THEORY OF ACCOUNTING AND SOME PHILOSOPHICAL THOUGHTS ON ITS PRACTICALITIES.

You will find no long obscure words in this article. Neither will you find equations with Greek letters in them. But what I hope you will find is a simple explanation of the principle underlying double-entry book-keeping.

Do you really understand the principle underlying double-entry book-keeping? Perhaps you think it is too difficult to understand and you leave everything to your bookkeeper and accountant to sort out.

What is the basic principle underlying double-entry book- keeping? Is double-entry merely a collection of well-recognised conventions for recording business transactions, without any theoretical foundation? The answer is No. Double-entry book-keeping is essentially an equation. The equation is Liabilities of the Business = Assets of the Business. Or, put in another way, "owners" or financiers of the business = assets of the business. The proprietor of the business is, of course, a financier of the business but one with very special rights. The business is regarded as a separate entity from the proprietor. Accordingly, the business owes the proprietor the funds that he has invested in the business. Let us look at a typical Balance Sheet of a professional person.

Capital of John Smith, proprietor  12,000
Long-term loan  10,000
CURRENT LIABILITIES
Creditors    5,000
Commissioner of Taxation    6,000
TOTAL LIABILITIES               $  33,000
ASSETS
NON-CURRENT ASSETS
Furniture and equipment  15,000
Motor vehicle  10,000
CURRENT ASSETS
Debtors    6,000
Balance at bank    2,000
TOTAL ASSETS                         $  33,000

As you can see, total assets of $33000 equal total liabilities of $33000. The Balance Sheet is in equilibrium.

The object of all our double-entry book-keeping from this point on is to keep our Balance Sheet in equilibrium. Obviously, to do so, if we add to one asset, we must either add to a liability or subtract from another asset. The same applies to a liability. If we add to one liability, we must either add the same amount to a corresponding asset or deduct the same amount from another liability. Obviously, the converse rules will apply if we deduct an amount from an asset or a liability.

Examples will make matters clearer. John Smith pays an outstanding account of $600. Decrease an asset (bank balance) and decrease a liability (creditors) by $600 each. John Smith buys a desk for $500. Decrease one asset (bank balance) by $500 and increase another asset by $500 (furniture and equipment). A debtor pays his account of $1000. Increase one asset (bank balance) by $1000 and decrease another asset (debtors) by $1000. John Smith hands over his vehicle worth $10000 in satisfaction of his long-term loan of $10000. Decrease an asset (vehicle) and a liability (long-term loan) by $10000 each.

So far, so good. But, you may ask, what happens when I pay an expense, say rent of $500? Obviously, I will decrease an asset (bank balance) by $500 but what asset do I increase or what liability do I decrease?  To answer this question, we must realise that all expenses are really short-term assets. When you pay the rent of $500, you will gain a lease for a term of, say, a week. When you pay for electricity, you get actual electric current. As a rule-of-thumb, if an asset lasts for less than a year, it is regarded as an expense. If it has a life of over a year, it is regarded as an asset. At the end of each financial year, all expired assets , i.e. with a lifetime of less than a year, are amalgamated as expenses. They are then offset against the owner's capital account, representing a loss of capital. The double-entry, therefore, at year end is decrease expense- assets by $x and decrease liability (owner's equity) by $x.

What happens when the owner carries out professional services and thereby increases his bank balance and also increases his capital account? The answer is you increase an asset (bank balance) by $x and increase a liability (owner's equity) by $x.

Suppose for example that the owner carried out the following professional work during the year and incurred the following expenses.

INCOME
Professional services 100,000
LESS EXPENSES
Rent  10,000
Salaries  40,000
Other expenses  10,000
TOTAL EXPENSES  60,000
NET PROFIT FOR YEAR     $  40,000

The double-entry records for the above are as follows. First, increase asset (bank balance) and increase liability (Owner's equity) by $100000. Next, decrease assets (decrease all expense assets to zero) and decrease liability (owner's equity) by $60000. The net result of these entries is of course to increase the owner's capital account by the amount of the net profit for the year i.e. $40000.

So that is all there is to double-entry book-keeping.



MEASUREMENT OF ASSETS AND LIABILITIES.

As explained above, to ascertain the profit or loss made by a business, we measure the growth of assets at intervals e.g. cash, inventory, fixed assets, debtors, creditors etc. An ideal accounting system would measure and record the value of each asset and liability at micro-second intervals. But present-day technology cannot manage this. Even with the best "on-line" systems some assets are measured only at yearly intervals. Perhaps in the not-too-distant future, assets and liabilities will be constantly monitored, measured and recorded. We will then have a Balance Sheet which changes second by second.

Until that time arrives, the interval at which assets are valued is mandated by a) each time a transaction is concluded and recorded e.g. cash, b) annual Financial Statements i.e. yearly recordings of inventory, depreciation of assets, valuation of shares, increase/decrease farming produce etc.

Assets owned by a business can increase in value because of a) general increase in value e.g. land, b) inflation e.g. CPI increase and c) natural increase e.g. crops growing.

Some are assets are continually increasing in value second-by-second e.g. land, buildings (some), farming crops, farm livestock. For example, it is self-evident that in a farming operation, the crops grow continually and imperceptibly. The increase in value can only be measured at intervals and then recorded.

Assets owned by a business can decrease in value because of a) general decrease e.g. shares, b) usage and wear-and-tear e.g. depreciation of plant.

Some assets are continually decreasing in value second-by-second e.g. plant, buildings (some), inventory (some).

Some assets may be increasing or decreasing e.g. buildings, inventory, shares etc.

Generally, for cash, a record is kept of each change in the value of cash, i.e. each cash transaction is recorded. Some businesses, with an adequate inventory system, keep a record of all changes in the quantity (but not the value) of the inventory.

When valuing assets that we own but we do not have possession of, then we must discount the value appropriately. For example, if we own land and it is leased to someone else and they pay only a pepper-corn rent, then the value must be discounted. If full rent is being paid, no discounting would be necessary. Similarly, if we have debts or loans owing and the amounts will be paid to us sometime in the future and the debts or loans carry no interest, then we must discount the value of the debt or loan. It is obvious that a $1,000 payable in a year's time is not as valuable as $1,000 payable today.

CREATION OF RECORDS

Normally, the increase/decrease in the value of an asset must by measured and recorded by someone who had an eye-witness view of the transaction. Examples: a) when cash is passed from one person to another, there are two eye-witnesses present. A receipt is written out by the receiver of the money. The receipt is given to the payer and a copy receipt kept by payer. Both the payer and the receiver are now in possession of a record created by an eye-witness to the transaction; b) when goods are transferred in exchange for cash, the receipt is created as above by an eye-witness. In addition, the seller of the goods creates an invoice. He gives this to the buyer when handing over the goods. He keeps a copy for himself. There is thus a record created by an eye-witness for the transfer of the property. c) When goods are sold on credit terms, an invoice is created as above by an eye-witness when the goods are transferred.

When there is a transfer of goods or property from one person to another, generally only one record is prepared by one eye-witness. Generally, the person who transfers the goods prepares the record. He gives the original of the record to the person who receives the goods and keeps a copy himself. As can be seen, only one record is prepared and both parties rely on this one record. Thus, when preparing financial statements at year-end, the accountant relies on records prepared by his client and on records prepared by persons with whom the client had dealings.

Generally, a person will create an accounting record or insist that a record is created when it is in his interest to do so. A person who transfers goods will raise an invoice on the opposite party. A person who pays cash will insist upon a receipt. A person will be less likely to raise a record and record a transaction when it is not in his interest to do so. Those who wish to avoid paying tax will not record moneys received. Some businesses will not keep a list of amounts owing by them. They will rely on the creditor sending them a monthly statement of account.

OBTAINING INFORMATION

Accounting is concerned with a) the obtaining of information and b) the processing of that information. The information may be obtained from a) written records kept by the client e.g. cheque-book stubs, b) written records created by persons the client had dealings with e.g. bank statements, other party to a transaction e.g. invoices, receipts etc. Often written records for a small business are inadequate or incomplete and additional oral information must be sought at interviews with the client. Oral information is not as trustworthy as written information because of lapses of memory etc.

Can an accountant certify e.g. to the Tax Department, a bank etc that the financial statements he has prepared for a client are correct? This would be almost an impossibility. An accountant is only passing on the information supplied to him by someone else. An accountant almost never has been an eye-witness to the transactions that he records. In this case, the aphorism "Garbage in, garbage out!" applies. In many ways, the accountant is performing a function similar to a computer bureau which processes data received from clients. The accountant cannot vouch for the accuracy of the information provided to him. In other ways, the accountant is in a similar situation to a lawyer who receives instructions from a client and appears in court on his behalf. The lawyer does not vouch for the accuracy of the information provided to him by his client. The information provided to an accountant may be deficient because a) information has been omitted either deliberately or unintentionally e.g. a client does not disclose all income received, b) the information that has been provided may be deliberately false or c) the information provided may be unintentionally false.

VERIFICATION OF INFORMATION

If the accountant undertakes verification of the information provided to him i.e. he audits the financial statements, he can indeed greatly reduce the chances of some of the information provided to him being incorrect. But generally, it is not possible to verify all of the information provided because a) corroborative evidence is not provided by the client for all information provided and b) the cost of obtaining and examining all of the corroborative evidence would be prohibitive. Normally, auditors do a test cheque of some 10% of transactions. In addition, there are few ways of detecting that information has not been provided as distinct from proving that the information provided was false.

Again, it must be remembered that when an auditor is asked to audit financial statements, all the information to do so is provided by the client to the auditor. The auditor has no other source of information other than that provided by the client. It must be asked "Is it likely that a fraudulent client would provide the auditor with the information to catch him out?"

DISCLAIMER:  See disclaimer on home page. 

Copyright 2002.




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