The most important difference between the first two types and the last two is not in terms of how the profit is taxed but in the type of liability.

In sole traders the owner is entirely responsible for the debts of its firm. If for some reason the firm having run out of cash is faced with a bill due to a creditor and cannot pay it, the creditor can turn to the owner and ask the owner to pay the bill. This is also true for partnerships.

For limited liability companies the story is different. If a limited liability company cannot pay a bill to a creditor, the creditor can launch in court a procedure against the firm for payment failure (eventually leading to bankruptcy), but cannot ask the owners to pay the bill. The owners may have lost whatever money they put in the firm at the outset, but no more. This is what is meant by limited liability. And this applies to privately owned limited liability companies as well as publicly owned limited liability companies.

Later on this course we shall study the historical circumstances that lead most developped countries, in the nineteenth century, to create the legal structure of a limited liability company. It is a very interesting topic having to do with industrial and economic development and with capitalism, but it is too early to study it right now. We need frist of all to know more about accounting.

Even within each of the four types of firms we saw, there are fine differences between countries in the exact legal structures. This is not the topic of this course. During the first semester whenever we look at a firm we will implicitly consider the most simple legal structure: the sole trader.

When a firm runs out of money and cannot pay a bill to a creditor, there are several possible consequences:

1. the manager of the firm in difficulty can ask the creditor for a delay,
2. the manager of the firm in difficulty can ask the creditor if he would accept a "payment in nature",
3. the manager of the firm gets ready to go to court and argue the case of his firm, and try to get a delay decided by the court.
4.  

The anecdote of an advertizing agency "paid in nature" by a supplier who had run out of money:

Once, I visited my friend Pascal at his advertizing agency, and there were 250 Swiss cuckoo clocks all over the shelves. Pascal being a transversal guy, and in the advertizing trade to boot, I was used to excentricities from him.
- Hey ! You started a new collection, I said
- No, he cheerlessly replied, don't insist...
A cuckoo just rang then. And then another one. And a third one.
- Oh, this one's got a nice chirp !
- Yeah, they don't even fu...ing all ring at the same time !, he said droopingly. He had been paid a debt from a bad client with physical goods ! So let's cross fingers Joe won't get paid, like my friend Pascal, with 250 Swiss cuckoo clocks.

Of course payment defaults are not usual situations, and a payment with 250 cuckoos is particularly unusual ! I told you this true story to lighten the course before we get back to serious stuff.

Balancing accounts

At any time we can compute how much money we have in the Cash account. For example after the first six transactions of the journal, in the Cash account we have £2500 left.

That is simply because altogether £6500 entered the cash account during the month of January, and altogether £4000 left the cash account during the month of January.

The difference between the two figures (the sum of the debits and the sum of the credits)  is called "the balance" of the cash account.

Note that the end of January 3rd the balance of the cash account was £2000. And at the end of January 7th it was £1000.

We can compute the balance of the cash account at any date we like. At the end of the 9th it was £2500, and since the cash account did not move from then on until the end of the month, the balance of the cash account was also £2500 at the end of the month of January.

This balance of the cash account is on the debit side. A cash account is necessarily in debit because, the cash box, just like my pocket, cannot hold less than zero money. (Money entering the cash account, we saw, is recorded on the debit side, and money leaving the cash account is recorded on the credit side.)

The computation of the balance can be done for any account. For instance the balance of the bank account (go back to the account) is zero.

For the other accounts it is even simpler: the journal for January recording only one movement for the other accounts their balances does not require any addition and subtraction.

Accountants will distinguish "the balance carried down" and "the balance brought down". These distinctions come from the old days when computations were done by hand and required much care. In those times we would "complete" the smallest of the two columns with a number to make the two columns of an account equal, this was called the "balance carried down". And then we would write the same balance on the other side and call it "the balance brought down" (we also say "brought forward"). Go to the textbook for details on this. In this course when I talk about the balance of an account it is always the balance brought down.

The cash account is always in debit. This is not true of the bank account. The bank account of a firm is usually in debit, but it could be in credit if the firm has an agreement with its banker and is allowed to draw more checks than it has money at the bank.

The balances of all the accounts are interesting numbers. What do we do with them ?

The trial balance

A fundamental accounting document of the firm (one may argue "the most important accounting document of the firm") computed at any point in time is the list of balances of accounts. It is called the trial balance. Here it is for Joe's firm computed at the end of January :

we list the accounts simply in alphabetical order

The accounting documents created so far:

The first accounting document is simply the journal. All the accounting information we are interested in is contained in the journal, but not in a convenient and therefore useful way to manage the firm.

The second accounting document is the series of accounts. Each of them used to be a piece of paper. We could bind them into a book. This book was called the ledger. Ledger in english means "big book" (in french "le grand livre" des comptes). Accounting has kept the term ledger for the collection of accounts, even in the electronic age, where accounts are rarely kept on pieces of paper anymore.

The third accounting document created so far is the list of account balances (computed at the end of January). It is called the trial balance at the end of January. The trial balance is not an account, but it is a document.

More on the Purchases account :

Remember: in the accounting system of a shop the "Purchases account" records only the purchases of goods that will be sold. The other purchases (a delivery van, office equipment, the rent for the month etc. even the salaries are purchases of some sort: purchases of work) are recorded in other accounts. The reason for this is that accounting is designed to provide useful information. If we mix up all our expenditures into one big account "expenditures" we lose interesting information, useful to manage the firm.

The logic of the treatment of information by the accounting system :

The accounting system is design to keep track of all the transactions (expressed in monetary terms) and to provide useful documents to manage the firm.

1. The recording of the "raw information" is done in the journal. But the journal as such is not useful to manage the firm. The information there is a big heap of writings.

2. Then this "raw information" is organized into accounts. (The process of going from journal entries to double entry recordings into accounts is called "posting".) Things get better in the view of creating useful information. All the accounts, bound together into a ledger, do present useful organized information. But it is not synthetic enough.

3. The third step in information treatment is the creation of the Trial balance. The Trial balance contains less information than the ledger (it loses all the movements in each account, it looks only at balances), but it is synthetic, convenient, and therefore useful.

If you arrive as a new boss into a shop you will want to look at the journal at first, to make sure the accounting system is properly set and running. But then you will not look at it every day. You won't even look every day at all the accounts. But you may want to look every day or at least very frequently at the Trial balance.

In the next sessions we shall meet two more synthetic documents : the balance sheet, and the income statement. (And there will be a couple more.) But I have met bankers when you wanted to discuss with them for example a new loan for your firm (I'm talking about small firms), the document they wanted to see was the Trial balance.

A bit of history :

These techniques were invented in the XIIth and XIIIth centuries, two centuries before the Renaissance. It used to be thought that the Middle ages were a dark age of humankind in the Western world, but this opinion has been profoundly revised after the works of such medievalists as Duby, Le Goff, Pernoud (I'm familiar with the French ones), and many others. In fact the XIIth century was a time of plenty of new ideas, and achievements, conceptual ideas (like accounting, banking, new social and private relationships) and achievements like the gothic cathedrals (that required a new understanting of the transmission of forces in a building...). Marco Polo came back from China and described the civilization of the Far East to the Europeans. It is now thought that all this was made possible by the social security brought by feudality. Security is necessary to think and to do commerce. One of the genius traits of the counts of Champagne was to guarantee safe travel to merchants coming to their fairs. This spurred a tremendous development ot these fairs, that in turn (through reasonable taxes) enriched Champagne. Later on the King of France, worried that Champagne was becoming too powerful, transferred it all to Paris. The competition between Paris and the French provinces hasn't disappeared yet...

Whenever there is safety civilization flourishes. In Western Europe there happened a Carolingian Renaissance at the time of Carolus Magnus (around 800), because he organized a powerful and safe empire.

Rebuilding Carolus Magnus empire was the main concern of the Habsburgs as well as of Napoleon one thousand years later. Now, since 1957, we are building Europe. And the UNO is laboriously trying to make the whole world a safe place.

Next topics (listen to the sound file put on the Net, from 38 minutes after the beginning until 1 hour 30 minutes ):

The 14 rules of accounting

Learning how to learn

A complete posting exercise

Read chapters 1, 2 and 3 of the Textbook.