Accou nting Conce pts

Accounting Period Concept:Covers the period for which the income has been measured. It is the time between the preparation and presentation of two successive statements of financial position by an organization. The income statement presents the changes in owners equity due to operations and other events between one balance sheet and the next. Accrual Concept:Supports the idea that income should be measured at the time major efforts or accomplishments occur rather than when cash is received or paid. Realization Concept:Determines whether a revenue or expense has occurred so that itcan be measured, recorded and reported in the financial reports. In general, revenue is recognized along with the associated expenses when an exchange has taken place, the earnings process is complete, the amount of income is determinable, and collection of amounts due is reasonably assured. Matching Concept:Determines that the expenses associated with revenue are identified and measured. Money Measurement Concept:All data is expressed in a common monetary unit that can be added, subtracted, multiplied and divided to produce financial statements and reports, which can then be analyzed. Business Entity Concept:Delineates the boundaries of the organization for which amountsare kept and reports are made. Going Concern Concept:It is assumed that an entity will continue to operate much as it has been operating for an indefinitely long period of time.

Cost Concept:Assets are initially recorded by measuring the amount paid for them. As time passes, asset measurements are not changed even if the current value of these assets is changing. Conservation Concept:Revenues and gains are recognized slower and expenses and losses are recognized quicker. Consistency Concept:Once an entity has selected an accounting method for a kind of event or a particular asset, that same method should be used for all futureevents of the same type and for that asset. Comparability is enhanced from one period to the next. Materiality Concept:Insignificant events need not be measured and recorded. Eventsjudged to be insignificant can be ignored or disregarded.
Study Notes: Business Finance & Accounting Accounting concepts and conventions
In drawing up accounting statements, whether they are external "financial accounts" or internallyfocused "management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of the business and the results of its operation. The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately the business' activities. To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently. Accounting Conventions The most commonly encountered convention is the "historical cost convention". This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost. Under the "historical cost convention", therefore, no account is taken of changing prices in the economy. The other conventions you will encounter in a set of accounts can be summarised as follows: Monetary measurement Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc. This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.

Separate Entity

Realisation

With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or transfer of legal ownership - rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the transaction is legal - at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later - if the customer has been granted some credit terms.

Materiality

An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the "materiality" convention suggests that this should only be an issue if the judgement is "significant" or "material" to a user of the accounts. The concept of "materiality" is an important issue for auditors of financial accounts. Accounting Concepts Four important accounting concepts underpin the preparation of any set of accounts: Going Concern Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities. Consistency Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change. Prudence Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are "provided for" in the accounts" as soon as their is a reasonable chance that such costs will be incurred in the future. Matching (or Income should be properly "matched" with the expenses of a given accounting "Accruals") period. Key Characteristics of Accounting Information There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria: Criteria What it means for the preparation of accounting information

Understandability This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users - who are generally assumed to have a reasonable knowledge of business and economic activities Relevance This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?) This implies consistent treatment of similar items and application of accounting policies

Consistency

Comparability

This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability. This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor). This implies that accounting information is prepared and reported in a "neutral" way. In other words, it is not biased towards a particular user group or vested interest

Reliability

Objectivity

Cash Flow Statement Example-Direct and Indirect Method:

Unlike the major financial statements, cash flow statement is not prepared from the adjusted trial balance. The information to prepare this statement usually comes from three sources:

1. 2. 3.

Comparative balance sheets provide the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period. Current income statement data help the reader determine the amount of cash provided by or used by operations during the period. Selected transaction data from the general ledger provide additional detailed information needed to determine how cash was provided or used during the period

Preparing the statement of cash flows from the data sources above involves three major steps: Step 1. Determine the change in cash: This procedure is straight forward because the difference between the beginning and the ending cash balance can be easily computed from an examination of the comparative balance sheet. Step 2. Determine the net cash flow from operating activities: This procedure is complex. It involves analyzing not only the current year's income statement but also comparative balance sheets and selected transitions data. Step 3. Determine net cash flows from investing and financing activities: All other changes in the balance sheet accounts must be analyzed to determine their effects on cash.

Cash Flow Statement Example:

A Comprehensive illustration
To illustrate a statement of cash flows we will use the first year of operations for Tax Consultants Inc. The company started on January 1, 2003, when it issued 60,000 shares of $1 par value common stock for $60,000 cash. The company rented its office space and furniture and equipment, and it performed tax

consulting services throughout the first year. The comparative balance sheets at the beginning and at the end of the year 2003 appear as follows.

Assets Dec. 31, 2003 Cash Accounts receivable Total Liabilities and Stockholder's Equity Accounts payable Common stock Retained earnings Total $ 5,000 $60,000 $20,000 --------$85,000 ======= $-0$-0$-0------$-0===== $49,000 $36,000 ----------$85,000 ====== Jan. 1, 2003 $-0$-0--------$-0=====

Change Increase/Decrease $49,000 increase $36,000 increase

$ 5,000 increase $60,000 increase $20,000 increase

The income statement and additional information for Tax Consultation Inc. are as follows.
Tax Consultants Inc. Income Statement For the year ended December 31, 2003

Revenue Operating expenses Income before income taxes Income tax expenses Net income

$125,000 $ 85,000 --------$ 40,000 $ 6,000 ---------$ 34,000 =======

Step 1: Determine the Change in Cash: To prepare a statement of cash flows, the first step determining the change in cash is a simple computation. The company has no cash on hand at the beginning of the year 2003, but $49,000 at the end of 2003. Thus the change in cash for 2003 was an increase of $49,000 Step 2: Determine Net Cash Flow from Operating Activities: A usual starting point in determining net cash flow from operating activities is to understand why net incomemust be converted. Under generally accepted accounting principles, most companies must use the accrual basis of accounting, requiring revenues be reported when earned and that expenses be recorded when incurred. Net income may include credit sales that have not been collected in cash and expenses incurred that may not have been paid in cash. Thus, under the accrual basis of accounting, net income will not indicate the net cash flow from operating activities.

To arrive at net cash flow from operating activities, it is necessary to report revenue and expenses on cashbasis. This is done by eliminating the effects of statement transactions that did not result in a corresponding increase or decrease in cash. The conversion of net income into net cash flow from operating activities may be done through either a direct method or an indirect method as explained in the following discussion.

1.Direct Method:
(also called the income statement method) reports cash receipts and cash disbursements from operating activities. The difference between these two amounts in the net cash flow from operating activates. In other words, the direct method deducts from operating cash receipts the operating cash disbursements. The direct method results in the presentation of a condensed cash receipts and cash disbursements statement. As directed from the accrual based income statement, Tax consultants Inc. reported revenues of $125,000. However, because the company's accounts receivable increased during 2003 by $36,000, only $89,000 ($125,000 $36,000) in cash collected on these revenues. Similarly, company reported operating expenses of $85,000, but accounts payable increased during the period by $5,000. Assuming that payable related to operating expenses, cash operating expenses were $80,000 ($85,000 $5,000). Because no taxes payable exist at the end of the year, the$6,000 income tax expense for 2003 must have been paid in cash during the year. Then the computation of net cash flow from operating activities is as follows:

Cash collected from revenues Cash payment for expenses Income before income taxes Cash payments for income taxes Net cash provided by operating activities

$89,000 $80,000 --------$ 9,000 $ 6,000 --------$ 3,000 ======

"Net cash provided by operating activities" is equivalent of cash-basis net income. ("Net cash used by operating activities" would be equivalent to cash-basis net loss)

2 Indirect Method:
(or reconciliation method) starts with net income and converts it to net cash flow from operating activities. In other words, the Indirect method adjusts net income for items that affected reported net income but didn't affected cash. To compute net cash flows from operating activities, noncash changes in the income statement are added back to net income, and net cash credits are deducted. Explanations for the two adjustments to net income in this example namely, the accounts receivable and accounts payable are as follows. Increase in Accounts Receivable Indirect Method: When accounts receivable increase during the year, revenues on an accrual basis are higher than on a cashbasis because goods sold on account are reported as revenues. In other words, operations for the period led to increased revenues, but not all of these revenues resulted in an increase in cash. Some of the increase in revenues resulted in an increase in accounts receivable. To convert net income to net

cash flow from operating activities, the increase of $36,000 in accounts payable must be deducted from net income. Increase in Accounts Payable Indirect Method: When accounts payable increase during the period, expenses on an accrual basis are higher than they are on a cash basis because expenses are incurred for which payment has not taken place. To convert netincome to net cash flow from operating activities, the increase of $5,000 in accounts payable must be addedback to net income. As a result of the accounts receivable and accounts payable adjustments, net cash provided by operating activities is determined to be $3,000 for the year 2003. This calculation is shown as follows.

Net income Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable Increase in accounts payable Net cash provided by operating activities

$34,000

$(36,000) $ 5,000

($31,000) ---------$ 3,000 =======

Note that net cash provided by operating activities is the same whether the direct or indirect method is used. Step 3: Determine Net Cash Flows from Investing and Financing Activities: Once the net cash flows from operating activities is computed, the next step is to determine whether any other changes in balance sheet accounts caused an increase or decrease in cash. For example, an examination of the remaining balance sheet accounts for Tax Consultants Inc. shows that both common and retained earnings have increased. The common stock increase of $60,000 resulted from the issuance of common stock for cash. The issuance of common stock is a receipt of cash from a financing activity and is reported as such in the statement of cash flows. The retained earnings increase of $20,000 is caused by two items:

1. 2.

Net income of $34,000 increased retained earnings Dividend declared of $4,000 decreased retained earnings.

Net income has been converted into net cash flows from operating activities, as explained earlier. The additional data indicates that the dividend was paid. Thus, the dividend payment on common stock is reported as cash outflow, classified as financing activity. We are now ready to prepare the statement of cash flows. The statement starts with the operating activities section. Either the direct or indirect method may be used to report net cash flow from operating activates. The statement of cash flows under indirect method for Tax Consultation Inc. is as follows.
Tax Consultants Inc. cash flow statement-Indirect Method For the year ended December 31, 2003

Cash Flows From Operating Activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable Increase in accounts payable Net cash provided by operating activities Cash Flows From Financing Activities: Issuance of common stock Payment of cash dividend Net cash provided by financing activities Net increase in cash Cash, January 1, 2003 Cash, December 31, 2003 $46,000 ----------49,000 -0---------$49,000 ======= $60,000 $(14,000) ---------$34,000

$(36,000) $ 5,000 --------------($31,000) ------------$ 3,000

Financial Statement Analysis:

Learning Objectives:

1. 2. 3. 4.

Prepare and interpret financial statements in comparative and common-size form. Compute and interpret financial ratios that would be most useful to a common stock holder. Compute and interpret financial ratios that would be most useful to a short-term creditor Compute and interpret financial ratios that would be most useful to long -term creditors.

Definition and Explanation of Financial Statement Analysis:

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

Tools and Techniques of Financial Statement Analysis:

Following are the most important tools and techniques of financial statement analysis:

1. 2.

Horizontal and Vertical Analysis Ratios Analysis

1. Horizontal and Vertical Analysis:

Horizontal Analysis or Trend Analysis: Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form. Click here to read full article. Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years' financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base. Click here to read full article. Vertical Analysis: Vertical analysis is the procedure of preparing and presenting common size statements.Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements. Click here to read full article.

2. Ratios Analysis:
Accounting Ratios Definition, Advantages, Classification and Limitations: The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios

can be found out by dividing one number by another number. Ratios show how one number is related to another.

Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under: y y y y y y y y y y y Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) Ratio Dividend yield ratio Dividend payout ratio Earnings Per Share (EPS) Ratio Price earning ratio

Liquidity Ratios:
Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most important liquidity ratios. y y Current ratio Liquid / Acid test / Quick ratio

Activity Ratios:
Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios: y y y y y y y Inventory / Stock turnover ratio Debtors / Receivables turnover ratio Average collection period Creditors / Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading

Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios.

y y y y y y y

Debt-to-equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage ratio Capital gearing ratio Over and under capitalization

Financial-Accounting- Ratios Formulas: A collection of financial ratios formulas which can help you calculate financial ratios in a given problem. Limitations of Financial Statement Analysis: Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.

Advantages of Financial Statement Analysis:

There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.

Cost of Goods Manufactured and Sold Statement Formulas:

Prime Cost = Direct Materials Cost + Direct Labor Cost Total Factory Cost or Manufacturing Cost = Direct Materials + Direct Labor Cost + Factory Overhead Conversion Cost = Direct Labor Cost + Factory Overhead Cost Cost of Goods Manufactured (COGM) = Total Factory Cost + Opening Work in ProcessInventory - Ending Work in Process Inventory Or Cost of Goods manufactured = Direct materials cost + Direct labor cost + Factory overhead cost + Opening work in process inventory - Ending work in process inventory Cost of goods sold (COGS) = Cost of goods manufactured + Opening finished goods inventory- Ending finished goods inventory Or

Cost of goods sold = Direct materials cost + Direct labor cost + Factory overhead cost + Opening work in process inventory - Ending work in process inventory + Opening finished goods inventory - Ending finished goods inventory Number of units manufactured = Units sold + Ending Finished Goods units - Opening finished goods units Per unit cost of goods manufactured = Cost of goods manufactured / Units manufactured Materials used or consumed = Opening inventory or materials + Net purchases of materials - Ending inventory of materials

Income statement formulas:

Gross profit = Net sales - Cost of goods sold Operating profit = Gross profit - Operating expenses Operating or commercial expenses = Selling or marketing expenses + General or administrative expenses Per unit gross profit = Gross profit / No. of units sold Per unit net profit = Net profit / No. of units sold Percentage of GP to sales = (Gross profit / Net sales) 100 Percentage of net profit to sales = (Net profit / Net sales) 100

Cost Volume Profit (CVP) Formulas:

Contribution margin = Sales - Variable expenses (manufacturing and non-manufacturing) Net operating income = Contribution margin - Fixed expenses (manufacturing and non manufacturing) Contribution margin ratio = Contribution margin / Sales Break even point (units) = Fixed expenses / Unit contribution margin Break even point (dollar sales) = Fixed expenses / CM ratio Units sales to attain target profit = (Fixed expenses + Target profit) / Unit contribution margin Dollar sales to attain target profit = (Fixed expenses + Target profit) / Contribution margin ratio

Margin of safety = Total budgeted or actual sales - Break even sales Margin of safety percentage or margin of safety ratio = Margin of safety / Total budgeted or actual sales Degree of operating leverage = Contribution margin / Net operating income

Basic Accounting Concepts 2 - Debits and Credits

A tutorial to help you understand the bookkeeping/accounting concepts of Debits and Credits Most people dont find the math of Accounting as difficult as understanding the concepts of accounting, and for many there is no more difficult concept to grasp than that of Debits and Credits. Now the concept of Debits and Credits is actually more than 500 years old, being used extensively by the Venetian merchants of Italy in the 15th century Renaissance period. The concepts were first documented in Latin in the 1400s and were later translated into English in the 16th century. Is it any wonder then, with the passage 500 years, that we may have become a little confused about the original meaning and concepts, particularly with the English language adopting new legal and everyday meanings for these age old words. So it may be beneficial then, as we try to understand the concept of Debits and Credits, to go back to where it all begun ... but first some background.
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Basic Accounting Concepts - for bookkeeping students

This training session is targeted at students who have a desire to learn more about bookkeeping. While specifically developed for students other people interested in understanding more fully the accounting concepts, may also find this training session beneficial.

Prior to commencing this training session, it is recommended that you first complete the Basic Accounting Concepts 1 - Definitions.

This training session assumes that you know a little about bookkeeping but that you realise to progress in your work application or your learning, you need to understand more fully the concept of Debits and Credits. So, this session seeks to deliver training on the concept of Debits and Credits, from the student bookkeeper's point of view.

KEYWORDS

Accounting Knols
1 Accounting Definitions 2 Breakeven Calculation

credits, debits, firm, accounts, accounting concepts, bookkeeping, financial transaction, accounting system, Luca Pacioli, account group, double entry bookkeeping, duality of financial transactions.

Learning Outcomes
At the completion of this training session, you will be able to answer the following focus questions: 1. 2. 3. 4. 5. What is the origin of Debits and Credits? Why was it called Debit and Credit? What are the underpinning concepts for Debits and Credits? How would they have applied Credits and Debits in the 1400's? Is there another way to look at applying Debits and Credits?

Introduction - Debits and Credits

The dictionary defines Debits and Credits, for the bookkeeping system, as Debits being those entries recorded on the left side and Credits being those entries recorded on the right side. Now some people are comfortable with this definition and after learning all the other rules and axioms of bookkeeping, go on to become very good bookkeepers.

Debits on the Left ... Credits on the Right

However, there are others that want to know more about this concept of Debits and Credits so that they can apply them in a more meaningful way. If you are in the latter group, then this Knol is for you.

Before proceeding, it would be very useful for both the rule-learning and concept-understanding bookkeeping students to learn off by heart the table given below and to also have a solid understanding of the definition of each account group used in the bookkeeping/accounting process.

Note: One thing that is very clear is that the terms 'debit and credit', as used in bookkeeping, has its own special meaning and it should not be confused with any other meaning of the term. (i.e. Debt as in owing money to someone or Credit as in having time to pay for the purchase of goods are not definitions of the Accounting Debit and Credit) Also, the accounting meaning of a term may have a different application to the legal meaning within the same country.

Table 1 - Do I DEBIT it or CREDIT it?

ACCOUNT GROUP

When When you INCREASEthe youDECREASE the $ amount in this $ amount in this account group you account group you ... it. .. it.

Asset Liability Owners Equity Income Expenses

Debit Credit Credit Credit Debit

Credit Debit Debit Debit Credit

Under the Table 1 approach you would ask the following questions when ever required to record a financial transaction in the firm's accounts. 1. 2. 3. 4. 5. What accounts are involved? (There must be a minimum of 2) What account group do they each belong? (They must belong to one of the five) Has the financial transaction increased or decreased the $ amounts in this account? Apply the table logic. Make sure that the total amount $ of the debits = the total $ amount of the credits.

Table 2 - DEFINITIONS

ACCOUNT GROUP Asset Liability

Lay-person s definition

Alternative definition

Item of economic value over which the Asset firm has legal control. Monies owed by the firm to external Liability entities. (Creditors & Loan providers)

Equity (or Monies owed by the firm to internal Owners Equity Owners Equity) entities. (Investors, owners) Income Expenses Monies paid by others for goods and Income services provided by the firm. Assets and supplies consumed in the Expenses earning of income.

Whose Perspective? One 'credit' that worries most newcomers to accounting, is the one that appears on their bank statement. See they have just learnt that 'cash at bank' is an asset and according to Table 1 when you increase an asset you 'debit' it ... so how come the credit balance in my bank account goes up when I deposit money ... they ask.

Well the answer is one that is fundamental to the accounting system. Each firm records financial transactions from their own perspective. So, think about the bank's perspective for a moment ... how do they view the money you have just deposited? Whose money is it? That's right ... it is yours! So your deposit is treated, from the bank's perspective, as a liability (money owed by the bank to others). When you deposit money into your account, THEIR liability increases which is why (using Table 1) they credit your account.

The current teaching

Tradition Explanation of Debits and Credits

OK, on with the full story about Debits and Credits ....

Session - Debits and Credits

PART 1 What is the origin of Debits and Credits?

In more primitive trading times, bookkeeping was not such a big issue because the person who manufactured or produced the goods was usually the person selling or trading the goods in the market place. However, theRenaissance period saw a huge increase in both trade and banking systems brought about by the Roman-built transport systems and the growth of more sophisticated societies like those in Italy (particularly Venice). So, the merchants of Venice in the 1400s, developed an accounting system to accurately record these more complex financial dealings that were prevalant of the time.

Now a Franciscan friar and mathematician from that era, Luca Pacioli (14461517), is widely regarded to be the "Father of Accounting" because he was the first to codify and publish this accounting system in his book titled , "The Collected Knowledge of Arithmetic, Geometry, Proportion and

Proportionality" (translated). The book was published in 1494 (about the time that Columbus discovered America) and it was one of the earliest books published on the Gutenberg press.

Luca makes no claims about inventing the system but he does present it in a way that others can easily understand it. His motive for recording the bookkeeping system, that was used by the Venetian merchants during the Italian Renaissance period, was to help Guidobaldo, the Duke of Urbino, in the management of his financial affairs.

This documented system, described in only one section of the five-section book, has become known as the double-entry accounting system. The 36 short chapters on the accounting system contained in the book, became the only accounting text-book for the next hundred years and its principles have been continuously followed by accountants right up to today.

Image Source #4 - Polyhedra

Interestingly, Luca Pacioli was actually a colleague of Leonardo da Vinciand it was Leonardo who helped him illustrate his second most important manuscript De Divina Proportione ("Of Divine Proportions").

This fact was mentioned by the author and Leonardo Da Vinci mentions Pacioli many times in his notes. Opposite is a drawing of the Polyhedrawhich was one of the illustrations by Leonardo in Luca's book. Other interesting facts are uncovered by Marcino Guerrero in his Knol Pcaioli and Da Vinci#

#2 www.divulgamat.ehu.es

Most of Lucas work still underpins the accounting system we use today. Those concepts from his book in 1494 that are still practiced today include;

The accounting cycle

    

The use of journals and ledgers Debits equalled credits - double entry bookkeeping The account groups of assets (including receivables and inventories), liabilities, capital, income, and expenses Year-end closing entries The trial balance, which he believed should be used to prove a balanced ledger.

Summary In Part 1, we learned about the 500 years history of Debit and Credits and the significant contribution made to the world of accounting by the Franciscan friar and mathematician Luca Pacioli with his 'double entry bookkeeping system.

PART 2 - Why was it called Debit and Credit?

Image source #6 - Latin Coins

Now remember, Luca was more a mathematician than an accountant, so his mind would have been trained to look for the key principles, concepts and symmetry that underpinned the Venetian merchants financial recording system.

Key concepts he would have identified were (1) that in the accounting world, the business (or firm) was an entity in its own right and that that entity was separate and distinct from the owners. Another principle

he would have seen is that (2) the financial world is a closed system. That is, money just doesnt just materialise form nowhere. If money is received by someone it must have been given by someone else and vice versa.

This closed system of giving and receiving would have led him to see the concept of 'duality' in financial transactions relating to a firm. For example, when an amount of money is entrusted by someone to a separate and distinct firm, then that firm would now have an obligation and owe that person the same amount of money in return.

Using his native Latin, Luca named the act of entrusting - Credre (which means to entrust) and the corresponding obligation on the firm - Debere (which means to owe). So, from the point of view of the firm, he could see that this principle of duality held true for every financial transaction entered into by the firm. For him, it was not just a formula but an aspect of existence where one side could not exist without the other. In a closed system, every Debere must have a corresponding Credre and vice versa. In other words, Debere and Credre were two sides of the same coin. (In finance - when someone 'entrusts' money then someone else ends up 'owing' it')

He was so convinced of this concept of duality, that he is said to declare that no one should go to sleep at night without ensuring that the credre equalled the debere. (credits = debits)

The English translators used the Latin roots for these concepts and so named them Debits and Credits. It is highly probable that we also got the abbreviated forms of these terms (Dr and Cr) from the Latin roots as well, because there is no r in the English word Debit but there is one in its Latin form 'Debere'.

Summary In Part 2, we see the emergence of the concept of duality where debits and credits are just two sides of the same coin in the way that the Chinese concept of 'yin and yang' are complementary opposites within a greater whole. We begin to see the concepts that underpin the application of Debits and Credits and the link to the original Latin root with its original meaning.

PART 3 - What are the underpinning concepts for Debits and Credits?
Image Source #5 - Accounting Concepts

To properly understand Debits and Credits you will need to first understand the concepts that underpin the whole accounting process. Some of these are called Accounting Conventions and others are simply re-enforcing the way that the accounting systems looks at and records financial transactions.

Accounting Concept 1 The business or firm is an entity. In simple terms, the legal system defines an entity as a person or non-person that is capable of suing or being sued under the laws of the land. In most countries of the world, companies are given this nonperson entity status and are given the same rights and obligations of individual persons. Accounting takes this concept a step further by stating that every firm (including sole traders and partnerships), creates its own accounting entity and that the income and net worth of each entity must be calculated based on its own financial transactions. Accounting Concept 2 The business (firm) is a separate entity distinct from the owners A firm, while it has 'legal' control over items of value, it is not the ultimate owner of those things. In other words, if the firm sold everything it had, it would be obliged to distribute all those monies to meet the claims made by other people or entities. The firms first obligation is to pay the claims made by external people (i.e. loans and creditors) with the balance being given to meet the claims made by the owner(s). The business would then return to how it all began, as a blank sheet without obligations or the control of any items of value. Accounting Concept 3 People can wear multiple hats. While this a not a strict accounting concept, it is an important one to understand when getting the right perspective on financial transactions. Just like one person can be a parent, sibling, cousin or an offspring, so too a person can be an investor in a firm, a creditor/debtor of a firm, the manager of a firm or a director of a company that controls the operations of a firm. The important thing to remember is, that in accounting the financial transactions are always analysed and recorded from the firms point of view with you as the manager (not owner). Accounting Concept 4 Every financial transaction has two sides to it.

The financial world is a closed system. That is, money does not just arrive from nowhere. If money is received by one person or entity, it must have been given by another person or entity. This gives us our first insight into the Debits and Credits system that we use in accounting today. Accounting Concept 5 The profit from the firm's activities belongs to the owners. As understood from Concept 2, the firm does not really own anything, from an accounting perspective. It may have legal rights of ownership or control, but fundamentally in accounting terms it is an accounting entity set up by the owners to manage their affairs. So, when a firm makes a profit it does so for the owner's benefit, not for the firm's. Remember, if everything was sold off the firm would be left with nothing because everything of value would be used to first pay off liabilities with the remainder going to the owners.

www.wordle.net - Debits and Credits

Summary In Part 3, we get to understand the accounting concepts that not only underpin the concept of Debits and Credits, but the whole accounting system as well. We learnt that; 1. 2. 3. 4. 5. The business or firm is an entity. The business (firm) is a separate entity distinct from the owners People can wear multiple hats and operate in multiple capacities. Every financial transaction has two sides to it. The profit from the firm's activities belongs to the owners.

PART 4 - How would they have applied Credits and Debits in the 1400's?

Image Source #1 - http://www.flickr.com Venice

As Lucia pointed out, the accounting system he documented was being widely used by the Venetian merchants. These people seem to be the 15th century entrepreneurs. Lets say that a Venetian entrepreneur named Antonio asked Lucia to record the financial transactions of his new business (firm) prior to Luca completing his famous Summa book in 1494.

(Note: For the purposes of this story we will use the $ rather than the Venetian ducat or Florence's famous fiorino d'oro 'golden florin' and use the English accounting terms rather than the Latin)

The story goes ... Antonio had spotted an opportunity to sell Italian olives to Egypt. Antonio thought he could make a killing. So, Antonio (as manager of the new firm) approached an Italian olive provider and convinced him to supply $100,000 worth of olives but with the promise to pay him on his return from Egypt. Antonio did not mention the profit he was going to make because the olive providers only interest was in being paid for the olives.

So, Lucia had his first financial transaction, and noted the following using the Latin meanings for Debits and Credits:

The firm had increased its obligations to the Italian olive producer because the producer had entrusted $100,000 to the firm in the form of olives - Credit (Cr) and

The firm was now in possession of Olives which it could use (sell) to repay the obligation (what it owes) to the Italian olive producer $100,000 Debit (Dr) Using the Table 1 approach we would make the following entry: Asset - Stock (increase) Liability - Accounts Payable - Olive Provider (increase) $100,000 Dr $100,000 Cr

Soon after, Antonio took Luca to see the $50,000 ship he had bought, using $30,000 of his own money and $20,000 from a bank (loan funds). Antonio was excited because he now knew that he had the means to make his idea a reality and make that fortune he dreamed of from selling these olives.

Luca realised that while Antonio was always speaking about what he had done, Luca knew that he was really speaking about what the firm had done with Antonio as its manager.

Luca realized that the firm had been involved in its second financial transaction and again noted the following from the firms point of view: y The firm had increased its obligations to the bank because the bank had entrusted $20,000 to the firm in the form of a loan - Credit (Cr) and

The firm had also increased its obligations to the Antonio (as owner) because Antonio had entrusted $30,000 to the firm in the form of Capital - Credit (Cr) and

The firm was now in possession of a Ship which it could use, if it chose to sell it for $50,000, to repay the obligation (what it owed) to the bank and to Antonio Debit (Dr) Using Table 1 approach we would make the following entry Asset - Ship (increase) Liability - Bank Loan (increase) $50,000 Dr $20,000 Cr

Owners Equity - Capital - Antonio (increase)

$30,000 Cr

Luca was happy because in both financial transactions the total of the debits equalled the credits and the underlying concepts of the 'double entry bookkeeping' system had been adhered to.

Summary Armed with the underpinning 'double entry bookkeeping' concepts and his Latin definitions of Debit and Credit, we attempt to see what Luca saw as he contemplated the entries that would be made in the fictitious books of the 15th century entrepreneur, Antonio.

PART 5 - Is there another way to look at applying Debits and Credits?

Today we look at Luca's notes and we discover an emerging pattern. It appears that Luca could use the Latin meanings of Debits and Credits to describe every transaction in relation to the OBLIGATIONS of the firm.

It seems that ...

'Obligations Approach' to applying Debits and Credits

... on with the story.

Antonio was soon back in town after successfully completing his sales trip. Antonio explained that he (as manager) had sold all the olives for $200,000 and the trip had only cost $30,000 including the $1,000 interest he paid to the bank. He explained that he had paid these amounts out of the sale proceeds and that he had visited the Olive provider to repay his account. He also said that he had used $10,000 of the sales proceeds to buy furniture for his house in celebration of a successful trip.

We soon realise that a third series of financial transaction for the firm has happened involving five main parts. Part 1 The sale of the olives for $200,000 cash Part 2 The use of the $100,000 of olive stock to create the income of $200,000 Part 3 The Olive provider was paid for his outstanding account. Part 4 - The use of $30,000 of cash proceeds to pay for the trip costs and interest expense Part 5 - The withdrawal and use of $10,000 by Antonio (as owner) Taking over from Luca, we will look at these transactions and apply the obligations approach to determining the Debits or Credits of the transaction - always remembering to take the obligation of the firms point of view.

Here is what we would have come up with;

Action by the firm Transaction PART 1

Obligation Option Affected

Dr/Cr

Account Group

&

The firm had received (A) the firm had increased its Debit $200,000 in cash for the capacity to repay future obligations (Dr)

$200,000

Cash (Asset increase)

sale of the olives (B) the firm has increased its obligations to Antonio (as owner) The firm had made sales Credit Sales (Income because sales are potential income $200,000 (income) of $200,000 (Cr) increase) which the firm ultimately owes to the owners (investors) Transaction PART 2 Stock (Asset The firm no longer had the (D) the firm had reduced its capacity Credit $100,000 decrease) olives, because they to repay future obligations (Cr) have been sold (C) the firm has decreased its The firm had used its obligations to Antonio (as owner) Debit purchase of the olives to because the income due to the (Dr) make the sales proceeds owner has been reduced by the cost of purchasing the olives Transaction PART 3 The firm paid the (C) the firm has reduced outstanding promise to the obligations to the Olive provider Olive provider Accounts Payable $100,000 (Liabilities decrease) Purchases (Expense $100,000 increase)

its Debit (Dr)

The firm used its cash from (D) the firm has reduced its capacity Credit Cash (Asset $100,000 the sale to pay the Olive to repay future obligations (Cr) decrease) provider. Transaction PART 4 (C) the firm has reduced its obligations to Antonio (as owner) The firm had to pay for the Debit because the income he was to costs of the sales trip (Dr) receive has been reduced by the cost of the sales trip (C) the firm has reduced its The firm had to pay for the obligations to Antonio (as investor) Debit interest costs to the bank because the income he was to (Dr) receive has been reduced by the Travel Costs (Expense increase)

$29,000

$1,000

Interest expense (Expense increase)

interest expense The firm had to pay cash for the travel costs, including (D) the firm has reduced its capacity Credit $30,000 interest, from the sale to repay future obligations (Cr) proceeds Transaction PART 5 (C) the firm has reduced its Antonio (as owner) used obligations to Antonio (as owner) Debit $10,000 of the firm's cash because he has already taken a share (Dr) for personal use. of the profits that were due to him. Capital Antonio (Owners Equity decrease) -

Cash (Asset decrease)

$10,000

The firm paid out $10,000 (D) the firm has reduced its capacity Credit $10,000 in cash to repay future obligations (Cr) End of Transactions

Cash (Asset decrease)

All the account groups have been affected in this transaction, yet you can see that we still achieve the same outcomes as the learned-Table 1 approach, but there is an underlying meaning to the questions and they are in keeping with Luca's original Latin meaning.

Summary In Part 5, we explore the idea that all financial transactions could be interpreted from the point of view of the firm's obligation. Having just two main questions, we are able to apply a different and more meaningful approach to determining a Debit entry in to the firm's books, or a Credit one. We have attempted to link this approach to the likely meaning that Luca Pacioli had for the terms Debits and Credits. So, apart from learning and applying the logic of the Table 1 approach to your debits and credits, you could also apply this alternative view developed from the first principles of Luca Pacioli's work using the Latin Debere = 'to owe' and Credre = 'to entrust'

'Obligations Approach' to applying Debits and Credits