expenses would include the cost of electricity used to power the coffee grinders and roasters in Coffee Supreme’s manufacturing operations in Hopper Street, Wellington. Expenses would not include a reduction in cash (an asset) as a result of Coffee Supreme paying a dividend to its shareholders.

Revenue and Expenses relate to something the firm has done to create or destroy value during a period of time. The reason we do not include transactions between a firm and its equity owners as revenue or expenses is because these transactions transfer value between the equity investors and the firm; they do not create or destroy value for equity investors. For example, if equity investors buy new shares in a company then they will pay the firm some cash (increasing the value of the interests of equity owners in the firm; but reducing their own personal cash by the same amount); or if a company pays its equity investors a dividend on their shares then the firm will pay some cash to its equity investors (decreasing the value of the interests of equity owners in the firm; and increasing their personal cash by the same amount).

As a general rule, you cannot create value by simply moving things around from one pocket to the next; life, and business, is meant to be easy, but not that easy. Revenue increases the value of the interests of our equity investors in a firm (that is, increases a firm’s equity) and expenses reduce the value of the interests of our equity investors in a firm (that is, reduces a firm’s equity). If a firm’s revenue is greater than its expenses during a period the firm has added (or, perhaps magically ‘created’) value for its equity investors. If a firm’s expenses are greater than its revenue during a period, then the firm has reduced (or, perhaps less magically ‘destroyed’) value for its equity investors.

Extended accounting equation

The relationship of the five elements of accounting can be viewed as:

Assets = Equity + (Revenue – Expenses) + Liabilities

Or (if we ‘add’ Expenses to each side)

Assets + Expenses = Equity + Revenue + Liabilities

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This is often called the extended fundamental accounting equation because it includes changes in value over a period (Revenue and Expenses) as well as measures of value at a point in time (Assets, Equity and Liabilities). Understanding the extended fundamental accounting equation is essential to understanding what accounting is about. It is also a necessary first step in our journey to being able to potentially use accounting information to help us connect to the economic and business realities of firms. In this section, we have looked at the five elements of accounting: Assets, Liabilities, Equity, Revenue and Expenses. These five elements or ideas underpin the view of business that accounting can give us. Accounting captures those aspects of a firm that will support this view of business reality. A key part of this view of reality are precise dollar measures of value at particular points in time (Assets, Liabilities and Equity) and precise dollar measures of changes in value during particular periods of time (Revenue and Expenses).

Conclusion

In this chapter we have seen that a firm’s accounts are not themselves the economic and business realities of firms. Each firm experiences its own economic and business realities quite independently of what gets recorded in its accounts. Accounting involves recording in a firm’s accounts some aspects of what is going on in a firm. The way this is done has developed over many centuries. Embedded in the approach used in accounting is a particular view of business reality. Over time this view of reality has proved to be a powerful one. It has resulted in a profession of accounting that has an insatiable appetite for university graduates from around the world, in many ways regardless of where we are in the economic cycle. It has also resulted in many of those in senior management and board positions of firms having backgrounds in accounting.

These powerful ideas sit in behind and are the reason for the way we include aspects of a firm’s economic and business realities in its accounts. This is what we have looked at in this chapter. It has been perhaps your first introduction to these powerful ideas and ways of viewing business. In the next chapter, we will see that when firms provide their accounting information to people generally outside their firm there are a lot of rules with which they need to comply. Yes, a lot of rules. We will now have a look at understanding the rules of this ‘game’ called accounting.

Questions

Question 1-1

Why do we have double-entry accounting? Why do we put in everything twice? Why not just once?

Question 1-2

For your firm, identify three Assets, three Liabilities and three items of Equity. Describe what each item means to you (you may find some footnotes in your firm’s financial statements may help you to make more sense of these items). Put on your blog your answer to this question and comment on the answers to this question of at least three other people. Include links to your blog and also to your comments in other people’s blogs.

References

Foulke, RA 1968, Practical financial statement analysis, 6th edn, McGraw-Hill, New York.