You may be able to come up with this number by remembering each of the sales that you made during the day. Or, if you prepare invoices or sales receipts, you may be able to come up with this number by adding all the individual sales. If you have a cash register, you may also be able to come up with this number by looking at the cash register tape.
Other revenue and expense numbers get calculated in the same crude manner. The $1,000 of rent expense, for example, gets calculated by either remembering what amount you paid for rent or by looking in your checkbook register and finding the check that you wrote for rent.
The balance sheet values get produced in roughly the same way. You can deduce the cash balance of $1,000, for example, by looking at the checkbook or, in a worst-case scenario, the bank statement. You can deduce the inventory balance of $3,000 by adding the individual inventory item values. You can calculate the liability and owner’s equity amounts in similar fashion.
Some of the values shown in an income statement or on a balance sheet get plugged – meaning that they’re calculated by using other numbers from the financial statement. You don’t look up the profit amount in any particular place; instead, you calculate profit by subtracting expenses from revenue. You can also calculate balance sheet values such as total assets, owner’s equity, and total liabilities, of course.
Okay, I admit it: The fiddle-faddle method of accounting works reasonably well for a very small business as long as you have a good checkbook. So for a very small business, you may be able to get away with this crude, piecemeal approach to accounting.
Unfortunately, the fiddle-faddle method suffers the three horrible weaknesses for a firm that doesn’t have super-simple finances:
✓ It’s not systematic enough to be automated. Now, admittedly, you may not care that the fiddle-faddle approach isn’t systematic enough for automation. But this point is an important one: A systematic approach like double-entry bookkeeping can be automated, as you can do with QuickBooks. This automation means that the task of preparing financial statements requires – oh, I don’t know – maybe five mouse clicks. Because the fiddle-faddle approach can’t be automated, every time you want to produce financial statements, you or some poor co-worker must do an enormous amount of work to collect the numbers and all the raw data necessary to produce information like that shown in Table 2-1 and Table 2-2. In reality, of course, with more complicated financial statements, someone does much, much more work.
✓ It’s very easy to lose details. This sounds abstract, but let me give you a good, concrete example. If you look at Table 2-1, you see that the hot dog stand incurs only three operating expenses: rent, wages, and supplies. If you know the operating expense categories that the business incurs, it’s fairly easy to look through the check register and find the check or checks that pay rent, for example. You can use a similar approach with the wages and supplies expenses. But what if you also have an advertising expense category, a business license expense, or some other easy-to-forget category? If you forget a category, you miss expenses. If you forget that you spent money advertising and, thereby, forget to tally your advertising expenses, that whole category of operating expense gets omitted from your income statement.
✓ It doesn’t allow rigorous error checking. This business about error checking may seem to be nitpicky, but error checking is important with accounting and bookkeeping systems. With all the numbers and transactions floating around, errors easily creep into the system. I discuss error checking more later in this chapter, but let me give you an example of the sort of error checking an accounting system can (and should) perform. Take a look at the example of the sales transaction. If you sell an item for $1,000, you can actually check that amount by comparing it with your record of what the customer paid. This makes sense, right? If you sell me an item for $1,000, you should be able to compare that $1,000 sale with the amount of cash that I pay you. A $1,000 sale to me should correspond to a $1,000 cash payment from me. The fiddle-faddle method can’t make these comparisons, but double-entry bookkeeping can.
You see where I am now, right? I’ve admitted that you can construct financial statements by using the fiddle-faddle method. But I hope I’ve also convinced you that the fiddle-faddle method suffers some really debilitating weaknesses. I’m talking about something as important as how you can best manage the financial affairs of your business. These weaknesses indicate that you need a better tool. Specifically, you need double-entry bookkeeping, which I discuss next.
How Double-Entry Bookkeeping Works
After you conclude that the fiddle-faddle method is for the birds, you’re ready to absorb the necessary accounting theory and learn the bookkeeping tricks required to employ double-entry bookkeeping. Essentially, you need two things to work with double-entry bookkeeping: an understanding of the accounting model and a grasp of the mechanics of debits and credits. Neither of these things is difficult. If you flip ahead a few pages, you can see that I’m going to spend only a few pages talking about this material. How difficult can anything be that can be described in just a few pages? Not very, right?
The accounting model
Here’s the first thing to understand and internalize to use double-entry bookkeeping: Modern accounting uses an accounting model that says assets equal liabilities plus owner’s equity. The following formula expresses this in a more conventional, algebraic form:
assets = liabilities + owner’s equity
If you think about this for a moment and flip back to Table 2-2, you see that this formula summarizes the organization of a business’s balance sheet. Conceptually, the formula says that a business owns stuff and that the money or the funds for that stuff comes either from creditors (such as the bank or some vendor) or the owners (either in the form of original contributed capital or perhaps in reinvested profits). If you understand the balance sheet shown in Table 2-2 and discussed here, you understand the first core principle of double-entry bookkeeping. This isn’t that tough so far, is it?
Here’s the second thing to understand about the basic accounting model: Revenue increases owner’s equity, and expenses decrease owner’s equity. Think about that for a minute. That makes intuitive sense. If you receive $1,000 in cash from a customer, you have $1,000 more in the business. If you write a $1,000 check to pay a bill, you have $1,000 less in the business.
Another way to say the same thing is that profits clearly add to owner’s equity. Profits get reinvested in the business and boost owner’s equity. Profits are calculated as the difference between revenue and expenses. If revenue exceeds expenses, profits exist.
Let me review where I am so far in this discussion about the basic accounting model. The basic model says that assets equal liabilities plus owner’s equity. In other words, the total assets of a firm equal the total of its liabilities and owner’s equity. Furthermore, revenue increases owner’s equity, and expenses decrease owner’s equity.
At this point, you don’t have to intuitively understand the logic of the accounting model and the way that revenues and expenses plug into the owner’s equity of the model. If you do get it, that’s great but not necessary. But you do need to memorize or remember (for at least the next few paragraphs) the manner in which the basic model works.
Now I come to perhaps the most important point to understand to get double-entry bookkeeping. Every transaction and every economic event that occurs in the life of a firm produces two effects: an increase in some account shown in the balance sheet or income statement and a decrease in some account shown in the balance sheet or income statement. When something happens, economically speaking, that something affects at least two types of information shown in the financial statement. In the next few paragraphs, I give you some examples so you can really understand