144 CHAPTER 7 ABOUT THESE NUMBERS
The way that bean counters think
If you are handling a business plan then wherever you are, whatever you do, you need to
be familiar with the preconceptions of the accounting profession. Some of their amusing
beliefs are listed on page 146. Three other little issues that are worthy of special mention
are as follows.
Debits and credits
This might seem to be another obvious thing to say, but make sure that you know the dif-
ference between debits and credits (see Who owes whom? on page 147). If you are new to
company bean counting, you might find that they move in opposite directions to the way
that you expect.
Double entry accounting
Double entry accounting is logic that simplifies the preparation of forecasts – it helps
make this process as painless as possible. (See page 146.)
Matching
Finally, matching transactions to the correct periods is important from a management
perspective (see Figure 7.3). It helps you understand the costs and profits associated with
specific activities and revenues.
3 Owners’ or shareholders’ equity. This is paid-up capital and undistributedprof-
its (otherwise known as retained earnings). You want to make it grow every year.
It is an immutable rule that assets = liabilities plus owners’ equity or, put an-
other way, assets less liabilities = owners’ equity. Bear this in mind for later.
Sources and uses of funds
Balance sheets show balances. If you calculate the difference between the figures in
a pair of corresponding balances (prepared at, say, the end of June and the end of
July) you see the flows that have occurred. This is a useful alternative way of looking
at the numbers. It reveals sources and uses of funds:
An increase in an asset account shows a use of funds. For example, a
$1000 increase in other assets – deposits paid indicates that $1000 has been
used to make a deposit, perhaps on office rent.
An increase in a liability account shows a source of funds. For example, a
$1000 increase in bank loans received means that $1000 has been borrowed
(sourced) from the bank.
THE WAY THAT BEAN COUNTERS THINK 145
Figure 7.3 is actually quite useful. If you can follow the logic, you will have no trou-
ble preparing financial statements. Spend a few moments making sure that you follow
it. It shows an example of how you deal with prepayments (cash paid in advance of the
accounting period to which it relates).
Accruals are identical but work in the other direction. They relate to cash payment due
but not yet disbursed. For example, suppose that your office rent was due in July but you
managed to hide from the rent collector. Your landlord has become one of your creditors. In
July you debit rents (as usual) and credit accrued rental payments (a liability account shown
in the liabilities section of the balance sheet). When eventually you are forced to make the
payment, you debit accrued rental payments to clear the liability and credit cash at bank.
The techniques for handling prepayments and accruals are applied in other useful ways.
Most significant, when you spend money on capital goods (a factory, machine, computer,
intellectual property, etc.) the outlay is recorded in an asset account (shown on the bal-
ance sheet – debit asset account, credit cash). The recorded value of the asset is reduced
over its life and an expense account (in the profit and loss account) is charged with an
appropriate amount each month (for example, debit expense account depreciation of
office equipment and credit asset account accumulated depreciation). Do not lose sleep
over this, we will cover it in more detail in Chapter 9.
CASH ACCOUNTING
Very small businesses and those which are entirely cash-based might not need to worry
too much about accruals accounting. I show the extremes here – allocating every penny
to the appropriate period – because it is rigorous and it helps management decision-
making. Subject to any requirements of your tax office or accountants, you can exercise
a touch of discretion. Passing the book-keeping entries to move $50 by one month prob-
ably is not worth the effort. Moving $50,000 definitely would be.
For probably the same reason that Americans call the profit and loss account
an income statement (quietly ignoring the fact that it includes expenditure),
the practice of matching payments to the relevant periods is known as accruals
accounting even though it embraces prepayments and other timing discrepancies.
146 CHAPTER 7 ABOUT THESE NUMBERS
Five of your accountant’s top beliefs
1 Money is everything. Accountants insist that everything can be measured by
money. Accounts do not take account of competitive forces, goodwill, quality,
location, etc.
2 Business is an ongoing concern. Accountants work on the basis that the
business will keep going for ever. The financial statements do not purport to
show what you would be left with if you closed the business tomorrow.
3 The value of something is what you paid for it. Accountants base all their
records on purchase prices. In most cases, it will be an accident if the recorded
value of a factory or machine coincides with the current market value or
replacement value. Your invaluable boffin in R&D is valued at the cost of his
salary package, regardless of what splendid and original ideas are running
around in his little grey cells.
4 Always play it safe. Accountants steadfastly refuse to anticipate revenue and
they include it in the accounts only when a sale is made, but they insist on
making provision for every expected expense or loss just as soon as someone
thinks about them.
5 Policies are set in stone. Honest accountants try to prevent you from changing
accounting policies so that your accounts remain consistent from month to
month and from year to year.
Double entry accounting
Accountants – who sometimes show flashes of brilliance – invented double entry
accounting. The concept is simple. For every debit there is a credit (or credits) with
an equivalent total amount. For example:
when you pay cash for a machine, you debit machinery and credit cash
at bank;
when you pay rent in advance, you debit prepaid rents and credit cash
at bank;
when you take a bank loan, you debit cash at bank and credit bank loans.
Do this right and your accounts will always balance. While it might not reflect
outstanding brilliance, it is nevertheless a useful technique to bear in mind when
preparing forecasts and budgets. It will help you create the financial statements later.
t
THE WAY THAT BEAN COUNTERS THINK 147
WHO OWES WHOM?
Here is one little area that sometimes causes confusion. You are no doubt familiar with
the terms debit and credit. It helps to remember that the words are derived from debt (in
this case an amount owed to you) and creditors (people to whom you owe money). Your
accountant treats them as follows.
Asset accounts have debit balances. If you extend credit to a customer you debit
accounts receivable for that customer (indicating that the money is owed to you);
similarly – but perhaps stretching the concept – if you buy a clump press you debit
machinery. The machine owes you money.
Liability accounts have credit balances. If you borrow money you credit, say,
short-term loans from the bank (that is, the bank is your creditor).
Expense accounts have debit balances. This is easy. When you pay out money, you
debit the expense account. When you pay office rent, you debit office rents paid.
The area of confusion is that when you take money out of your bank deposit account, in
your company accounts you show a credit to the bank – the bank owes you less. When you
show an increase in your bank deposit you show a debit entry – the bank owes you more.
This is the exact opposite of what we normally say. When you go into your bank to
put money into your account you fill in a credit slip not a debit slip. This is because you
are then looking at it from the bank’s perspective. When you put money on deposit you
become one of the bank’s creditors. Thus, if you are drawing up a business plan for a bank,
customer deposits are liabilities with credit balances and loans to customers are assets
with debit balances.
It is straightforward if you look at it from the viewpoint of who owes money to the
business.
148 CHAPTER 7 ABOUT THESE NUMBERS
Your year planner has the date of your August holiday marked, I would guess, against August.
It would not be so helpful for work scheduling purposes if you marked it on the day that you de-
cided on Jamaica, or when you paid the deposit. So it is with financial transactions. For analyti-
cal purposes, debits are matched against the related credits, and they are each matched to the
appropriate period of activity. This is not necessarily the same as the date when money changes
hands. One example should suffice. Suppose that:
you are producing a monthly expenditure plan;
your office rent is $1000 a month; and
you pay it once every three months in advance.
For example, on 28 June you pay the $3000 that relates to calendar months July, August and
September. The accounting entries are shown on the right.
1 In June, you credit (reduce) your bank balance by $3000 and debit (increase) the asset ac-
count prepaid rents by the same amount.
2 In each of July, August and September, you debit (increase) office rental payments by $1000
and credit (reduce) prepaid rents by the same amount.
If the only other transaction is a 10,000 share issue in May, the transactions that show in your
financial statements are as follows. Note the way that a change in the balance sheet between two
dates (e.g. the change in prepaid rents between the end of June and the end of July) equates
to a flow in the intervening period (P&L account – rents paid in July). This is examined in more
detail in Chapter 9.
May Jun Jul Aug Sep
Balance Sheet
End month
Assets
Cash at bank 10 000 7 000 7 000 7 000 7 000
Prepaid rents 0 3 000 2 000 1 000 0
Total 10 000 10 000 9 000 8 000 7 000
Liabilities and
shareholders’ equity
Paid up share capital 10 000 10 000 10 000 10 000 10 000
Profit (loss), current year 0 0 (1 000) (2 000) (3 000)
Total 10 000 10 000 9 000 8 000 7 000
Profit & loss account
Whole month
Office rental payments 0 0 1 000 1 000 1 000
Net profit (loss) 0 0 (1 000) (1 000) (1 000)
Cash flow
Whole month
Share issue 1 0000 0 0 0 0
Office rental payments 0 –3 000 0 0 0
Total for month 1 0000 –3 000 0 0 0
Net cash balance 1 0000 7 000 7 000 7 000 7 000
Figure 7.3 When financial transactions count
The
changes
in the
balance
sheet
are flows
in the
other accounts
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