The Fundamentals of Accounting

What is enough and how do we determine it?

There is a story about Kurt Vonnegut (Slaughter House V) and Joseph Heller (Catch 22). They’re at a party at a billionaire’s house and Vonnegut teases Heller saying that the billionaire who owns the house made more that week than Heller’s book will make in its entire life. Heller responds by saying that he (Heller) has something that the billionaire will never have - that he has an idea of what enough is. In our lives most of us will never be on the level of Vonnegut, Heller, or billionaires, but that doesn’t mean we can’t be - nor that we can’t take charge of our finances. So where do we start? We start by breaking it down into fundamental understandings.

In business contexts we look for things to be much more black-and-white than life often is. At a very rudimentary level we start understanding forecasting what is “enough” as a measure of accounting. So what then is accounting? Merriam-Webster’s definition of accounting says that it’s the “system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results.” (https://www.merriam-webster.com/dictionary/accounting) However, for this course we want to really focus in on an applied look more than a theory, so we’re going to add a focus on things like consistency, accuracy, and the data being relative in formats (so as to make it useful. With that in mind we’re going to use the following definition:

Forecasted plans for finances in a set period are refereed to as “budgeting.” This process involves you effectively laying out a plan to account for incomes and outflows. Businesses rely on income statements and balance sheets - ledgers of revenue streams, one-off costs vs. long-term debts vs. incomes/properties, etc. These income statements and balance sheets are very important in that they identify trends and present financial health!

The people who organize these assessments, forecasts, plans, reports, and other such financial transactions are accountants - but they can also hold position titles including Director of Finance, Financial Analysts, Chief Financial Officers, Auditors, and many more. It is not uncommon to see accountants employed in roles outside of their formal education because they have incredibly in-depth and formally-qualified grasps of key business concepts and legal standards. While the profession of accountant is one which is organized and maintained by an organization known as the Chartered Professional Accountants of Canada, you do not have to be a registered chartered professional accountant to do many of the basic practices they are familiar with: such as organize a basic budget, prepare and file your taxes, etc. (Could you imagine if you needed to be CPA qualified just to budget for things like groceries?!?) That said, they obviously benefit from the formal training, and hold licenses to practice many things that the average person, bookkeeper, and accountant would not.

Why do we need to study these things? Why does accounting have to be so formal and consistent?

At its core, accounting concerns really not so much with the numbers themselves (although those are absolutely CRITICAL) but rather with what questions the numbers can answer. Looking at why your profits (a term we’ll explore in a bit) were higher two years ago than they are today can lead you to consider changes in what you’re doing. They can also help you to understand if perhaps two years ago there was something different outside of your organization that might explain it. You might be able to see trends in your numbers that suggest that you can afford to invest in something new that will suit you or perhaps your business better - or you might see something looming ahead that would indicate it’s time to batten down the hatches and prepare to weather a storm. Accounting can help you decide if investing the value of those two coffees out a week with compound interest might mean retiring two years earlier, or if you should consider writing those coffees off on your taxes given that you’re having them with business partners anyways. The benefits and questions that can be answered through the application of accounting is endless!

Terms

If you were to pursue a career in the business field the list of terms you would need to learn would be INCREDIBLY long, but for an introduction to business course we’ll keep it pretty simple. The first terms we have to learn and understand in these contexts are ‘Profits,’ ‘Losses,’ ‘Revenue,’ ‘Expenses,’‘Assets,’‘Liabilities,’ and ‘Equity.’ The understanding of how to balance our finances is an understanding of how to determine if you should have enough, too little, or too much (hopefully in the right direction), yet the definitions of some of these terms - especially assets and liabilities have changed particularly lately, so we will be both exploring them in this lesson and in some of the industry profiles ahead. This is a good way of seeing if things will go well - assuming there are no bumps in the road ahead (we’ll explore some of those in later lessons). Right now I’m going to try to keep this as directly applicable and simple as possible. Here are a couple of short ones, then the more complex ones we can go through below in their own sections.

Bookkeeping - the method of recording and organizing financial transactions. Generally organized/assigned to representative accounts, they are entered as individual detailed journal entries.

Transaction - A recorded organizational financial activity.

Profit

Surely this should be simple, right? If you’re making more than you’re spending, you’re making a profit… well, it’s not always that straightforward. Say I were to start a lemonade stand and the cost of each cup in lemons, sugar, water, and cups is 25¢. If I sell each cup at the side of the road at $1, that means I’m making a 75¢ profit, doesn’t it? The equation would look like this:

Sales per unit $1
Cost per unit of sales 25¢
Balance 75¢

That looks pretty good! That’s a 300% markup, I’m off to the races and I can quickly hand in my notice as a teacher, I’m on the way to retirement quickly! Here’s the thing though, the cost for each cup isn’t actually likely 25¢ per unit of sales. What we’re looking at is actually referred to as a 75% Gross profit margin. It doesn’t account for things like the business startup, operating/overhead costs (indirect costs like fuel to get the supplies, marketing, etc.), taxes (because I’m obviously going to pony up to the government with my fancy lemon delights), loans (maybe I couldn’t afford the wood to build the stand), employee wages (I’m the boss, I’m CERTAINLY not going to be down at the stand, I’ll be at the cottage!), dividends (maybe someone else saw the spark in my dream and has invested in my stand, they get some share of the benefits back too), and the list goes on. These are things we’ll explore in future lessons. That said, profits aren’t so simple as A-B=C. Profit is generally broken down into a few different forms (Gross, Operating, and Net) and you need to know which one you’re looking for in context to be best informed. For this course unless otherwise specifically identified as Gross, Operating or Net, profit is best defined as: the financial benefit realized when revenue generated from a business activity exceeds the expenses, costs, and taxes involved in sustaining the activity in question. (source: https://www.investopedia.com/terms/p/profit.asp)

Loss

If you haven’t read what a profit is above, please do that before you explore this section on loss. Given that loss is often defined as when the expenses/liabilities exceed the incomes/revenues (the next two sections will expand on those definitions), understanding profits is an important element. Put simply, if the cost of doing business is more than the associated money brought in (or promised/owed) in a set period then you are operating at a loss. But wait!!! Just because you or a business is operating at a loss doesn’t mean you’re doing poorly! Sometimes you need to take a hit (not literally) in order to make necessary changes. Be careful though, the history of cutting too much is an ugly one. That said, sometimes it’s necessary to cut poor spending, bad supply price points, or other such things to serve you better in the long run.

Income

It should be noted from the outset that income and revenue are indeed different terms. The simplest way to define the term income would be to say, “Income is the total amount of money made from every source.” I should warn you not to get too business-minded in this one, as you might be getting a bit of tunnel vision and only considering things like a person’s salary. I operated a wedding photography business on the side while I was in the military, my income during any given year would have reflected both my military salary, my wedding photography sales, anything I sold like a car or a camera, or anything else which generated cash inflow be it good or service.

In company contexts the income represents revenue - expenses, something we refer to as “net profit,” or sometimes “net income.” On an Income statement for a company you would see the revenue posted at the very top. Which leads us to…

Revenue

So how is revenue different than income then? The simplest way to remember this is that individuals earn income, but individuals do NOT earn revenue. It may be confusing when come tax time you have to file your tax return to the Canada Revenue Agency, but trust me, that’s just an unfortunate coincidence in the title. Revenue is something an organization generates, whereas income is something an employee of the organization would bring in. The size of the business (be it a single person or ‘sole proprietorship’ or massive corporation), or the nature of its management (things we’ll explore later), have nothing to do with it. The revenue represents the total of all sales.

Assets

If you’re very math-minded, then it may be helpful to consider assets to be positives to the negatives that are liabilities. In most contexts that simple understanding will suffice and give you more than enough to have a base understanding of inputs and outflows to any business context, be it personal finances or larger scale organization.

That would mean that if you’re running a small business, any time money flows in, or anything of value to your business, which the business owns/controls, that has value or will bring money in would be considered an asset. Do you have a car paid off that has value to it? That’s an asset. Do you have cash in the bank? That’s an asset. Do you have an employee working for you? That’s… complicated. Employees represent human capital. They bring value into the company, but strictly speaking, companies do not “own” them.

It’s a complicated mess that’s existed for a while - recognizing employees as capital expenses, as it risks putting them on the ‘negative’ side of an accounting ledger. If you think about it, when you invest in an employee you simultaneously make them more valuable to your company and to others. It does carry risk, but the ROI might be substantial. We’ll get back to it later.

Examples of Assets

• Cash or “Liquid Assets”

• Real Estate

  
  One thing to remember is that assets sometimes lose their value over time, and that process is referred to as “depreciation.” Also, assets can be broken into subcategories as is seen in business balance sheets which identify current assets (Cash-able within a year) and fixed assets (real estate).

Liabilities

Put simply, a liability is an outstanding debt or obligation which extends over an extended period. If a company has a liability (or outstanding debt for an extended period) such as a company vehicle payment, it generally lumps those costs into a category in its accounting record under the term “accounts payable.” The opposite of that would be “accounts receivable” which would be anything owed to the company. However, it’s not as frequent that an individual has ongoing outstanding incoming debts being paid-off, so when we’re talking about debts on an individual level we often just refer to them as liabilities and expenses.

While an asset often will lose value or “depreciate,” liabilities aren’t generally known to do that. In fact, quite the opposite. If you fail to pay your outstanding debts fast enough you often are punished by watching them grow with interest or fees for missing/late payments. Also, if you pay too much or too fast there are often clauses which penalize you for paying (unless you have a clause that the debt repayment is “open” detailed in the contract). Be sure you understand the nature of your agreements and tally up how much you will be paying across the term of the contract including interest and associated fees for things like processing!

Examples of Liabilities

• Loans

• Mortgages

  
  Much like assets, liabilities can be broken into subcategories in business balance sheets which identify current liabilities (Paid within a year) and long-term liabilities (Longer than a year).

Expenses

Expenses are generally very short-term if not single payment debts. Where a liability might reflect long-term property payments spread over months, years, decades, etc., an expense might include a single payment for an order of paper or other such supplies. Expenses are far more common than liabilities, but because of their nature they rarely factor into larger applications for things such as credit.

Now we’re going to get back to that employee bit from earlier. While employees can often be more of a value to your organization than any other asset, and while they are often more long-term than many liabilities, they are most often considered an expense and treated by Human Resources as such. You’ll even see them documented accordingly as ‘Wage Expenses,’ to reflect them being identified as an expense. However, you should always keep in mind that while they may be technically an expense, so are many investments - employees are often your greatest investment in organizational success.

Examples of Expenses

• Printer Paper

• Karen from HR is considered a capital expense (If she isn’t HR at Virgin, where apparently Mr. Branson says she’s an asset)

If expenses and liabilities represent money leaving an organization, we should also consider one other thing… money and assets sometimes have a tendency to grow legs. One of the issues we’re going to be discussing in the lesson The Good, the Bad, and the Ugly is how there is an unfortunate (and sadly common) element of theft and unethical behaviour when it comes to business. As a result, there are things like Internal/External Controls in the forms of auditors, forensic accountants, third-party oversight, law enforcement agencies, and other such parties/government bodies who act to ensure that financial statements are scrutinized routinely. There’s a reason why those top positions pay so well, it’s not only the intellectual capital and lifetime of experience/qualifications required to attain them, but the responsibility falls on their shoulders if there is a violation and the consequences can include prison time.

The Accounting Equation

Assets = Liability + Equity

Personally I’ve always preferred to rearrange the equation into a structure that just made more sense in my own head: Equity = Assets - Liabilities, choose whichever works for you, they’re both the same thing. Equity is essentially the value in a thing which remains once all outstanding debts (short or long-term) are satisfied. As we move through the course we’ll explore the expanded accounting equation (Assets = Liabilities + Equity + Revenue - Expenses) which includes a more dynamic consideration for things we discuss here. For now it suffices to understand the basic accounting equation to understand how to determine any of the main three elements.

Equity

Equity can be a bit difficult to understand in that it has different applications depending on the contexts. Let’s start with individual equity. Probably the most common time you hear the word ‘equity’ used with regards to individual finances is when talking about home ownership. When people are buying a home, condo, or other such living property, they frequently refer to how they make payments into their mortgage and they are “building equity.” So, what does that actually mean or represent? An easy way to understand it would be to say that the equity is what the property is worth after deducting what you owe to the bank in the mortgage. That would mean if we apply the accounting equation from above that if the home (the asset) has a current value of $800,000 and you only owe $200,000 to the bank in your mortgage (the liability), you can solve for equity like you would with any algebraic equation and determine it to be $600,000 of equity. Houses aren’t the best examples though, as on one hand the equity will go up while you pay the mortgage down, but on the other, housing markets can be pretty volatile; the equity can change if the market shifts and your house is assessed differently than when it was purchased, and your equity can actually go down!

Equity is something in a business that can vary drastically depending on the nature of the company and its ownership. It may have a single owner, or multiple shareholders invested, and if those shareholders have an interest in ongoing returns on investment (ROI) then the nature of equity growth can be incredibly different. Generally, in a business equity in the balance sheet goes up with the profitability of the business - assuming that the company retains the earnings. The equity in a company can go down when the debts consume all revenues, or when the shareholders draw dividends (shares of the profits paid to the shareholders as a part of the agreement and overseen by the board of directors).

All Roads Lead to Rome… Or do they?

If you’ve done any type of research at this point you may have run into a few prominent names in the industry to talk about. Two of the more modern names which come to mind right now who have had active roles in trying to revolutionize the way that students and the West at large have viewed their relationships with money are Dave Ramsey and Robert T. Kiyosaki. They each have enjoyed remarkable successes and have had significant impacts on the educational environment when it comes to financial literacy and approaches. Their attitudes towards managing debt, and definitions of critical terms such as “asset” are stark contrasts, but yet they both have achieved incredibly success. The activity at the bottom will encourage you to look at them and others a bit more.

An optional activity

Research some of the more modern approaches to financial success. Earlier we mentioned Dave Ramsey and Robert T. Kiyosaki, but you can choose another, perhaps you’re familiar with someone else such as Gary Vaynerchuk, or Tony Robbins, the list is incredibly long. Specify your metric for justifying them as a financial success, profile who they are - their attitudes, approaches, successes and failures, and give an overview of anything particularly unorthodox in how they do what they do. Ask yourself, what sets them apart from all the others? Would their approach suit you? Would it match your current/future lifestyle? Organize your research and thoughts into a short Google Doc and be prepared to discuss it briefly in groups and with the class.