Accounting - An Introduction

Accounting - An Introduction

This Chapterintroduces you to accounting as a profession, and as it is used to make financial and business decisions. Billions of dollars exchange hands every day, in millions of separate business transactions. These are recorded and reported on using a comprehensive set of guidelines, referred to as Generally Accepted Accounting Principles (GAAP). 

Accounting

- n. The bookkeeping methods involved in making a financial record of business transactions and in the preparation of statements concerning the assets, liabilities, and operating results of a business.

System

-  n. A group of interacting, interrelated, or interdependent elements forming a complex whole.

Accounting System

- the people, procedures, and resources used to gather, record, classify, summarize and report the financial information of a business, government or other financial entity.

Double-entry bookkeeping

Each transaction describes both: 
(1) the object of the transaction - such as rent, telephone, or payroll expense; sales, fee or interest revenue. 
(2) the source of payment - cash or credit.

Money

eventually changes hands in (almost^**) all transactions, either at the time of the transaction, or perhaps at a future date in the case of items purchased on credit. Sometimes a transaction involves cash directly, at the time of the event, such as a cash sale at a grocery store. It is more common, and safer, to use a checking account for routine purchases. These are all considered part of the Cash account.

Many, and perhaps most, transactions in a business take place on a credit basis. Businesses usually purchase their supplies and merchandise on a 30-day account, known as a trade account, or Accounts Payable. Sales are typically made in a similar fashion, called Accounts Receivable. 

**Adjusting and closing entries are not typical, and represent special entries made by accountants to prepare financial statements, and reset certain accounts at the end of a fiscal year.

A short history of accounting 

Writing and numbers would be not be invented for about another 5,000 years. And what happens next will directly lead to the invention of both writing and number systems. 

At that time, merchants faced many of the same problems businesses face today. They had to ship their merchandise up and down the rivers, and that meant trusting a boatman with their goods. Unfortunately, not all boatmen were honest, and disagreements often arose about how much was shipped versus what was received at the other end. 

It is hard for us today to imagine a world without writing and numbers. Try to imagine yourself in their position.... what would you do?

To deal with the problem, merchants came up with an ingenious plan. They made small clay tokens, in various shapes and with various markings, to indicate different products. One would mean a basket of grain, another would mean a pot of oil, etc. They had over 200 such tokens to indicate a large variety of common goods, including food, leather, clothing, utensils, tools, jewelry, etc. 

Bollae and tokens circa 3300 BC

Before shipping their goods, a merchant would take one token for each item in the shipment, and encase the tokens in a ball of clay, called a "bollae" (pronounced "bowl-eye") - meaning ball. The ball would be dried in the sun, given to the boatman, and then broken by the buyer on the other end of the transaction. The buyer would match the tokens with the items in the shipment, to verify that everything sent was accounted for. 

This is the function of protection of assets, and is a major function of all modern accounting systems. It was important 10,000 years ago and is just as important now. Today we see merchants doing the same thing as their counterparts 10 millennia ago - today they get a bill of lading - a listing of the merchandise entrusted to a shipper. 

The system of using bollae continued for almost 5,000 years, all before the invention of writing or numbers. One day, probably by accident, a wet clay bollae was rolled over a loose token, laying on the ground. The impression of the token was left in the wet clay. Merchants began pressing the tokens on the outside of the bollae, in addition to putting the tokens inside the ball. 

Eventually they would press tokens into a flat piece of clay, leaving an impression for each item. Remember, they didn't have numbers yet, so they would press a token into the clay for each individual item. Probably by accident one day the right token couldn't be found, and someone used a stick or other object to make the right marks in the soft clay tablet. And writing was born...

New symbols were soon created representing multiple items, and suddenly both writing and number systems were invented. The last phase of this remarkable process took about 500 years, but once writing was invented, it caught on like wildfire, and was the most popular thing anyone had ever seen.

People were so much in love with writing they did it every chance they could. We have a huge amount of archaeological evidence to support this notion. Thousands of small clay tablets still survive today. 

A common example: a worker sent his boss a note saying he would be late for work that day because he had chores to do. He would hire a scribe to write the tablet (only a few people could read or write), and hire a child to carry the note to his boss. They sent notes like we use the phone today, and they loved it. They wrote for the sheer joy of it - the ability to communicate at a distance.

Written accounting records are some of the oldest writings that have survived until today, and they date back to circa 3300-3200 BC. These early records were simple single-entry listings of wages paid, temple assets, taxes and tributes to the king or Pharaoh. This simple system was used until the mid-1400s, and a period known as the Renaissance.

Picture in the Tomb of Chnemhotep, pharaoh of Egypt circa 1950 BC. The ancient Egyptian scribe (seated on the left) prepared his accounts on papyrus with a calamus. The accompanying text reads "Minute care is not only taken in the case of large amounts, but even the smallest quantities of corn or dates are conscientiously entered." In ancient Egypt, the accountants were literally bean-counters. They also counted rice, beer, and everything else. Ancient Egyptians were paid in "kind" - they had not invented money yet so workers were paid with food, beer, clothing, etc. (Everyone drank beer back then, because it was more sanitary than the water. The alcohol content was very low, because they used a short brewing process. )

It is interesting to note that the Mediterranean and European nations had no concept of the number zero until the middle ages. They learned the concept of zero from Middle Eastern mathematicians, who also knew about the movements of the stars and planets, and had figured out the earth was round, and revolved around the sun in an orbit, etc. It took the Europeans another 500 years to figure that out, largely because those concepts were contrary to views held by the Roman Catholic church at the time. It's also hard to do math using Roman numerals, so their math skills were limited until they started using Arabic numbers.
 

By the time Christopher Columbus was trying to sail west, a new form of accounting was in use by merchants in Venice . Luca Pacioli (pot-chee-O-lee) set down in writing for the first time a description of the double-entry system of accounting, which we still use today in much the same form. Alhough he didn't actually invent the system he is called "the father of accounting" for his contributions and for documenting the system in his fifth book on mathematics Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion).

Written as a digest and guide to existing mathematical knowledge, bookkeeping was only one of five topics covered. The Summa's 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added "in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business," and to "give the trader without delay information as to his assets and liabilities" (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli's Treatise, 1914).. 

Luca Pacioli was a remarkable man. He was one of the best mathematicians of his time, and was a close friend of Leonardo DaVinci. They collaborated  on many projects. Pacioli helped DaVinci lay out his painting, The Last Supper, with mathematical precision. And Leonardo illustrated Luca's books on mathematics and accounting. History is full of instances of collaboration between these two great thinkers and Renaissance men.

Modern accounting follows the same principles set down by Luca Pacioli over 500 years ago. However, today it is a highly organized profession, with a complex set of rules for the fair disclosure and presentation of information in financial statements. Every day trillions of dollars in transactions are recorded by business, government and financial institutions world-wide. They all follow the same general set of rules. 

In the United States, we follow Generally Accepted Accounting Principles (GAAP) as specified by the Financial Accounting Standards Board (FASB). We use the US Dollar for all financial statements and transactions. Other countries use similar accounting rules as the US, but there are differences from country to country. If you had a business in France, you would use the French equivalent to our GAAP.

GAAP developed over 500 years from the basic concepts Luca Pacioli set forth in the 1400s. There is a great deal of similarity in accounting practices around the world because they all have a common origin.

What accountants do....

Forms of Business Organizations

The business entity is the legal form the owners have chosen, depending on their particular needs. The legal form will determine how the company will file tax returns and the owner's individual exposure to legal liability for lawsuits brought against the company. 

Corporations and LLCs both provide a layer of legal protection for the owners. Sole Proprietors and General Partners are exposed to unlimited legal liability. This is why most business are organized as corporations. The LLC form has been available in the US for about a decade, but has become a very popular business form. The number of LLCs is growing rapidly, but the predominant business form is still the corporation.

The Balance Sheet presentation and accounts used will vary depending on the way the company is organized. Sole Proprietorships use the Owner's Equity account. Corporations have accounts for stock and retained earnings. Partnerships have accounts for Partner's Capital, contributions and distributions.  LLCs may be organized like a corporation or partnership, and will use the appropriate set of accounts depending on how the company is set up.