I was in a particularly repetitive meeting a couple weeks ago and filled my time by starting to write an accounting textbook for people who don't understand accounting. One of my goals is to use as much plain language as I can. There's no point in trying to explain an idea with words that no one understands.
DOUBLE ENTRY ACCOUNTING
Almost all accounting today is based on a very old approach known as "double entry accounting." The idea is pretty simple: for every item or event that you record, you increase numbers (or decrease) in two places.
In the old days, you would write down every event in the history of a company in a book (also called a journal). Then, occasionally, you would transfer all of those journal entries into a running tally of the sum of each account, which is known as the ledger. This process was called posting. These days, we still use those terms, but in practice, all of that information is stored in a file on a computer (typically a relational database, go talk to a computer expert for a plain English explanation of that one), then that file is used to create various views of the activity over time, so there's really no posting involved. It used to be a major concern because if the ledger wasn't posted to, then you couldn't rely on those numbers to reflect the current situation of the company.
Since you're making your entry in two places, it's a good idea to start by explaining the various accounts that you could be making entries (posting) against. Basically, they fall into two groups stuff, and a list of people who own that stuff. There are other accounts used during the year, but in the end, they are all added back into the permanent accounts at the end of the year (this is called closing).
At the end of the year, after closing the temporary accounts, you have all of the information that's used on a financial report called the balance sheet.
It's called the balance sheet because in double entry accounting, unless you've fucked up pretty badly, the total of the numbers representing stuff and the total of the numbers representing ownership are going to be the same (or, in other words, they will be in balance).
Accounting is like any other profession, we like to make up funny words that no one else understands so that we can keep our customers from doing what we do for them on their own.
Some definitions are in order:
- Assets --> Stuff (this includes both real stuff (tangible assets) and imaginary stuff (intangible assets).
- Equity --> Ownership (the right to have stuff).
- Owner's Equity --> The rights of the owners of the company to take or keep the stuff that the company has.
- Liabilities --> The rights of people who don't own the company to take the company's stuff (this could be the right to take stuff right now, also known as a current liability, or it could be the right to take stuff later, which is called a long-term liability).
- Capital --> This actually has several meanings. In normal use, it just means Owner's Equity.
In double entry accounting, we don't use negative numbers (because negative numbers belong to SATAN! No, seriously, that's why, long story), we therefore use positive numbers that offset one another instead. There are two special words that are used to explain the two "sides" of an entry:
- Debit --> This is a number that increases an asset, or decreases equity.
- Credit --> This is a decrease in assets, and an increase in equity.
In modern practice, we show credits as negative numbers because it's easier, but it's important to remember that even though there is a minus sign there, that doesn't always decrease whatever that account is. It could be an increase if the effect of that side of the transaction is to increase equity.
CUMULATIVE ACTIVITY -
Ok, so all that text above is great. We can make a list of stuff and an anti-list of people's rights to take stuff. That's all well and good for determining who owns stuff at any point in time, and reflecting how much stuff the company has, but it doesn't tell you much about what the company is actually doing.
We record current events using two groups of temporary accounts that are closed into the balance sheet (permanent) accounts at the end of the year. These groups are as follows:
- Revenues --> ooh, we got stuff, let's write that down
- Expenses --> oh crap, we lost stuff
Since revenues and expenses are temporary accounts that are closed into owner's equity at the end of the year, they have "normal balances" (ie, they increase with a debit or credit usually) that reflect the normal balance of owner's equity. If you want to show revenue, then you use the credit side of an entry to increase revenue. Expenses have a normal debit balance.
At the end of the year, the revenues that you got during the year belong to the owners of the company, and are added to their ownership number. Similarly, expenses decrease the owner's right to take stuff.
SIMPLE TRANSACTIONS
Ok, so we kind of know the lay of the land, let's do something.
When you start a new company, you need to have some assets to be able to do anything. This might be buildings, but in most cases, it's cash money. So when you toss some money into a company that you own, you debit cash, and credit owner's equity.
Cash $1000
Owner's Equity $1000
(to record contribution of capital)Ok, when accountants write out entries, they typically show the debit first, then they show the credit indented a bit to avoid confusion.
So, our company now has some assets (cash). Cash is great because if the company goes out of business, that cash is worth exactly what's on the face of the bills. You can also trade cash on a one for one basis for other stuff. This business is in the business of business, so let's buy some stuff from China that we can sell for crazy profits.
Inventory $500
Cash $500
(to record purchase of lead painted toys from China)But hey, isn't buying inventory an expense? Yep, but not yet.
Ok, let's sell these toys to children who will grow up with severe learning disabilities as a result of chewing chips of lead paint off their Hotwheels (tm, used without authorization).
Cost of Goods Sold $500
Cash $700
Inventory $500
Revenue $700
(to record sale of inventory)Ok, I'm being a little sneaky here, I've combined two entries into one. The expense of buying or building things to resell is only recorded when you actually sell it. A typical expense account title for that is "Cost of Goods Sold." So we're debiting that expense, and we're crediting Inventory (to show that we lost an asset). Meanwhile, we gots paid yo, so we'll increase cash by $700 and we'll increase revenue (by crediting it) by $700.
If we subtract our total expenses from our total revenues, we get our net profit or loss, in this case, a profit of $200. You've got to admit, a nation of retarded worker drones is a small price to pay for $200 in cold hard cash.
At the end of the year we'll close our expenses and revenues into owner's equity so that our temporary accounts all have zero balances, and our permanent accounts will balance each other out.
Revenue $700
Cost of Goods Sold $500
Owner's Equity $200
(end of year closing)So our ending balance sheet now looks like this:
Assets Equities
=====================================================
Cash $1200 Owner's Equity $1200
It's a new year, and our goal is to triple our profits. To do that we've got to buy three times as many toys, and sell them for the same margin. But, OH NO, we've only got $1200, and we need $1500 to buy three times as many toys.
We're going to have to get more cash. We can either get it by admitting a new owner, or we can borrow it from someone. If we admit a new owner, then that guy is going to get a share of the net profits or losses at the end of the year. We're greedy bastards, so we're just going to have to borrow some money.
Cash $300
Debt $300
(to record loan proceeds)Ok, so we're showing that we received cash from Banco Popular, and we're showing on the equity side that it isn't really our cash. We have to pay those guys back, or they're going to send Maria and Gwendolyn to break our legs. Oh, and they're going to want some interest. Money isn't free you know.
Let's just rush out the entries for buying and selling inventory for the year here:
Inventory $1500
Cash $1500
Cost of Goods Sold $1500
Cash $2000
Inventory $1500
Revenue $2000Alright, looks like we had to lower prices a bit to clear out that inventory, but we're still managing to keep a good margin by selling our stuff for more than we paid for it.
Unfortunately, those loan sharks are charging us 200% interest, and if we want to keep our legs in working condition, we need to pay them back, including the interest, by midnight on December 31st.
Interest Expense $600
Debt $300
Cash $900
(to record payoff of loan)Let's add up our expenses and revenues for the year and see how we did:
Statement of Profit and Loss:
Revenues: $2000
Expenses:
Cost of Goods Sold $1500
Interest Expense $600
Total Expenses: $2100
===========================================
Net Loss ($100)Well, shit. Let's close our revenues and expenses into owner's equity:
Revenue $2000
Owner's Equity $100
Cost of Goods Sold $1500
Interest Expense $900Since that owner's equity number is a debit, that decreased our rights to stuff, which is exactly correct, since we've now got less stuff than we had at the beginning of the year.
Balance Sheet:
Assets Equities
===============================================
Cash $1100 Owner's Equity $1100
