Accounting The TRUE basics

THE TRUE BASICS OF ACCOUNTING The purpose of this article is to highlight the true basics of accounting. Why the emphasis on true? It is because of the various formulas, rules, recipes, etc., used in the elementary teaching of accounting. They do a lot of harm as learners are not guided to discover, reason and understand but are taught or drilled to do. Learners are not guided to discover the why (reasons why certain things are done) – they are taught the what-to-do, whether they understand it or not. The end result of the accounting process is in the form of reports and financial statements. These show how a business or organisation has performed and provide the information required to plan for the future. The Balance sheet (Statement of financial position) is one of the relevant statements and shows the financial position of a business on a specific date. It shows what the business owns (assets), what they owe (liabilities) and the difference, known as equity or owner’s equity. If we write these three items in equation form, we get: Assets – Liabilities = Owner’s equity. However, we usually work with positive amounts in accounting. So the equation known as the basic accounting equation is written as: Assets = Owner’s equity + Liabilities. This basic accounting equation is the TRUE basics of accounting. Everything done in accounting is a result of the effect that transactions have on one, two or all three of the elements of the basic accounting equation. Note that reference to this will be made further on in the article. The following ten transactions of Rufus Plumbers can serve as an example to support this statement: 1. Rufus started his business, Rufus Plumbers, by depositing a capital contribution of R80 000 in the current bank account of the business; receipt 001 was issued. 2. Bought a vehicle from Bingo Motors and paid by cheque 001, R25 000. 3. Issued cheque 002 for R15 000 to Coastal Stores for equipment. 4. Paid the local newspaper, Daily News, for advertising, cheque 003, R400. 5. Rented a storeroom from First Street Properties; paid rent by cheque 004, R900. 6. Cash received for services rendered, cash register roll, R3 300. 7. Rufus Plumbers bought a vehicle on credit from Oxford Motors, R90 000. 8. Services rendered on credit to J. Mapaka, invoice A01 issued, R6 000. 9. Rufus Plumbers paid Oxford Motors R20 000 by cheque 005 as part payment of debt. 10. Received R4 000 from J. Mapaka as part payment of his account, receipt B01. If we record the effect of each of the above transactions on the accounting equation and prepare a cumulative summary after each transaction, we will arrive at the following solution: Effect on the accounting equation (The reason given is important and must make sense.) Assets Equity Liabilities Effect Reason Effect Reason Effect Reason 1. +80 000 Cash increases +80 000 Owner’s capital contribution 2. –25 000 Cash decreases +25 000 Vehicles increases 3. –15 000 Cash decreases +15 000 Equipment increases 4. –400 Cash decreases –400 Advertising – expense 5. –900 Cash decreases –900 Rent – expense 6. +3 300 Cash increases +3 300 Income earned 7. +90 000 Vehicles increases +90 000 Creditors increases 8. +6 000 Debtors increases +6 000 Income earned 9. –20 000 Cash decreases –20 000 Creditors decreases 10. +4 000 Cash increases –4 000 Debtors decreases 1 © Martin Snyman

Cumulative summary after each transaction No. Assets Owner’s equity + Liabilities 1. Cash R80 000 Capital contribution R80 000 2. Cash 55 000 Capital contribution 80 000 Vehicles 25 000 R80 000 R80 000 3. Cash 40 000 Capital contribution 80 000 Vehicles 25 000 Equipment 15 000 R80 000 R80 000 4. Cash 39 600 Owner’s equity 79 600 Vehicles 25 000 Equipment 15 000 R79 600 R79 600 5. Cash 38 700 Owner’s equity 78 700 Vehicles 25 000 Equipment 15 000 R78 700 R78 700 6. Cash 42 000 Owner’s equity 82 000 Vehicles 25 000 Equipment 15 000 R82 000 R82 000 7. Cash 42 000 Owner’s equity 82 000 Vehicles 115 000 Creditors 90 000 Equipment 15 000 R172 000 R172 000 8. Cash 42 000 Owner’s equity 88 000 Vehicles 115 000 Creditors 90 000 Equipment 15 000 Debtors 6 000 R178 000 R178 000 9. Cash 22 000 Owner’s equity 88 000 Vehicles 115 000 Creditors 70 000 Equipment 15 000 Debtors 6 000 R158 000 R158 000 10. Cash 26 000 Owner’s equity 88 000 Vehicles 115 000 Creditors 70 000 Equipment 15 000 Debtors 2 000 R158 000 R158 000 2 © Martin Snyman

Using the cumulative summary of the effect of the ten transactions on the accounting equation, we can report to management as follows: Assets Cash in the bank 26 000 Vehicles with total cost price 115 000 Equipment costing 15 000 Debtors owe the business 2 000 Total assets therefore 158 000 Less Liabilities Owing to creditors 70 000 Owner’s equity 88 000 Owner’s equity after the transactions 88 000 Owner’s contribution was 80 000 Net income/Profit 8 000 However, the cumulative summary does not tell us: • What the total income amounted to. • What expenses were incurred. • Any other information that management might like to know. The main aim of accounting is to provide information in the form of reports or financial statements to allow managers to make decisions. To achieve this, a systematic method of recording in accounts is essential. This is where ledger accounts come in handy. Ledger accounts are used as an aid to make more information available. For instance, one can open a separate ledger account for each asset, liability and expense as well as one (or more) to record the business income. However, this does not make ledger accounts part of the true basics of Accounting. Ledger accounts are an aid – and that’s all! The effect of the ten transactions in the example on the accounting equation shows clearly that assets, owner’s equity and liabilities can increase or decrease, depending on the relevant transaction. Ledger accounts are in the form of a capital T and are called T-accounts. Increases are recorded on the one side of the account and decreases on the other side. The name of the account is written at the top in the middle. The left side of the account is called the debit side and the right side the credit side. Accounts are kept in a book called the General ledger. Each T-account is identified by the name which is written at the top in the middle. There are rules which allow us to apply logical reasoning in deciding which account to debit and which account to credit. These rules are applicable to all transactions and are the only rules that learners need to know. 3 © Martin Snyman

They are: Dr. ASSETS Cr. = Dr. OWNER’S EQUITY Cr. + Dr. LIABILITIES Cr. Increase with Decrease with Decreases with Increases with Decrease with Increase with a debit entry a credit entry a debit entry a credit entry a debit entry a credit entry INCOME ACCOUNTS Are credited because income increases owner’s equity EXPENSE ACCOUNTS Are debited because expenses decrease owner’s equity If we draw up simplified ledger T-accounts of the effect of the ten transactions in the example on the accounting equation, we will arrive at the following solution: General ledger of Rufus Plumbers Asset accounts Dr. BANK Cr. 1. Capital 80 000 2. Vehicles 25 000 6. Current income 3 300 3. Equipment 15 000 10. Debtors 4 000 4. Advertising 400 5. Rent expense 900 9. Creditors 20 000 Dr. VEHICLES Cr. 2. Bank 25 000 7. Creditors 90 000 Dr. EQUIPMENT Cr. 3. Bank 15 000 Dr. DEBTORS Cr. 8. Current income 6 000 10. Bank 4 000 Accounts that affect owner’s equity Dr. CAPITAL Cr. 1. Bank 80 000 Dr. ADVERTISING Cr. 4. Bank 400 Dr. RENT EXPENSE Cr. 5. Bank 900 Dr. CURRENT INCOME Cr. 6. Bank 3 300 8. Debtors 6 000 4 © Martin Snyman

Liabilities Dr. CREDITORS Cr. 9. Bank 20 000 7. Vehicles 90 000 Although ledger accounts are not part of the true basics of accounting, they do supply more information than the cumulative summary we prepared. The Current income account shows us that the total income amounted to R9 300 (services rendered for cash R3 300 and services rendered on credit R6 000). The expense accounts (Advertising and Rent expense) show us that the expenses incurred were R400 for advertising and R900 for rent. Total expenses thus R1 300. The net income (profit) therefore can be calculated as R(9 300 – 1 300) = R8 000. This calculation is normally done by preparing an Income statement. The Bank account shows us how much money was received R(80 000 + 3 300 + 4 000) = R87 300 and how much money was paid out R(25 000 + 15 000 + 400 + 900 + 20 000) = R61 300. Therefore, there must still be R(87 300 – 61 300) = R26 000 in the bank. The Vehicles account shows us that two vehicles were bought. One for cash (R25 000) and one on credit (R90 000). The total cost of the two vehicles is thus R115 000. The Equipment account shows us that equipment costing R15 000 was bought for cash. The Debtors account shows us that services costing R6 000 were rendered on credit and that R4 000 of this amount has been paid by the debtor. Therefore debtors still owe Rufus Plumbers R2 000 (6 000 – 4 000). The Creditors account shows us that a vehicle costing R90 000 was bought on credit and that R20 000 has been paid to the creditor. Therefore Rufus Plumbers still owe creditors R70 000. The accounting equation should balance if our calculations are correct: Bank 26 000 Capital contribution 80 000 Creditors 70 000 Vehicles 115 000 Net income/Profit 8 000 Equipment 15 000 Debtors 2 000 Assets 158 000 = Owner’s equity 88 000 + Liabilities 70 000 Back to the statement: Everything done in accounting is a result of the effect that transactions have on one, two or all three of the elements of the basic accounting equation. The effect on the accounting equation shows clearly that assets, owner’s equity and liabilities can increase or decrease, depending on the relevant transaction. When we apply the rules which allow us to apply logical reasoning in deciding which account to debit and which account to credit, we find that one account will be debited and another account will be credited with the same amount. This has resulted in what is known as the double entry principle or double entry system. However, it is not a principle in its own right – the double entry principal/system is a result of the effect of transactions on the elements of the accounting equation. We used ten transactions in the example discussed above. However, in most businesses large numbers of transactions take place every day. Entering each of these transactions in ledger accounts would be an impossible task. This is where subsidiary journals come in handy. Subsidiary journals are used as an aid to summarise similar transactions before posting them to the ledger. This does NOT make subsidiary journals part of the TRUE basics of accounting. Subsidiary journals are an AID – and that’s all! 5 © Martin Snyman

For the sake of completeness the recording procedure of accounting is set out schematically below: Transaction Basics of accounting: Effect on A, O and L Subsidiary journals/books (Books of first entry) (“What happened?”) They do not form part of the ‘basics of accounting’. ↓ Cash receipts journal (summarises all cash received) ↓ Cash payments journal (summarises all cheque payments) ↓ Petty cash journal (summarises petty cash payments) ↓ Debtors journal (summarises the credit sales of trading goods) ↓ Creditors journal (summarises all credit purchases) ↓ Debtors allowances journal (summarises returns by debtors) ↓ Creditors allowances journal (summarises returns to creditors) ↓ (The sole purpose of the above subsidiary journals is to summarise ↓ similar transactions. Each one summarises one type of transaction.) ↓ In addition to the above specialised subsidiary journals, a ↓ General journal is used to record transactions that do not belong in any of ↓ the other subsidiary journals.) ↓ ↓ Subsidiary journals are posted to the General ledger at month-end. Learners need to understand what the totals of the various analysis Ledger entries: columns in the relevant subsidiary journal mean and should then apply Acc to debit the rules which allow us to apply logical reasoning in deciding which Acc to credit account to debit and which account to credit. Back to the statement: Everything done in accounting is a result of the effect that transactions have on one, two or all three of the elements of the basic accounting equation. Subsidiary books are posted to the General ledger at month-end. Learners need to understand what the totals of the various analysis columns in the relevant subsidiary book mean and should then apply the rules which allow us to apply logical reasoning in deciding which account to debit and which account to credit. The same logical reasoning applies throughout when recording transactions in ledger accounts or posting subsidiary journals to ledger accounts. It makes sense to use the TRUE basics as a starting point for the elementary teaching of accounting. However, the methodology discussed does not end here. Be consistent throughout all the grades. Then you will find that it will not be necessary for the learners to use a formula to identify income and expense accounts when they have to prepare an Income statement. So let learners first consider the effect of all new transactions on the accounting equation and then reason what entry should be made to record the relevant effect. By doing this, you will enable the learners to think and reason for themselves and soon they will be able to work on their own. You can read more about the methodology in the article Accounting: Do you guide or do you just teach? and its follow-up: Accounting: How to guide – not just teach! Both these articles can be downloaded from Via Afrika’s website, http://www.viaafrika.com/downloads-page/ The articles are also available in Afrikaans (Rekeningkunde: Begelei jy of onderrig jy net? and Rekeningkunde: Hoe om te begelei – nie net te onderrig nie!) on the same website. 6 © Martin Snyman