Double Entry Bookkeeping, Trial Balance, Financial Statements, Financial Ratios, Italian City-States and Capitalism

Posted by PITHOCRATES - January 8th, 2013

History 101

The Government Finances are a Train Wreck because they have the Power to Tax and to Print Money

President Obama averaged a deficit of $1.3 trillion for each of his first 4 years in office.  Bringing the national debt up to $16.4 trillion at the end of 2012.  And there will be another drop-down, drag-out fight to raise the debt limit in a couple of months.  Why does the government spend this kind of money?  Because they can.  And because they can they can buy a lot of votes by giving stuff away.  Stuff paid for with all of that spending.

When the government implemented Social Security and Medicare there was still an expanding birthrate.  More people were entering the workforce than were leaving it.  Providing an ever expanding tax base.  And a rising level of tax revenue.  Without ever having to increase tax rates.  And the smart government planners thought the good times would just keep rolling.  But they didn’t.  Thanks to birth control and abortion.  Which reversed the equation.  The population growth rate slowed down.  Fewer people entered the workforce than left it.  Resulting in a declining tax base.  And falling tax revenue.  Pushing Social Security and Medicare to the brink of bankruptcy.

The government finances are a train wreck.  And they keep digging their hole deeper.  Because they can.  For they have the power to tax.  And to print money.  Something private businesses can’t do.  Which is why few corporations’ finances are train wrecks.  Except those with unionized workforces with defined-benefit pension plans.  Something long discontinued by most in the private sector.  As it’s a failed economic model.  Just like Social Security.  And Medicare.  Over time more people move from being contributors to being beneficiaries.  Pushing defined-benefit pension plans, too, to the brink of bankruptcy.

At the End of each Accounting Period they run a Trial Balance to Verify the Total of Debits Equals the Total of Credits

The difference between private sector businesses and the federal government is that private sector businesses have to be responsible while the federal government does not.  The federal government focuses on what’s politically expedient.  While private sector businesses must focus on the bottom line.  Spending only the money they have.  Because they can’t tax or print money to fix their messes.  Like the government can.  And does.  A lot.  So they have to avoid making messes in the first place.  They can’t kick the can down the road.  Because in the private sector there is accountability.  And that accountability begins with getting their hands around their business numbers.  So they can understand what their businesses are doing.  And when it’s time to take appropriate actions.  To prevent a financial train wreck.  And it all begins with double-entry bookkeeping.

Double-entry bookkeeping includes debits and credits.  Each transaction is posted to the accounting records with at least one debit and at least one credit.  The dollar amount of debits equals the dollar amounts of credits.  If they don’t equal after recording a transaction they were posted incorrectly.  For example, when someone pays cash for something at a retail store there are two debits and two credits to post.  First we debit cash $20 and credit sales revenue $20.  Then we debit cost of goods sold $18 (the cost of the item sold) and credit inventory $18 (the cost of the item in inventory).   If posted correctly the total debits equal $38.  And the total credits equal $38.  If, for example, someone debited sales revenue instead of crediting sales revenue the total debits would equal $58 while the total credits would equal $18.  Because they don’t balance we know something was posted incorrectly.  And can go back, find the error and correct it.

A business accounts for every penny that flows through their business.  Each accounting period will have thousands of such entries.  And at the end of each accounting period they will run a trial balance to verify that the total of debits equals the total of credits.  When they do they can be pretty sure that the financial information they recorded fairly represent the financial activity of the business at the end of that accounting period.  Then they prepare the financial statements (the income statement, the balance sheet, the statement of cash flows and the statement of retained earnings and stockholders’ equity).  Businesses study these statements to assess the health of their businesses.  They calculate financial ratios to assess the liquidity, long-term debt-paying ability and profitability of the business.  As well as calculate ratios for investor analysis.  To make sure they are satisfying the owners of the company.  The stockholders.

The First Use of Double-Entry Bookkeeping dates back to the Italian City-States of Florence, Genoa and Venice

This is a lot of valuable information.  Courtesy of that double-entry bookkeeping.  Something that can be so mundane and mind-numbing at the data entry point.  Especially if you’re trying to figure out why your trial balance doesn’t balance.  But when it does balance.  And the financial information is fairly represented.  Business owners and managers can make informed decisions to avoid doing what our federal government does.  Including making the hard decisions that permit these businesses stay in business for a decade or more.  Even a century or more.  Thanks to merchant banking.  And the Italian city-states.

For those of you who hate bookkeeping blame the Italians.  Some of the Florentines were using it as early as the 13th century.  The Genoese were using it shortly thereafter.  Soon Florence, Genoa and Venice were using double-entry bookkeeping.  This mastering of economic data made these city-states the dominant economic powers of the Mediterranean.  Making them masters of trade.  And merchant banking.  To manage that trade.  This system of accounting even made it into textbooks in the late 1400s.  Helping to spread good business practices.  Where they were picked up by other great traders.  The Europeans.

With double-entry bookkeeping businesses were able to grow.  First with the help of government.  Mercantilism.  Then without.  Free market capitalism.  Which created the British Empire.  And gave us the Industrial Revolution.  Then the United States came into their own in the late 19th century.  And surpassed the British Empire.  Economic activity exploded in the United States.  Because they were able to get their hands around all of those financial numbers.  And thanks to free market capitalism they focused on the bottom line.  And made the necessary decisions.  No matter how painful they were.  Something that the federal government just can’t do.  Because those decisions aren’t politically expedient.

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Accounting Shenanigans

Posted by PITHOCRATES - August 13th, 2012

Economics 101

Two Important Accounting Principles are the Realization Principle and the Matching Principle

Accounting isn’t exciting.  It’s dull.  And tedious.  Anyone who struggled to get a trial balance to balance knows this well.  But accounting is a necessary tedious.  Someone has to put those numbers into the proper accounts.  Correctly.  Down to the penny.  Because only then can you prepare financial statements that are useful to business owners.  As well as investors.

When we post these numbers correctly we can produce the income statement.  Or as some call it the profit and loss statement.  Or P&L.   Which tells you whether you made a profit or a loss for an accounting period.  And some of the most important accounts on the income statement are income accounts (or revenue accounts).  The money they get when they sell their goods or services.  And expense accounts.  But not all expense accounts.  They’re all important but some are particularly important.  The expenses used to specifically generate that revenue (the cost of sales).  Production labor.  Production material.  The labor and material that make the things a business sells.  These expenses are variable.  They go up and down with sales.  As opposed to fixed overhead.  Which remains the same regardless of sales.

We have to define the accounting period carefully.  It can be annually.  Quarterly.  Even monthly.  The smaller the period the more useful information for business owners.  Investors study a company’s quarterly statements.  As well as annual statements.  The shorter the accounting period, though, the more careful the posting to the accounts is.  Because of two accounting principles.  The Realization Principle.  And the Matching Principle.   Which places revenue into the accounting period it occurs.  And then matches the expenses to the revenue it created into the same accounting period.  So when you subtract expenses from revenue in that accounting period you get the gross profit for that accounting period.  Given a measure of how business was during that accounting period.  If business was good there is revenue remaining after subtracting all variable expenses and all fixed expenses.  If sales are down there may be a gross profit.  But there may not be enough left over to pay the fixed overhead costs.  Resulting in a business loss.  For that accounting period.

The Smaller the Accounting Period the Greater the Math required to apportion Revenues and Expenses

When businesses ‘cook’ their books they are making business results look differently from what they actually are.  Perhaps the most common way to ‘cook’ the books is to violate the Realization Principle and Matching Principle.  Such as moving revenue or expenses to other accounting periods instead of where they belong.  If a business needs better business results for investors they may realize revenue early.  Or push expenses out to a subsequent accounting period.  Thereby increasing profitability for the one period better than it actually is.  As revenue will be greater and expenses will be smaller.

As an example consider a now common summer business model.  Selling ice-cold water at traffic intersections.  You need some cases of bottled water.  Ice.  And a cooler.  If you buy all the water in July but sell some of it in August you have to split the expense of the water between these two months.  If you don’t your expenses will exceed your revenue in July because it includes water purchased for both July and August.  You would subtract two months of water expense from one month of water sales.  Making July business show an operating loss.  While August would subtract no water expense from August sales making August more profitable than it actually was.  However, if you combine the two months together there will be no misrepresentation of the accounting data.  As you would subtract two months of water expenses from two months of water revenue.

This is why larger accounting periods are easier to post.  As they get smaller you have to do a lot of math to apportion these revenues and expenses into the proper accounting periods.  And sometimes mistakes happen.  Honest mistakes.  A business could have felt they had a good month but their income statement shows a loss.  Or the month could be far better than you feel it should be.  If you look hard enough you can often find a timing error.  Revenues or expenses appearing in the wrong period.  Such as recording a down payment as revenue.  It’s not.  A down payment is a liability.  Because it is a prepayment for you something owe someone at a later date.  And it’s at that later date when you can realize that down payment as revenue.

As you Pull Revenue Up and Push Expenses Out each Subsequent Accounting Period Starts with a Larger Operating Loss

But some businesses cook their books.  And once they start it becomes more difficult with every accounting period.  Which is why most companies that do cook their books fail.  And they fail big.  Here’s why.  If you realize revenue early in this period instead of next period (where it belongs) the following accounting period will underreport revenue.  Worse, the expenses to produce that revenue are still in that period.  When you subtract the properly reported expenses from the underreported revenue it will result in an operating loss.  Unless they cook the books in the following period, too.  By pulling revenue into that period from another period.  Or pushing out expenses to a later period.

The problem is when you keep doing this it makes the following accounting period more difficult to ‘fix’.  For as you pull revenue up and push expenses out each subsequent accounting period starts with a larger operating loss.  And if a business is having problems (which they typically do when they start cooking their books) actual revenue for that period will be depressed as well.  So as they go through subsequent accounting periods beginning operating deficits grow larger in the face of falling revenues.  To keep the scam going they have to take it up a notch.  Taking things ‘off balance sheet’ (basically ignoring some bad financial information).  Creating a shell company to dump bad financial data on.  And other accounting shenanigans.  The bigger the scam, though, the harder the fall.  And there is always a fall.  Think Enron.  And WorldCom.

But it’s just not businesses that cook their books.  Government does, too.  Especially when they want to pass unpopular and costly programs.  They will send the financial data for a program to the Congressional Budget Office to score.  To determine the cost over a 10 year period.  But to make the program less expensive and more palatable to the taxpayers they will cook that data.  Their bill may include new taxes over the ten year period.  But benefits may kick in a few years after the new taxes start.  So you may have 10 years of taxes paying for only 8 years of benefits.  But everyone thinks it’s 10 years of benefits.  Making the program appear less costly than it actually is.  Of course when they get caught in their accounting shenanigans nothing happens.  They just say, “Oops.  We goofed.  Shucks.  Looks like we’ll have to raise taxes.”  Not quite the same thing that happens in the private sector.  Just ask those who were running Enron.  And WorldCom.

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Capital and Capitalism

Posted by PITHOCRATES - May 7th, 2012

Economics 101

Entrepreneurs have an Insatiable Desire to Think and Create

It takes money to make money.  For it is money that buys the means of production.  The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things.  The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods.  These physical assets are capital.  From assembly lines to inventory control systems to accounting software.  Things that let businesses conduct business.  And make profits.

This is the key to capitalism.  Profits.  It’s what allows businesses to make the things we need and enjoy.  Profits are what make an entrepreneur take a risk.  To spend their life savings.  To mortgage their home.  To borrow from a bank.  They do these things because they believe they will be able to earn enough profits to replenish their life savings.  To make their mortgage payments.  To repay their loans.  AND to earn a living in the process.  It is a risky endeavor.  And far more risky than working for someone and earning a steady paycheck.  But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane.  All of which were brought to us because one person had an idea.  And then invested in the capital to bring that idea to market.

Some business ideas succeed.  Many more fail.  But people keep trying.  Because of that insatiable desire to think and create.  And the ability to earn profits to pay for their ideas.  To build on their ideas.  To expand their ideas.  From the first thoughts of it they kicked around in their head.  To the multinational corporations their ideas grew into.  All made possible by the profits they earned.  The more they earned the more they could do.  As they reinvested those earnings into their businesses.  To buy more capital.  That allowed them to build more things.  And use even more capital to bring these things to market.  Creating jobs all along the way.  Jobs that only came into being because of those profits that started as a single thought in someone’s head.

If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy

This is where corporations come from.  From a single thought.  Profitable business operations grow that thought into the corporations they become.  For corporations are not the evil spawn of the damned.  Corporations come from people having a great idea.  Like Starbucks.  And Ben and Jerry’s.  Who are now everywhere so we can enjoy their products wherever we are.  All made possible by the profits of capitalism.

Who’s up for a little accounting?  You are?  Well, then, you came to the right place.  For we’re going to learn a little accounting.  Right here.  Right now.  Corporations determine their profits by closing their books at the end of an accounting period.  A series of accounting steps culminate in the trial balance.  Where the sum of all debits equal the sum of all credits.  Or eventually do after various adjusting entries.  Once they do the books are balanced.  And business at last can see if they were profitable.  By producing an income statement.  Which lists revenue at the top.  Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue.  Subtracting these costs from revenue gives you gross profit.  Then comes overhead costs.  Fixed costs.  Like rent and utilities.  And overhead labor (corporate officers, management, accounting, human resources, etc.).  They sum these and subtract them from gross profit.  Which brings us to earnings before interest and taxes (EBIT).  A very important profitability number.  For if there is any money left by the time you reach EBIT your business operations were profitable.  Your business was able to pay all the due bills to produce your revenue.  Which leaves just two numbers.  Interest they owe on their loans.  And income taxes.

EBIT is a very important number.  For if it’s not large enough to service your debt everything above EBIT is for naught.  Because if you can’t service your debt your creditors can and will force you into bankruptcy.  Never a good thing.  And what follows is usually the opposite of growing your business.  Shrinking your business.  By seriously cutting costs (i.e., massive layoffs).  And eliminating unprofitable lines of revenue.  Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services.  A price determined by your competition in the market.  If you cannot downsize and reorganize sufficiently to become profitable then you go out of business.  Or you sell the business to someone who can make a profit.  Because unless you can turn a profit your business will consume money.  And that money has to come from somewhere.  Typically it is the business owner until they run out of life savings and home to mortgage.  Because a bank can’t give you money to lose in your business.  For their depositors put their money into the bank to grow their savings.  Not to shrink them.  So a bank has to be profitable to please their depositors.  And if the bank is using their money to make bad loans they will remove their money.  As will other depositors.  Perhaps creating a run on the bank.  And causing the bank to fail.  So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term.  Which isn’t good for anyone.

Capitalism works because with Risk there’s Reward

As you can see getting those accounting reports to fairly state the profitability of a business is crucial.  For it’s the only way a business knows if it can pay its bills.  And the way they pay their bills complicate matters.  Revenue and costs come in at different times.  To bring order to this chaos businesses use accrual accounting.  Which includes two very important rules.  To record accurately when revenue is revenue (for example, a down payment is not revenue.  It’s a liability a business owes the customer until the sale transaction is complete).  And to match costs to revenue.  Meaning that every cost a business incurred producing a sale is matched to that sale.  Even long-term fixed assets like buildings and machinery.  Which they depreciate over the life of the asset.  Charging a depreciation expense each accounting period until the asset is fully depreciated.

Because of these accounting reports that fairly state business operations a business knows if they are profitable.  That they can pay all of their bills.  Their suppliers AND their employees.  Their health insurance AND their payroll taxes.  The interest on their debt AND their income taxes.  They can pay all of these when they come due.  And not run out of money when other bills come due.  Which is why they can have confidence when they read their income statement.  Knowing that they paid all their costs due in that accounting period.  Including the interest on their debt.  And their income taxes.  Which takes them to the bottom line.  Net profit.  And if it’s positive they have money to reinvest into their business.  To expand operations.  To increase sales revenue.  Create more jobs.  And they can grow.  But not too much that they lose control.  So they can always pay their bills.  So they can keep doing what they love.  Thinking.  And bringing new ideas to market.

This is capitalism.  Where people take risks.  In hopes of making profits.  They invest in capital to make those profits.  And then use those profits to invest in capital.  It works because there is a direct relationship between risk and profits.  It’s why people take risks.  Create jobs.  And provide the things we need and enjoy.  Because with risk there’s reward.  And accounting reports that fairly state business operations give a business’ management the tools to be profitable.  By matching costs to revenue.  Telling them when they are not using their capital efficiently.  Helping them to stay profitable.  (Unlike anything the government runs.  Because there is no matching of costs to revenue.  Taxes come into the treasury and the treasury pays for a multitude of things.  With no way to know if they are using those taxes efficiently).  And this is capitalism.  Risk and reward.  And accountability.  For when you’re risking your money you become very accountable.  Which is why capitalism works .  And government-run entities don’t.

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