Sunday, June 5, 2011

Chapter 3 Analyzing and Recording Transactions


Chapter 3

Measuring Wealth

In Chapters One and Two you studied why financial accounting is an important component of our financial market.  Without standardized financial reporting in accordance with rules issued by an authoritative body (FASB), investors would have a difficult time comparing competing financial instruments (IOU’s), and markets would be less efficient.  In the next two chapters you begin to investigate what information financial accounting is designed to record and report in a standardized format.  At the dawn of the Industrial Revolution, Adam Smith observed and painstakingly documented a phenomenon with empirical evidence gathered though observation and quantitative data analysis.  His findings were the basis for a new scientific paradigm devoted to studying England’s new economic culture.  Wherever you live, Smith’s words from 1776 are still relevant to you today.  Please read: Volume One Introduction and Plan of the Work and Book I, Chapter I Of the Division of Labor http://www.econlib.org/library/Smith/smWN.htmlThis reading should take no more than 30 minutes, that is if you are able to stop…
In Chapter One, you studied the “invisible hand” that moves the economy.  Adam Smith described the economy’s change in focus from King and country to the motivation of each individual citizen.  Whereas Socrates described the economic benefit of teaching men to work for the greater good, Smith asserted that expecting a benevolent economic architect to create a greater good was an impossible and unrealistic dream.  Smith observed that a rational man acting in his own self-interest produced the greatest amount of wealth.  Through specialization and division of labor, each man becomes more productive by deciding for himself how best to spend his time.  In short, the paradigm can be described as thinking small, concentrating on the individual desires and motivation of men, in order to accomplish something grand, creating the greatest amount of wealth.
Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. (Smith, 1776, Book 1, Chapter II, Paragraph 2)
The idea to provide ALL men with the knowledge and freedom to act in their own best interest was revolutionary and represented the destruction of the previous “top-down” economic paradigm and is the philosophical basis of our free market economy.


In order to protect and promote a free market economy, Smith proclaimed that the role of government should be limited to only three types of activities each of which supports the individual; defense from foreign threats, domestic police and civil court systems and providing services to individuals that the market cannot provide due to market failure (Smith, 1776).  This does not mean he was for limited government, to the contrary, he strongly advocated for competent government where it was needed to support the individual, enabling him to act rationally in his best interest to facilitate a free market.  If government does not provide services to the citizenry that they cannot provide for themselves because of market failure, then a free market economy cannot be achieved.  Smith proclaimed public education to be an example of an indispensible government service.
The institutions for instruction are of two kinds: those for the education of youth, and those for the instruction of people of all ages (Smith, 1776, Book V, Chapter I, Paragraph 70).
Loudly demeaning necessary public services like education or Social Security as “socialism,” a dirty word in 21st century American politics, is the tool of a demagogue who in fact seeks to diminish the ability of America to achieve a free market.
In Chapter Two you studied how investors and borrowers have competing interests with regards to the money market.  Each person desires to increase his wealth by trading in markets, including the money market.  This tension is part of the invisible hand that creates more wealth in the economy.  As evidence, Smith observed that an 18th century English laborer had a higher standard of living than an African King who commanded 10,000 people in a non-industrialized economy[1].  I would like for you to discuss the following points with your classmates.
1.     Is the theory of each man working in his own best interest the same theory competition for limited resources?
2.     Does stealing (or ripping people off) lead to greater wealth in society?
3.     Is it possible for mankind to work for the common good in a free market economy?

Defining Wealth

Since the self-interest of each person is to increase his or her wealth, it is worthwhile to define what wealth is, since that is what financial accounting is designed to record and report.  The concept of wealth has been extensively chronicled throughout recorded history, yet it is not a universally descriptive term.  To narrow the focus of this literature review I will begin by eliminating positive personal attributes that can be confused with wealth.  What isn’t wealth is explained well by Socrates’ student Xenophon[2] in Oeconomicus, “Does this horse have wealth?” Socrates asks of a revered “noble animal”.  The resounding answer from his fellow Athenians was NO (Xenophon, 362 BCE).  Health, strength, intelligence, confidence, happiness, ability and the adoration of others are not wealth, though in the opinion of the author, they do not hinder a man who is attempting to acquire it. 
This is very significant to financial accounting, because wealth is money and stuff that can be objectively measured by money, in financial accounting language, an asset.  Money provides man a means of exchange that enables him to trade for things he needs as well as an ability to store wealth for future consumption.  It is a man-made creation, the value of which is dependent on its acceptance by people and it represents a common language spoken throughout the world; and throughout recorded history, it is a good thing to have.  Philosophers have proclaimed that wealth can encompass a far greater scope than merely money and the ability to consume, including happiness, a pleasant community, making a contribution to society, health and opportunities for children.  However, the current economic paradigm defines it simply as assets minus liabilities (debts quantified in money), things “owned” minus things “owed.”  Does this sound familiar?  It should, it is the Accounting Equation, which describes the nature of the Balance Sheet, one of the four primary financial statements required by GAAP.

Money Aint Everything…

Attributes that are important to savers and investors, but are not easy to subjectively measure by financial accountants are ignored in financial reporting.  Recall that in Table 2.1 you observed that investors valued things other than net assets.  The importance of financial reporting to savers is also limited by the fact that it describes economic events that occurred in the past.  Investors want to know what is going to happen in the future, and while past performance can help predict future performance, it is far from a perfect indicator. 

Knowledge = Wealth

French economist Jean Baptiste Say[3] observed the notable phenomenon that wealth is a function of knowledge, early in the 19th century.
Objects, however, cannot be created by human means; nor is the mass of matter, of which this globe consists, capable of increase or diminution. All that man can do is, to re-produce existing materials under another form, which may give them an utility they did not before possess, or merely enlarge one they may have before presented. So that, in fact, there is a creation, not of matter, but of utility; and this I call production of wealth (Book I, Chapter I, Paragraph 7).
Therefore, mankind only increases societal wealth by improving scientific knowledge of himself and his environment.  Since financial accounting is designed to objectively measure an organization’s wealth, it would be beneficial to come up with a methodology that allowed savers and investors to evaluate an organizations knowledge and compare it to other organizations that may be operating in completely different industries.  You see how complicated this is.  Consider the pin company that Adam Smith described in Book I Chapter 1.  By improving its knowledge of material science, manufacturing, machinery and people (the organization had to know that people needed more pins), the pin company increased individual productivity from 10 lousy pins a day to almost 5,000 inexpensive pins that were of high quality.  How could I compare this very impressive bit of information to an iron foundry to determine which organization has a more favorable wealth (knowledge) position?
This brings us to the standardized financial statements that are part of GAAP financial reporting.  These reports allow readers to compare an organizations wealth position over time as well as providing a basis to compare dissimilar organizations with a common albeit imperfect measuring tool.

Recording Transactions


The spreadsheets used in this chapter are available on Google Docs at https://spreadsheets.google.com/spreadsheet/ccc?key=0AgmH5rG6dzTmdHhEWVdZVDBtVEVwV1RKQ2JDQlZiVmc&hl=en_US#gid=0 .  The companion YouTube lecture is available at http://www.youtube.com/watch?v=Ooibihp3QPo .  Please replicate this work, using paper and pencil, on columnar paper[4].  The remainder of this Chapter will be dedicated to identifying and recording certain transactions in the accounting records.  As you have already learned, not every event can be objectively measured with money, so in most cases this type of economic event will be ignored.  Examples of extremely important events that are not recorded in the accounting records are:
1.     Hiring a new employee may be one of the most important things a company does, however, until the employee actually works and earns wages, it is ignored in the accounting records.  Is there any other place this transaction is recorded (think Human Resource records).
2.     The company discovers a new scientific breakthrough.  The research costs are recorded, but until the great idea translates into revenue, it is ignored.
3.     Another company discovers a scientific breakthrough that renders the product of your company obsolete.

Step 1 Table 3.1 Chart of Accounts

Before beginning the accounting cycle for an organization, the accountant must define the organization’s Chart of Accounts.  Recall that in Chapter One you memorized some typical accounts.  Accounts will be used to classify transactions into buckets of information that can be accumulated and used create financial statements.
Notice that the Chart of Accounts does not have any numbers on it or a date.  This is because it is the first accounting task that is completed, before any numbers can be recorded, and it is never complete.  As an organization grows in complexity its information requirements change, necessitating new accounts.  In computerized systems account numbers are used but in this textbook we will only use account names.  These are the only places we can store accounting information so all journal entries must choose from accounts on the Chart of Accounts.

Step 2 Tables 3.2 and 3.3 General Journal and General Ledger

All transactions are entered into the General Journal (3.2) as journal entries, and then each journal entry is posted to the General Ledger (3.3).


Notice that neither the General Journal nor the General Ledger is dated.  Both of these will be used as long as the organization requires accounting.  The General Journal is the place where transactions are recorded and these are tracked by date and sequentially.  The General Ledger has a T (Debits are the left side of the T and Credits the right side) account for each account listed in the Chart of Accounts.  As journal entries are recorded, they are immediately posted to the General Ledger and referenced by date and by sequential General Journal number.  Notice journal entry #1 from the General Journal is posted to the Dr. column for Cash ($100) while the Cr. column is posted to the Common Stock General Ledger account.  This work must be done very precisely or your records will be corrupt.  The good news is that computer software now does all of this for you.  However, it is still important to understand how the software works so you can learn to analyze how different transactions will effect the financial statements.

Step 3 Identifying, Analyzing and Recording Transactions

Acquiring Assets with Common Stock Journal Entry # 1

Lizzie Incorporated received its approval from Secretary of State to create a corporation dedicated to selling toy mice[5].  Lizzie Incorporate is a separate entity from Lizzie the person, it must file a tax return, it can sue or be sued in a court of law, it can be indicted for a crime… about the only thing Lizzie Incorporated cannot do is vote in elections.  The first activity of Lizzie Incorporated is to acquire some assets, so it creates a financial instrument (100 shares of common stock) and sell it in the marketplace.  The only person who sees the potential of Lizzie Incorporated, is Lizzie the person, so she purchases all of the common stock for $100.  Lizzie Incorporated’s Cash increases by $100 and its Common stock increases by $100.  See Table 3.2 above for the for of this journal entry and Table 3.3 to see it posted to the Cash and Common Stock General Ledger T accounts.  All journal entries will have their Debits = Credits.  If we were to total up the General Ledger at this point, Lizzie’s Accounting Equation would be Assets (Cash $100) = Liabilities ($0) + Owner’s Equity (Common stock $100).

Acquiring Assets with Trade Debt Table 3.4

After six months of intensive research, Lizzie Incorporated devised a plan of what it wanted to sell and how it wanted to sell it.  It located a vendor who would manufacture and sell it product with credit terms of net 60 days.  Accounts payable is a form of trade debt and represents the most important type of financing for many small businesses.  Lizzie places an order on June 30 for $18,839 and receives the merchandise on the same day.  Lizzie’s Inventory increases by this amount and her Accounts payable increases by the same amount.
Post both sides of this journal entry to the General Ledger.  After this transaction, Lizzie Incorporated’s Assets (Cash $100; Inventory $18,839) = Liabilities (Accounts payable $18,839) + Owner’s Equity (Common stock $100).

Borrowing Money (Selling an IOU) Table 3.5

Lizzie Incorporated needs to acquire some working capital to fund its operations, selling toy mice.  It creates an IOU and finds a saver who is willing to purchase it for $20,000 on July 1.  The terms of Lizzie Incorporated’s IOU are face amount, $20,000, term of 2 years, interest of 10% payable annually.  This transaction increases Cash and Long-term Notes payable by $20,000.
How does this transaction effect Lizzie’s Accounting Equation?  If the saver would have been willing to purchase 95% of the common stock (1,900 shares) for $20,000, what should the stockholder of Lizzie Incorporated have done?  There is not a right or wrong answer here.  Consider the upside of the company and the risk that debt brings to the organization.  Post the transaction to the General Ledger.

Purchasing a Long-Term Asset with Cash Table 3.6

Lizzie Inc. is trading its most precious asset… cash, for equipment that will help it sell its product.  The business plan calls for a handcart that will enable an employee to push it to a desirable location, and attractively display product.  The handcart will be used for many years, and without it, Lizzie Inc. cannot sell its product.
How did this transaction affect the wealth of Lizzie Inc.?  The Accounting Equation did not change in total; one asset went up while another went down.  Cash is the most important asset because it is the lifeblood of a business, running out of it is fatal.  On the other hand, Lizzie Inc. cannot transact business without sacrificing its cash.

Purchasing a Short-Term Asset with Cash Table 3.7

Lizzie Inc. purchases a one-year liability insurance policy with cash.  Since the policy will benefit future periods, it is recorded as an asset rather than directly expensed as a period cost.  If Lizzie Inc. had elected to pay the insurance premium monthly, the debit would have been to Insurance expense.  Please take a look at this short video lecture on insurance http://www.youtube.com/watch?v=SvwINGDx-Z4 .
Notice how similar this transaction is to journal entry #4 (Table 3.6) above.  Cash is sacrificed for an asset that will benefit future periods.  As the asset expires, it is reduced
by crediting the account and debiting an expense account.

Settling a Portion of Accounts Payable with Cash Table 3.8

Recall that in transaction #2, Lizzie Inc. purchased inventory with trade credit.  This vendor relationship is very important to Lizzie Inc. because if they become dissatisfied, they will not sell her any more products on credit.  While Lizzie Inc. is the customer; it cannot treat its vendors like crap or it could threaten its business[6].  In this case, Lizzie Inc. is only paying a portion of the Accounts payable balance, but the vendor agreed to this arrangement since Lizzie Inc. is just starting out.
Cash goes down (credit) and Accounts payable goes down (debit).  I put the credit entry first to show you that it does not matter what order you do your journal entries.  Textbooks that make a big deal about the order of the lines in the journal entry are archaic and missing the point of the purpose of accounting.  How does this transaction affect the Accounting equation?  Does the transaction have any effect on Lizzie Inc.’s wealth?

Recording a Sale on Credit Table 3.9

Lizzie Incorporated made its first sale.  Hooray, this is why it exists, to buy low and sell high!  This is your first entry to an account that is used on the Income Statement.
How does this transaction affect the wealth of Lizzie Incorporated?  You do not know the cost of the merchandise sold (yet) because Lizzie Incorporated uses a periodic inventory system, i.e. it adjusts inventory and records Cost of goods sold only one time at the end of the period.  If she used a perpetual inventory system, it would record the Cost of goods sold (and reduce Inventory) every time it recorded a sale.  What does the accounting system fail to capture in this transaction?  What if Lizzie Inc. just established an important and profitable business relationship that will benefit the organization for years to come?  Is this captured in the accounting records[7]?

Receipt of Cash to Settle Accounts Receivable Table 3.10

In this transaction, Lizzie Inc. trades one asset (Accounts receivable) for another very important asset… Cash.
The Accounting Equation is unchanged; one asset goes up while another goes down.  Did Lizzie Inc. make a good trade in this transaction?

Adjusting the Periodic Inventory Table 3.11 and 3.12

At December 31, 2010, Lizzie Inc. performs a physical inventory and discovers that no product remains.  In accounting language, there are no more assets (inventory) that will benefit a future period, therefore, the Inventory balance must be adjusted to zero with a corresponding entry to Cost of goods sold.
This “rollforward” should look familiar to you, go back to Chapter Two and see which financial statement uses the same approach.  While you are at it, total up each General Ledger Account, then use the account totals to create a Trial Balance and then, Income Statement, Statement of Retained Earnings and Balance Sheet.  Make sure to clearly differentiate your current and long-term assets and liabilities so the reader of the Balance Sheet can quickly wee the respective totals.

Total Each General Ledger Account Balance 3.13

Net the debits and credits and enter the balance on the correct side.

Kuhn Paradigm Science… The Importance of PRACTICE

Kuhn’s observations can be extrapolated to society at large because a scientific community is a social system organized around a single paradigm just as society is organized around an economic paradigm.  The framework is the foundation upon which the community is built, providing its rules for communication and social interaction.  Without the framework the community does not exist.  Understanding the framework, how it was established, its rules, terms of communication, tools, boundaries and even its known flaws is invaluable in understanding its product.  Kuhn (1996) declared that the paradigm is not theoretical for its members, rather, it is part of their life and each member has personally observed evidence of its accuracy.
If, for example, the student of Newtonian dynamics ever discovers the meaning of terms like force, mass, space, and time, he does so less from the incomplete though sometimes helpful definitions in this text then by observing and participating in the application of these concepts to problem-solving (p. 46-47).
What this means to you is that this practice is NOT a waste of your time or merely busy work.  It is HOW you learn the function of the financial accounting paradigm.  Practice the work in Chapter Three at least three full times using the same numbers.  Then experiment with changed to the entries and see how the financial statements are affected.  Compare financial statements (with your changes) to understand the impact of various decisions.  What if Lizzie Inc. only sold stock instead of borrowing money?  How would the financials change if Lizzie paid Cash for everything?  This chapter is instrumental in learning accounting, if you practice hard, the remainder of this course will be easy!


[1] Smith actually referred to “savages,” which sounds kind of stupid, but in Book I Chapter 2 Paragraph 4 you get a better indication of his belief in the equality of all men.
[2] Xenophon’s writings inspired The Warriors, http://www.youtube.com/watch?v=SXmPH2nTcac, perhaps the greatest American film ever produced.  There really are NO new stories to tell.
[3]  A treatise on Political Economy: Or, The Production, Distribution and Consumption of Wealth can be investigated here: http://www.econlib.org/library/Say/sayT.html
[4] http://www.printablepaper.net/category/columnar
[5] Lizzie is a cat
[6] In my experience, customers who are the biggest pains in the ass are not worth the trouble.  They bitch about price, return broken product, pay late and eventually, they will go bankrupt.  Send them to you competitor.
[7] W. Edwards Deming is an important contemporary philosopher who urged business leaders to think in terms of systems, not to be constrained by the accounting paradigm.  Many successful businesses concentrate on only a few customer and vendor relationships.

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