Comparability of Transactions

Background

We've talked about how to record transactions, but in order to make the information even more useful, it'd be good if we could use it to compare current operations to past operations, and even to compare the performance of one financial entity to another...

Question

What are some ways that financial performance is made comparable to a. other time periods, b. other entities?

Answer

a. The reporting of transactions should cover equal time periods compared to other reported time periods,

b. Rules on how to record different kinds of transactions have been put into place, both in individual countries and internationally, to enhance comparability of financial performance of different entities. 

Analysis

We've talked about the recording of transactions but haven't covered the ways the recording of information can help a financial entity to enhance its performance and enable owners to make better decisions. So let's talk about that!

Let's talk about an example company and work our way through how comparability is important. Let's have that company be a new restaurant. It opens its doors for business at the start of Year 1.

The owners of the business would like to keep track of how the restaurant is doing and so they ask for updates from time to time from the store manager. The store manager, of course, would like to show the owners that he's doing a good job, and so without any further guidance from the owners, the manager will do what he can to make the restaurant look like it's doing well.

One thing the manager might do is to report more frequently when things are going well and less frequently when things are slow. The manager might not even report at all when things are going poorly! The restaurant could be running out of money and the owners wouldn't know!

And so the owners would want periodic reports on a regular basis to know how the restaurant is doing. Most businesses look at their operations on a yearly basis - and oftentimes they look at more periodic time periods as well (such as quarterly, monthly, and even weekly).

This reporting with equal time periods allows owners to compare how one time period (say Year 2) is doing compared to another equal time period (say Year 1). This makes the reporting more helpful - is Year 2 better than Year 1? Is it worse? What might be causing the difference?

This comparability of time periods makes the reports more useful.

Now let's expand this example a little bit.

A big restaurant chain is looking to buy a restaurant in the local area of our example restaurant. Let's say there are five contenders to be bought and our example restaurant is one of them. How will the big chain decide which to buy?

One big factor will be looking at the operating results of each restaurant and seeing which is doing the best. But here's the thing - if each restaurant has its own way of reporting operations, it becomes very hard for the big chain to figure out which restaurant is doing the best.

This type of consideration is why there are rules in place as to how to record transactions - so that different companies can be compared on an equal footing. (I should note that the rules get stricter and stricter as the business gets more and more complicated).

There are different organizations that issue rules about how to account for transactions. Governments will sometimes issue rules on accounting, taxation bodies can do it as well. Organizations such as the Financial Accounting Standards Board (FASB) in the USA issue rules that big companies in the USA are required to follow. And internationally, there is a movement towards having a standardized set of rules so that the accounting rules in the USA and in, say Germany, are the same.

Vocabulary used:

For more information check out these links (comment to add your favourite link):

FASB

Where might you have come from?

Fact-orials Index

Accounting Principles

• Double Entry Accounting
• Recording Transactions
• Cash vs Accrual Accounting

Where might we go?

Accounting Principles

• Financial Entity 
• Accounting Reports 

Cash vs Accrual Accounting

Background

We now know how to record transactions. The next question is when to record them...

Question

On Feb 1, a plumber goes to a customer's business to clear a clogged drain. The customer asks for a bill to be mailed. On Feb 2, the bill is mailed to the customer. On Feb 3, the bill arrives at the customer's business. On Feb 4, the customer mails a check. On Feb 5, the plumber receives the check. 

For the plumber and the customer, walk through when transactions are recorded. Do two timelines for each - one for cash accounting and one for accrual accounting.

Answer

Plumber, cash method:

Feb 5, DR Cash, CR Income 

Plumber, accrual method: 

Feb 1, DR Accounts Receivable, CR Income

Feb 5, DR Cash, CR Accounts Receivable

Business, cash method:

Feb 4, DR Expense, CR Cash

Business, accrual method: 

Feb 1, DR Expense, CR Accounts Payable

Feb 4, DR Accounts Payable, CR Cash 

Analysis

Before we get into how to record transactions under different types of accounting schemes, let's talk about the two basic types and why we might use each.

Cash accounting is the easier to understand of the two systems. Essentially, you record income transactions when you receive money and you record expense transactions when you pay money. Because the system is based on the receipt and payment of cash, knowing when to record transactions is simple and straightforward.

So let's track the accounting of our question for the plumber on the cash method:

On Feb 1, the plumber does work but isn't paid. No transaction is recorded. In fact, all of that stuff with the bill being sent out has no effect on the plumber. We're waiting for the receipt of cash.

On Feb 5, when the plumber receives the check from the customer, he has now received money and so records a transaction:

DR Cash
CR Income

(DR is short for Debit and CR is short for Credit)

Now let's do the same for the business on the cash method:

On Feb 1, the business has work done but doesn't pay for it that day. Since money hasn't left the business yet, no transaction is recorded. In fact, it's only when a check is sent to the plumber that an entry is made:

Feb 4
DR Expense
CR Cash

Now let's talk about Accrual accounting. Essentially, you record income transactions when income is earned and you record expenses when they are incurred.

How does this play out for the plumber and the business? Let's watch the plumber first:

On Feb 1, the plumber does work. He has earned income. It doesn't matter that he hasn't received cash yet - he records income. We'll also record that he is owed money:

DR Accounts Receivable (i.e. he is owed money)
CR Income

On Feb 5 when he receives the check in the mail, he has now been paid. We reduce the account that says he is owed money and increase the account that says he has money:

DR Cash
CR Accounts Receivable

And now let's do the business:

On Feb 1, the business called in the plumber. An expense has been incurred which will eventually need to be paid. We record the expense and we also record that money is owed to the plumber:

DR Expense
CR Accounts Payable (i.e. the business owes money to someone)

On Feb 4, the business sends payment to the plumber. The debt is paid and cash is decreased:

DR Accounts Payable
CR Cash

*****

So let's now talk about why we might use the accrual method vs the cash method of accounting.

Clearly, using the accrual method requires more work - it took twice as many entries to record the transactions under the accrual method than under the cash method. So whatever reasons there are to use accrual accounting, it has to be worth the extra work.

One reason the accrual method is preferred is that it follows something called the Revenue Recognition principle - which is what we described above when the plumber recorded income when it was earned and not when the bill was paid.

For accountants, it's important that income transactions properly follow when income is earned. The payment of cash isn't always a good indicator of when income is earned. For instance, what if the plumber had had to wait 3 months for payment? It wouldn't be fair or right for the plumber to not record the income until he got paid.

Another reason is that the accrual method also follows something called the Matching Principle - which means that expenses are recorded only when they can be properly matched to the income they were incurred to produce.

A prime example of this, which we'll discuss in a later entry, is depreciation. Depreciation is the recognition of wear and tear on machinery and other expensive assets in order to make income. For instance, let's say a business that will make widgets is getting started. The company has a large factory built. Should the company be able to record the building of the factory as an expense all at once? Or should it be reduced in value over time as the wear and tear of making widgets decreases its value? The Matching Principle says it should happen over time.

*****

One more note before closing this entry - the use of accounting method is independent of other businesses. The plumber could easily be using the cash method while the business is using accrual, and vice versa (the plumber could be using accrual accounting and the business using cash accounting).

Vocabulary used:

For more information check out these links (comment to add your favourite link):

Where might you have come from?

Fact-orials Index

Accounting Principles:

• Recording Transactions

Where might we go?

Accounting Principles:

• Comparability of Transactions

Recording Transactions

Background

We've covered the fact that with financial transactions, two accounts (at least) are impacted. So what types of accounts are there?

Question

What types of accounts are there? Name an example for each. Are the balances in each of them normally debits or credits?

Answer

1. Assets are things we own and are normally debits. Cash is an example.
2. Liabilities are things we owe and are normally credits. Accounts Payable is an example. 
3. Equity is the net value of the business and is normally a credit. Owner's Equity is an example.
4. Income is cash and other consideration we receive in the course of business and is normally a credit. Sales is an example.
5. Expense is what is paid out in cash and other consideration in order to make income and is normally a debit. Salaries is an example. 

Analysis

We've discussed in prior entries about a merchant selling a cow for gold (i.e. cash). Let's talk about some transactions that are a normal part of business and examine the types of accounts that are impacted.

So let's start with that cow we keep talking about. We own it - it's ours. We call something like that an asset. Assets are things we own.

Along with the cow, things we own include cash (gold, silver, money, etc), land, buildings, inventory, and more.

Assets are normally debit balances - and so debits will increase assets and credits will decrease them.

Let's make a little story out of this. Let's say the only thing in the world we own is the cow and we're walking to the market town to sell milk.

Ok - we get to town late. We need to get a room for the night but the innkeeper only wants cash. We say we'll pay him when we sell milk tomorrow. The innkeeper agrees, and so we now owe the innkeeper money. That is a liability. Liabilities are things we owe, such as loans and debts.

Liabilities are normally credit balances - and so credits will increase liabilities and debits will decrease them.

Along with the debt to the innkeeper, we might also owe money to the tax collector, to a landlord, or to others.

At the same time, we now also record an Expense - money or value that we pay in order to make income. Other types of expenses include salaries, utilities, taxes, and more.

Expenses are normally debit balances - and so debits will increase expenses and credits will decrease them.

So let's now talk about what we're worth. Before going to town, we were worth one cow (for ease, let's say the cow is worth $100). And let's also say that we have to pay $1 per night at the inn. So after one night in the inn, we're now worth $99. Our equity is what we own less what we owe. Equity is Assets less Liabilities.

Equity accounts are normally credit balances - and so credits will increase liabilities and debits will decrease them.

We find a butter maker and we sell some milk to them. We get some money (let's say $2) so that is an increase in cash and so a debit. We also record Income. Income is money that we earn.

Income is normally a credit balance - and so credits increase income and debits decrease them.

Vocabulary used:

For more information check out these links (comment to add your favourite link):

Where might you have come from?

Fact-orials Index

Accounting Principles

• Double Entry Accounting

Where might we go?

Accounting Principles:

• Cash vs Accrual Accounting
• Comparability of Transactions