General accounting
IV. 14. The yearly accounting cycle
Video
We began to study the mechanics of double-entry accounting. We are not finished yet. But let's step back and take a glance at the big picture of firms.
Firms have a beginning date (a "birth date") and then, in theory, run forever. That's why they are called "going concerns". Accounting techniques take into account the fact that there will always be more operations in the future.
From a managerial point of view, their life will be split into accounting periods (usually years, and often calendar years).
The management monitors how the firm performs from one period to the next. It also compares its results with those of competitors when it is possible and meaningful (firms with similar structures).
The timeline
At the beginning of the first year, we start with a blank slate. The first operation, i.e. the first transaction, is the owners putting money into the firm: the cash or bank account is debited the amount, and a "capital account" recording the "receipts" given to the owners is credited the same amount.
Over the course of the first year, we record all the transactions, and then at the end of the year we compute an "Income statement" for the year, and we also compute a "Balance sheet" for the end of the year.
The Income statement is a document presenting the sales of the year, and the consumptions of the year (= costs) used to produce the sales. The difference is the profit of the year. The Balance sheet presents what the firm owns and what the firm owes at the end of the year.
The yearly accounting process (also called "accounting cycle")
It can be represented as follows:
click on image to enlarge it
During each accounting period, we record the transactions, first of all in chronological order into the Journal. Then we post each transaction into two accounts.
The book of accounts is called the ledger.
At the end of the accounting period, we transfer some information from the accounts into a preliminary document called the Trial balance (TB). It is the list of the balances of each account.
This Trial balance is then adjusted with some further transactions to compute as exactly as possible the costs (= the values consumed) that were incurred to produce the sales. This is when, for instance, we compute the amortization of the machines and include it into the costs of the year. We shall study this in detail in a forthcoming lesson. At present we are just taking a first look at the complete accounting process, to know where we are and where we are going: so far we have studied the journal, the transactions, and the posting into accounts. In subsequent lessons, we shall study the trial balance, the adjustments, etc.
Finally, from the "adjusted trial balance" we shall extract the "Income statement" (IS) and the "Balance sheet" (BS).
Income statement. Each accounting period, therefore, double-entry accounting will produce an IS presenting the sales (= revenues = turnover) and the costs (= consumptions = charges) to produce these sales.
The difference between sales and corresponding costs is the profit (or loss) of the accounting period. It is also called the "Net result", or more casually the "Bottom line".
Another name for the Income statement is "the Profit and Loss account", or "P&L".
Balance sheet. And at the end of each accounting period, double-entry accounting will also produce a BS. It is an organised presentation of what the firm owns (= its assets) and what the firm owes (= its liabilities).
Accounting periods revisited
- An IS can be computed over any period [t1, t2]
- A BS can be prepared at any date t
That's why it can be said that an Income statement (IS) is a movie, while a Balance sheet (BS) is a snapshot.
It is convenient however to use years as accounting periods, calendar years (from January 1, to December 31) or years shifted like for instance from March 1 to February 29.
Moreover, computing these "year end documents" (the IS and the BS) takes a lot of work once the year is over. The computations are usually finished in March or April. This is why annual reports of large corporations, with the calendar year as accounting period, are published only in April or May of the following year.
Why are years the most convenient?
Answer: because the operations of a firm can be meaningfully compared from one year to the next, whereas if we compare, say, one quarter to the next our comparison may be muddle by seasonality. Same if we were to use accounting periods of nine months: they would not be naturally comparable.
The sharing of revenues. The revenues (= sales) of a year are split into 4 parts
- what goes to the suppliers: raw material expenditures, other supplies from external agents
- what goes to the employees: salaries and fringes (contributions by the firm to a retirement fund, to medical insurance, etc.)
- what goes to the State: the taxes (mostly the value added tax (VAT), and the income tax)
- what goes to the owners: the rest, that is the profit
By definition : [part 2 + part 3 + part 4] = the value added (VA) by the firm.
The Gross Domestic Product (GDP) of a country, for a given year, is the sum of the VA's of all the firms and assimilated during that year.
The logic of the owners is
- to maximise their part of the pie (the profit)
- therefore, to reduce the other parts, per unit produced, via productivity improvements and cost of work reductions
- to make the firm grow: that is at least the standard viewpoint in the Western world
The logic of the employees is
- to increase their salary per unit of time worked
- or, equivalently, to reduce their work time without reducing their salary
This leads to natural conflicts. The two main sources of conflicts are
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Productivity improvements
- remplacing people by machines usually reduces the costs of production
- since the beginning of the Industrial Revolution this lead to many violent conflicts
- two famous ones are the Luddites movement in the UK in 1811, and the Canuts revolt in France in 1831
- both happened in the textile industry, which is where the Industrial Revolution began.
- Moving activity to a cheaper location (also called "offshoring")
- the globalisation of the world economy leads some Western firms to transfer labor intensive activities to regions of the world where wages are low
- this is one cause of unemployement in Western countries
- the capitalist logic says: "This is a great opportunity! They will be able to do something else and our whole economy will grow richer."
- but most people are not entrepreneurs and need a boss to tell them what to do
