Accounting Concepts- Money Measurement

Accounting Concepts are conventions that all accountants use in order to create records which provide a true and fair view of the business.

One of these conventions is the money measurement concept.

This states that only items that can be objectively stated in monetary terms can be included in the accounting records. This seems pretty straight forward right? It is.

So what are examples of things that you cannot put in the accounting records?

1. loyalty of your customers, sure your customers may be your greatest asset, but it does not mean that you can objectively and verifiably put a monetary figure on their worth.
   
2. staff morale, staff with good morale is another asset to your business, they are likely to work harder and become more productive, unfortunately this is another thing you cannot objectively state.

A confusing one sometimes is goodwill. The value of a business over and above its net assets. For example if a business' net assets (i.e. assets less liabilities) is $1million but the business was sold for 1.5 million, then goodwill will be 0.5 million. This is an example of externally generated goodwill, and because it has been paid for then it is objective. However internally generated goodwill may not be put as an asset.

So you may think that most intangible assets are not included as they cannot be measured in terms of money? Wrong. Patents is an example of intellectual property, they protect an idea or discovery, these are usually bought in x amount of years and their cost (which has been paid for and can be verified) can be distributed over its useful life.

There you go, money measurement. More concepts coming up!

Trial Balance

So in the last post we talked about balancing of ledger accounts, what you'll come across frequently in Cambridge Accounting is the Trial Balance. This is simply a list of all your credit and debit balances in the business. Since you have been following the duality system of accounting where each transaction has 2 entries into the ledger system, total debits should equal total credits; hence the trial balance.

Drawing one up is simple enough. Have a look below:







Life could not get any simpler right? What happens if it the trial balance does not balance though? What are the causes of this?

1. error of addition both in the trial balance and also in the balancing
   
2. not using double entry
3. not all balances have been included
4. incorrect entry of balance onto the trial balance

Unfortunately there are also errors that will not affect your trial balance but are still errors nonetheless.

1. Error of Omission- when an entry is completely omitted from the books, given that everything before was correct the trial balance should balance
2. Error of Commission- when an entry is entered correctly in terms of double entry, but the person or group that it has been entered into is wrong. e.g. A Smith $200 has been entered under J Smith $200
3. Error of Principle- numbers are correct, however how a certain transaction is treated is incorrect. e.g. something that should have been expensed has been capitalised (treated as an asset)
4. Complete Reversal of Entries- reversing the debit and credit entries, still balances but is incorrect
5. Compensating Errors- errors are both incorrect by the same amount e.g. both over by $100, will still balance but figures will be incorrect
6. Errors of Original Entry- An error made when going from the initial invoice or document to the ledger accounts.
   

While this is not a big topic, you will still need to know it. Usually is placed at the end of questions as mark fillers or in multi-choice.

T Ledgers and Balancing

Last time we talked about debits and credits if you missed that click here

Each transaction must have a debit and credit entry, remember that first transaction for the purchase of a motor vehicle by cash? Let's say that cost $500 then we would debit motor vehicles by $500 and credit cash by $500. Have a look below.
See? Two entries for every transaction. Obviously in an actual business there would be many many accounts, and more complex transactions. But once you understand this basic concept you're well on your way.

At the end of each month the accounts will have to be balanced. To do this simply follow these steps:

1. add up both sides of the accounts
2. place the larger total on the bottom of each side
3. on the smaller side, add a new entry - "balance c/d" with the amount that makes up the total.
   
4. Bring the balance down to the new side and call it "balance b/d"
   

Reading it in words is quite difficult the first time. Check it out in action!

Simple as that! Next time we will be looking at how this all fits together in a business through the use of a trial balance!

Duality and Double Entry System

This is based on the system of duality (which is also an accounting concept, more on that later). Every transaction must have 2 entries into the accounts.

All transactions are divided into different categories.

Assets + Expenses + Drawings = Liabilities + Capital + Revenue

An increase in the categories on left side of the equation i.e. Assets, Expenses and Drawings means a debit entry (Dr).

An increase in the categories on the right side of the equation i.e. Liabilities, Capital and Revenue means a credit entry (Cr)

It's as simple as that Dr for the left; Cr for the right. If it is a decrease in any of the categories it is simply the opposite e.g. decrease in assets will lead to a credit entry in the asset account.

Every transaction will have a debit entry and also a corresponding credit entry.

Let's take a look at some examples:


This last entry is a bit different from the others, the account involved is a sales returns which is contra account of sales. This means that this account is an account that decreases the sales balance. So why do we keep it separate and not just have the transaction in the sales account? Well its simple really, we want to be able to find out at the end of each period the amount that we sold and the amount that was returned. This helps management with their decisions.

Where to from now? Go look at the post on T-accounts, this shows the double entry system in action!

Assets and Liabilities

You here people talk about it all the time, but what exactly are assets and liabilities? 

Assets are things of value that provide future economic benefits. These benefits may mean that they can later be sold,  generate income etc. 

Liabilities are things that represent a present obligation and are most likely to result in an outflow of resources in the future. An example of such a resource may be cash. 

It is important to be able to distinguish between the two of them, the difference between them gives us the capital i.e. A-L = C 

Let's take a look at some examples:

1. Cash, contains intrinsic value and can later be exchanged for other resources perhaps. ASSET
2. Bank overdraft, arises when you spend over your available funds in your bank account. This creates an obligation which means that there is likely to be outflow of resources (money) at a later date. LIABILITY
3. Vehicle, despite many arguments that a vehicle is a liability from other areas of commerce, for accounting purposes we shall treat it as an ASSET as it will provide future economic benefits.
4. Loan on vehicle, now this is a LIABILITY, this presents a future obligation to pay.
5. Capital, money owed to the owner by the business e.g. the owner puts in money of his own to start the business, while this does present a present obligation. This is not considered a liability as it involves the owner of the business. Capital is in category of its own. 
6. Debtors or accounts receivable, people who owe the business money, arises through sales on credit. This is of future economic benefits to the business and is therefore an ASSET
7. Creditors or accounts payable, when we buy on credit, we have a present obligation to pay later- LIABILITY.

Quite simple isn't it? But it is important to be able to distinguish between the two so that entries in our accounting system are accurate. 

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Where is there a need?

Accounting refers to the system which businesses use to record their financial transactions. 

All businesses need to be able to record their transactions, this information is needed to report back to shareholders, bankers and other people who may have an interest in the business' performance. 

Besides from the obvious legal and tax requirements, accounting is also needed so that a business can accurately track its progress. With proper accounting procedures a business will even be able to tell if their staff is stealing from them!

Businesses can use accounting records to help compare their performance either within departments in the company, in different years or with different businesses. Information gained can then be used to make better business decisions in conjunction with other relevant information such as economics (see 101-economics.blogspot.com)

Because accounting records are objective and not subjective, they are more reliable than other sources of comparisons. 

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