1 Chapter 1: A way of viewing business

Reality leaves a lot to the imagination.

John Lennon

I hate cameras. They are so much more sure than I am about everything.

John Steinbeck

In this chapter, you will have the chance to ask yourself, what actually is accounting? Is accounting a game,

where we can just manipulate and move around accounting numbers to get the results we want? Or is

accounting perhaps about using a computer software package to manage a firm’s ‘accounts’, whatever that

might mean? You can google ‘Accounting software packages in Australia and NZ’ to find a long list of

packages people use, particularly in small to medium size businesses, such as MYOB (‘Mind Your Own

Business’), Xero, or Quicken/Quickbooks. Is this what accounting is about? Recording a whole lot of

transactions of a business, like a memory aid? At least such a task has been made easier with the use of

computers.

We will look at why and how aspects of the economic and business realities of firms are captured and recorded

into a firm’s accounts. Now a firm’s accounts are not themselves the economic and business realities of firms.

Accounting is also not like a corporate camera taking precise photos of what is going on. Rather, each firm

experiences its own economic and business realities quite independently of what gets recorded in its accounts.

But some aspects, or elements, of what is going on in a firm are recorded in its accounts in certain ways. We

will look at why these particular realities get captured and recorded in the way they do. Understanding this will

help us as we seek to learn how to use a firm’s accounts to engage with and connect to a firm’s economic and

business realities; that is, to know what is really going on in a business.

Accounting is supposed to help us connect to reality, to what is really actually going on in a firm; and in this

chapter we can start to ask ourselves whether or not we think accounting can really help us to do this. We will

look at some of the key ideas and concepts underlying the complex way we have developed of accounting for

business activities. And we will see that underlying accounting is a particular way of viewing business; a way of

imagining business. Accounting is, at the end of the day, a model. Not a fashion model, or a model plane, but a

business model. It is a model, or simplification, of each firm’s economic and business realities. It is an

abstraction of all the complex activities of a firm. If we are to consider whether we think accounting can help or

hinder us to better connect to what is really going on in a firm, we first need to understand the business model

underlying accounting; and to ask ourselves whether or not we think it is a powerful or useful way of viewing a

business. Before we do this, let us first look at what business reality is.

1.1 It is all about reality

First you must understand how numbers changed reality. Some people think numbers merely reflect reality... but

we believe that numbers create reality.

The Accountant Troll, teaching Dilbert how to be an accountant

Accounting is about using information to help us connect to the economic and business realities of a firm. It is

about understanding reality. Accounting is about understanding the realities of business: what is really going on

in a firm. Or is it? This is the question you will be able to reflect on in this chapter and throughout this book. It

is a key issue you will find you keep coming back to you as you develop your capacity to use and make sense of

accounting information. It is a great journey to go on; and a very important one for anyone with a serious

interest in business, whether working in, running or investing in businesses.

Business is a fascinating and wonderful world to work and live in. Business is about creating value: substantial,

real, actual value. Value is a word to describe things that matter to us, that we care about, that means something

to us. Business is about serving people’s real needs and desires, in a world and human society where we

constantly construct and develop and change our views of value, of what is important, of what we need, of

where we want to go in life, all the time. Business is where we can make a difference; and not just in our own

lives and in the lives of those close to us, but in the lives of many, many people (most of whom we may never

meet or know personally). As in all things in life, we can make a difference for the better, or for the worse.

In Australia, , New Zealand and the UKmany other countries of the world, a lot of economic and business

activity is conducted by people operating in firms that are interacting with other people and firms in markets; in

all sorts of markets. We are surrounded by markets everywhere, in which we are exchanging value between

each other. Indeed, firms are constantly creating and exchanging value with other firms and with individuals

through various markets: input markets (with suppliers and employees), product markets (with customers) and

in capital markets (with equity and debt investors). A firm also has interactions with government (through

taxation and a wide range of government regulations and services) and with the wider community. Now a firm

can create value, and it can also destroy value, through its business activities, just as we can in our personal

relationships and in our individual activities each day. Creating and or destroying value: this is the challenge

before us each day in business. How do we run our businesses to create value for ourselves and others, rather

than destroy value? How can we determine the value of businesses we might want to invest in, based on their

capacity to create value in the future? In this book you will have the opportunity to consider what the role

accounting might have to help, or perhaps hinder, us in creating value in business and in our investing activities.

There are people with accounting qualifications everywhere in business. About half of the directors of listed

companies in Australia and New Zealand have accounting backgrounds of some sort; as do about half of the

managing directors of these listed companies. For example, the managing director of Ryman Healthcare in New

Zealand (a company we will be looking at quite a bit in this book) is Simon Challies, a qualified chartered

accountant who was previously the chief financial officer of Ryman Healthcare. Also, the managing director of

Wesfarmers in Australia (which owns among other businesses Coles supermarkets) is Richard Goyder, who was

previously finance director of Wesfarmers.

One year recently I was at a Christmas function at a friend’s house. I had just submitted my PhD thesis on

accounting education the day before, and this was one of the topics of conversation during the party that day.

The then deputy prime minister of New Zealand was there (he was a ‘friend of my friend’) and he told me he

has an accounting degree (and also an Arts degree in English literature). As we discussed my PhD I could see he

fully understood the issues I was researching: how to support students studying accounting at university to not

just look at accounting numbers (such as ‘profit’) as being some sort of reality themselves but to see we use

accounting information to seek to engage with what is really going on in a business.

You see, something funny can easily happen as we study accounting and focus on ‘the numbers’. We can subtly

start to feel the numbers are the answer, rather than the business reality the numbers seek to represent. People

with accounting qualifications, and most importantly an understanding of how to use accounting to connect with

the economic and business realities of firms, are everywhere in business. I wonder why this might be?. Might

there be something important for me to connect to with the business discipline of accounting if I want to be

successful in business? Maybe, or maybe not. People have a range of views about this. These are questions you

can ask yourself as we have a look at accounting in this book.

A few years ago I was at a Christmas function at a friend’s house. I had submitted my PhD thesis on accounting

education the day before, and this was one of the topics of conversation during the party that day. The then

deputy prime minister of New Zealand was at the party and he told me he has an accounting degree (and also an

Arts degree in English literature). As we discussed my PhD I could see he fully understood the issues I was

researching: how to support students studying accounting at university to not just look at accounting numbers

(such as ‘profit’) as being some sort of ‘answer’ or reality themselves but to see we use accounting information

to seek to engage with what is really going on in a business. You see, something funny can easily happen as we

study accounting and focus on ‘the numbers’. We can subtly start to feel the numbers are the answer, rather than

the business reality the numbers seek to represent.

Firms can do many different things and be a range of different sizes. In fact, they seem to be all over the place in

terms of what they do and the types of businesses they are. Business reality for firms is a very diverse and fast-

moving world. This is the world accounting seeks to help us engage with and better understand. Firms can be

involved in providing services to customers, retailing products, or manufacturing products (that is, actually

making physical goods that they sell to their customers). In reality, many businesses can mix up in different

ways providing services, retailing products and manufacturing products. For example, a hairdresser may sell

hairdressing services and also sell hair products; a restaurant may sell meals it manufactures from raw

ingredients, as well as provide great table service and the experience of a great night out.

Businesses are everywhere

I am writing this chapter in Yeppoon, a small coastal town in Central Queensland near Rockhampton. I have

just had a short walk around the area, and businesses I saw include a dentist, Icon Dental Group, and right next

door The Coffee Club, a cafe with a great spot just near the beach. Nearby is Elders Real Estate, Yeppoon Car

Wash, Centrelink Yeppoon (a government agency providing social welfare payments) and Sullivan Nicolaides

Pathology (which provides medical services). There is also David Eaddy & Co (solicitors), Johnson & Tennent

(chartered accountants), CEADS (Capricorn Engineering & Drafting Services), Yeppoon Medical Centre, Betta

Electrical Yeppoon (electrical retailer), Marsden Tavern (retails alcohol and provides various entertainment

services), Young’s Coaches (the local bus company), Hill Street Pharmacy, Sandy’s Cafe, Subway, Rip Curl

(clothing & swimwear retailer), Betta Electrical Yeppoon (electrical retailer), Sleepzone (beds and bedding

retailer), Woody’s Foodworks Yeppoon (supermarket), Paintplace Yeppoon (paint retailer), Yeppoon Tattoo

Studio (tattoo services), Maggy’s cafe-bistro (makes great brunches on the weekend), Tanby Roses Florist

(retails flowers and manufactures flower arrangements), Tai Ho Indian Restaurant, and James Street Medical

Centre and Centrelink Yeppoon (a government agency providing social welfare payments).

Other businesses I saw were Dollars and Sense (discount variety store), Robert Harris & Co (solicitors), Sail Inn

Motel (sells accommodation services), Office National Express (retails office supplies), Happy Sun Chinese

Restaurant, S.M. Weston Optometrist (sells eye services and retails spectacles), Yeppoon Health & Fitness

Centre (gym services), Pacific Hotel, Wavelengths (hairdresser), Megalomania (bar and bistro), Jaques Coastal

Meats (butcher), Video Ezy, St Ursula’s College (a private school that sells education services), Maine Caravan

Park, Dollars and Sense (discount variety store), Wendy’s (ice cream/cafe), Coles (supermarket), Ian Weigh

Toyota (car dealer), Regals Dental (another dentist), Blue Dolphin Caravan Park, Shell (petrol station), Seaside

pools (builder of pools), AK Self Storage, Yeppoon Self Storage, Flexihire (equipment hire and sales), Wot A

Sign (sign makers, printer & website designer), Central Queensland Sailmakers (retails, installs and

manufactures yacht sails, shade sales, marine upholstery), Yeppoon Veterinary Surgery, Yeppoon Kitchens

(manufactures and installs kitchens), Hotondo Homes (house builder), Firewood2Furniture (manufactures

custom built timber furniture) and Trevor’s Trim & Upholstery (retails, installs and manufactures shade sales,

blinds, marine & household upholstery). I took a few photos of these businesses which are included in Figure 1-

1 b as Figure 1–1 below.

There were also many, many other businesses just a short walk from where I am living at Yeppoon. For

example, there are many hairdressers in Yeppoon besides Wavelengths, other butchers besides Jacques Coast

Meats and a number of gyms/fitness centres; although I did only see one tattoo parlour, Yeppoon Tattoo Studio..

There are businesses everywhere we look; everywhere. There are small businesses, and large businesses. There

are organisations run by government (such as Centrelink), and businesses owned by private people. Some

privately owned businesses are run and owned by one or two people (such as S.M. Weston Optometrist), others

are large businesses owned by thousands of shareholders and with large numbers of staff (such as Coles). Some

businesses provide services (such as CEADS: Capricorn Engineering & Drafting Services); others are retailers

and sell products such as meat (Jacques Coastal Meats) or cars (Ian Weigh Toyota); and others are

manufacturers and make various goods (such as Firewood2Furniture, maker of custom built timber furniture).

All these businesses which I saw on my short walk around Yeppoon would keep accounts. That is right; every

single one of them. Why would they do this? They would employ accountants. Some might have whole

departments of accountants (such as Coles and Centrelink) and others (such as smaller firms like Hill Street

PharmacyMarsden Tavern or Sandy’s Cafe) might employ the services of an external accountant, either a part-

time accountant who might come in say a few days a month, or the services of an accounting firm (such as

perhaps Johnson & Tennent, chartered accountants in Yeppoon). The owners of these businesses would also

spend quite a bit of time ‘keeping the books’ themselves, no doubt, recording transactions of their firms in their

accounts. If you were currently running, or were an owner, or was thinking of purchasing any of these

businesses you would find various accounting information coming your way. What would you do with this

accounting information? What would this accounting information look like and what would it be for? And what

sense do you think you could possibly make of it?

Types of businesses

Besides doing a wide range of activities, which we can broadly think of as service, retail or manufacturing,

businesses can also be organised in different ways. A small business with just one owner, who also runs the

business, may be organised as a sole trader that has no separate legal status apart from its owner (for example,

Tanby Roses Florist may use this structure). Most businesses in Australia and New Zealand (and in most

countries of the world) are small businesses run as sole traders. Where there is more than one owner the

business may be run as a partnership (such as perhaps David Eaddy & Co, solicitors). These groups of owners

pool their resources and share in the firm’s profits and losses. The relationship between the owners (called

partners) is usually set out in a partnership agreement. This helps make the relationship between the partners

clear.

Figure 4-1: Some businesses in Yeppoon, Queensland

Figure 1–1: Some businesses in Yeppoon, Queensland

Types of businesses

Besides doing a wide range of activities, which we can broadly think of as service, retail or manufacturing,

businesses can also be organised in different ways. A small business with just one owner, who also runs the

business, may be organised as a sole trader that has no separate legal status apart from its owner (for example,

Tanby Roses Florist). Most businesses in Australia and New Zealand (and in most countries of the world) are

small businesses run as sole traders. Where there is more than one owner the business may be run as a

partnership (such as David Eaddy & Co, solicitors). These groups of owners pool their resources and share in

the firm’s profits and losses. The relationship between the owners (called partners) is usually set out in a

partnership agreement. This helps make the relationship between the partners clear.

As those of us who may have gone flatting with others know, disputes and problems can arise between flatmates

as we live together. It is the same with a business. Once there is more than one owner, disputes and problems

can arise between the owners. It is for this reason there is usually a written partnership agreement to help the

partners sort out disputes they might have over time. Businesses can also be organised as a company. Unlike

sole traders and partnerships, companies are their own separate legal entity, separate to the owners, and have to

comply with the Corporations Act in Australia. Coles is a company with more than 100,000 employees and over

11 million customer transactions each week. It is wholly owned by a large Australian listed company,

Wesfarmers Ltd (you can click on the link to see how Coles fits into Wesfarmers).

Businesses can also be organised as a trust. A trust is a relationship where a trustee (which can be a person or a

company, but not a partnership) carries on a business for the benefit of certain beneficiaries (people who will

benefit from the business and who are its effective owners). Trusts would have a trust deed which sets out the

relationship between the beneficiaries and also with the trustee. Now a trust can only conduct business through a

trustee. It is very likely that some of the businesses I saw as I walked around Yeppoon have a trust somewhere

in their ownership structure.

In this book, we are not interested in learningconsidering how to prepare accounting information. That is

something accountants do. We want to learn about how we can use accounting information may or may not be

useful to help us better understand the economic and business realities of firms. So how can accounting help us

do this? Can accounting make it easier, or more difficult, to engage with and understand what is really going on

in a firm? This is a question you can ask yourself while you read this book. As you think about and study the

essentials of what accounting is, think about this question. There are many people in business and in our capital

markets who have a range of opinions about this.

Along with this book, you will be using a spreadsheet designed to support you to analyse your own listed

company. As you we have the chance to experience for yourself ourselves what it is like to use accounting

information to help you us make sense of and understand what is really going on in your firm, you we can start

to form your own judgements and opinions about the role of accounting in business; and in particular, whether

accounting information can help, or perhaps hinder, us to better engage with and understand what is really going

on in a firm. In this section, we have seen that business reality is all around us, including even in Yeppoon,

Queensland. Indeed, there are a lot of businesses everywhere we look. We have seen that accounting is

supposed to, but possibly may or may not, help us connect to and better understand this reality. In the next

section, we will see that accounting starts with keeping records about what is going on in a firm.

1.2 Keeping records

You have to know accounting. It’s the language of practical business life. It was a very useful thing to deliver to

civilization. I’ve heard it came to civilization through Venice which of course was once the great commercial

power in the Mediterranean. However, double entry bookkeeping was a hell of an invention.

Charlie Munger

In this section we will discuss the importance and necessity of first recording things a firm does, and in

particular its transactions with various parties, before a firm’s accounts can be of any use to anyone. Basically,

unless things a firm does are first recorded and included in a firm’s accounting system in some way, then a

firm’s accounts can give us no guidance or help in understanding its economic and business realities. A range of

different people have genuine interests in the operations of firms. These might include managers of a firm,

equity investors, debt investors, employees, customers, suppliers, the government and the general community.

Also, firms can be commercial enterprises, not for profit entities or public sector entities. What we will look at

about accounting can apply to any type of firm, although we will focus on commercial enterprises. Regardless

of the type of firm, or who might have a genuine interest in understanding and gaining insights into the

economic and business realities of a firm, the question we can reflect on is whether a firm’s accounts may help

or perhaps hinder us in gaining these insights.

Luca Pacioli

In the first instance, a firm’s accounts come from the transactions and other economic events someone has

recorded in a firm’s accounting system. A way of recording these transactions has developed over a long period

of time. It is called double-entry bookkeeping or double-entry accounting. Luca Pacioli (c. 1445–1517)

(pronounced pot-CHEE-oh-lee), an Italian mathematician and Franciscan monk, published the Summa de

arithmetica, geometrica, proportioni et proportionalita in 1494. It iwas a summary of the mathematical

knowledge of the time (which we see today as quite elementary arithmetic, geometry and algebra) and included

bookkeeping as one of five topics covered. Its section on bookkeeping is the first published book describing

double-entry accounting, a method of accounting that was being used by merchants in Venice during the Italian

Renaissance. His system included most of the aspects of accounting as we know it today.

Although Luca Pacioli is usually referred to as the ‘Father of Accounting’ he did not invent the system of

double-entry accounting. He was simply the first to describe it in a published book. Double-entry accounting

has probably been going on much earlier than Luca Pacioli’s time in the late 15th century. For example, ‘the

partners Francesco di Marco da Prata and Domenica di Cambio drew up a detailed statement of assets and

liabilities on August 30, 1389, quite in the modern manner’ (Foulke, 1968, p. 4). Why did accounting for a

firm’s economic and business realities develop in the way it did? Surely it would have been easier to simply

enter in transactions once rather than twice as occurs in double-entry accounting. Why make it so hard on

ourselves? Also, as we will see in Section 1.3 below, once a transaction is entered in twice they are then re-

entered again and manipulated in various ways. At first sight, this seems like a lot double handling. At second

and third look, it also seems like a lot of double handling.

We build on the past

History unfolds itself by strange and unpredictable paths. We have little control over the future; and none at all

over the past.

Winston Churchill

When we are present in each moment, the past gently rolls up behind us and the future slowly unravels before us.

Richard Levy

To understand how accounting is the way it is we need to remember we were not born into a world with a big

blank page in front of us. Many, many people have lived before us. The first civilizations of people sprung up in

a number of parts of the world about 5,500 years ago. Our societies, our cultures, the ‘way-we-do-things’ have

developed over many generations, with each generation starting with what the previous generation had left it

with. Our generation is no different.

One of the things I enjoy greatly is playing musical instruments, especially the piano. I would play the piano

most days and would play for hours every day, given the chance. When I went to university, PCs were only just

starting to make an appearance; typewriters were still everywhere. In my first year at university I quickly

discovered that in my Law degree I needed to hand in a lot of typed assignments. This would involve me paying

someone to type my assignments for me. It also meant I had to complete my assignments a few days before the

deadline to give my typist time to type them. So over the summer holidays at the end of my first year at

university I taught myself to touch-type. It took me 8 hours followed by a lot of practice. This was the most

valuable and useful 8 hours I have ever spent in my life (and the most boring).

Because I had played musical instruments over the years, and in particular the piano, the flexibility of my

fingers was very good. All I needed to do was memorise where the keys were on the keyboard and practice it a

bit so I could type accurately, and I was away. I found I could quickly type as fast as I could write, so I could

hand in my Law assignments without paying for a typist and I also did not need to have them written a few days

in advance of deadlines. But as I learnt how to type I quickly realised the keys for the letters often used together

in words in English were a long way apart from each other on the keyboard. This actually makes typing more

difficult and less intuitive. The layout of the keyboard did not seem to make any sense to me at all. It seemed to

me it would be a lot easier to type if the letters commonly used together in words were near each other rather

than a long way apart on the keyboard. And, in fact, it would.

So what gives? Why is the keyboard on our computer designed the way it is? The reason is that the keyboard we

use with our computers was first designed for typewriters. The most common English keyboard layout is called

QWERTY. Have a look sometime at the first six letters on your keyboard’s top first row of letters and you will

see why it is called QWERTY. Christopher Sholes invented this keyboard in the 1860s and it first appeared in

Remington typewriters in 1874. Christopher Sholes was a newspaper editor who lived in Milwaukee, Wisconsin

(just north of Chicago) in the US. He first set up the keys on his typewriters in alphabetical order. The second

row of letters on the keyboard (namely, ASDFGHJKL) seems to be a remnant of Christopher Sholes’ first

alphabetical layout that he replaced with the QWERTY layout.

Now typewriters had a ribbon of ink onto which individual letters in raised metal at the end of an arm were hit

in sequence. Christopher Sholes noticed that as the operators of his typewriters started typing faster the metal

arms that held each letter and which struck the paper started to hit each other and get tangled up. He found that

typing worked much better if the arms of the letters that were commonly used together in words were well apart.

Otherwise, the arms could tend to get caught up with each other as they moved onto and off the ribbon. You

have probably noticed that computers do not have these metal arms moving up and down as we type on our

computers. So why do we use the keyboard with our computers that was designed for use with typewriters? The

reason is simple. It would be very difficult to retrain everyone in the world who can already type to type in a

different way, compared to the reasonably limited benefits for people who cannot type yet to make it easier for

them to learn to touch-type in the first place.

Interestingly, one consequence of the QWERTY layout of our keyboards is that many more words in English

can be typed using only our left-hand compared to only using our right-hand. Indeed, thousands of words can be

typed in English using only the left-hand. With the arrival of the mouse with our computers this can actually

work quite well for many of us, with our right-hand usually using the mouse and our left-hand being the main

hand we can then type with. In any case, as we all possibly move to voice recognition software over the next

decade, this whole task of ‘typing’ may well disappear into the world of the quaint, unfamiliar past. If this

occurs, then Christopher Sholes’ invention of the English keyboard would have gone through its lifecycle in

about 150 years. Indeed, the only thing remaining may end up being an asteroid called ‘660 Qwerty’ powering

around our solar system, which has been named in honour of our humble keyboard.

It is the same with some terms we use in our word processing on computers, such as ‘cut and paste’ when we

delete something from one part of our document and put it somewhere else. When things were done on paper

we literally cut out a piece of text and pasted it with glue or sticky tape onto another part of our document. This

is the same with double-entry accounting. The process belongs to the world of the past. Yet we are caught up in

that past and it constrains and leads us forwards as we participate in the digital age. So today computers do a lot

of the steps of double-entry accounting for us. But we need to understand how these things work because our

whole accounting system is built on these ideas. If there is nothing else you remember from reading this chapter,

you should remember that ideas are powerful. If we had computers to keep the records of businesses a thousand

years ago we may well have gone about it accounting very differently, perhaps using quite different ideas. But

we did not.

As we will see later, the key thing to remember about double-entry accounting is that it is a system of recording

transactions of a firm in such a way as to ensure the relationship between the different elements of the business

model that underpins accounting is kept intact. Accounting is based on a particular model or way of looking at

business. It is a powerful way of looking at a firm’s economic and business realities. We will look at this

business model in Sections 1.3 and 1.4 below. A deep understanding by us of this way of looking at business

could transform challenge the way we view business reality from a perception of business based on commonly-

held misconceptions about how business works to a view based on a deep understanding of the powerful ideas

and concepts of accounting. These ideas pervade the way accounting is carried out. These ideas were developed

from a time way before computers, before the printing press, indeed when quills and paper were ‘hi-tech’.

Bookkeeping without books

With the growing availability of computers since the 1960s, progressively firms’ accounts have moved into a

digital form. Various accounting software packages have been developed, sometimes tailored to the specific

needs of a firm; other times, firms use general packages that they can adapt and use for their own purposes.

Some commonly used general accounting software packages that many small to medium size firms use in

Australia and New Zealand (and, indeed, in many other countries) are MYOB (‘Mind Your Own Business’),

Xero and Quicken/Quickbooks. Other accounting software packages have names such as Pastel, emPOWER,

Sage, SoEasy, Cashbook and MoneyWorks. Spreadsheet packages such as Excel are also widely used to record

and manipulate and manage data. In my own private equity business I managed the bookkeeping of the firm

myself for a number of years using MYOB. It was a straightforward process. I often recorded transactions on

the day they occurred or at the end of the week on a Friday or Saturday afternoon. As the business had only a

small number of transactions, it was easy to manage the bookkeeping myself. I then used a firm of accountants

to complete my firm’s financial statements and tax returns based on the information captured in the accounting

package. Slightly larger businesses may often employ someone to complete the bookkeeping each week or each

month on a part-time basis. Larger firms will often usually employ full-time staff to enter data and to ensure the

bookkeeping processes are being correctly followed.

The first decade of the 21st century is often called the ‘digital decade’. Quite quickly everything was converted

to digital formats that are readily able to be communicated between computers anywhere in the world though a

growing web of wireless and cable interconnections. In almost all cases, except perhaps for a few small

businesses, everyone’s accounting record-keeping or bookkeeping is being done digitally or electronically. So

the ‘books’ of the past have gone. Bookkeeping is now almost always done without any ‘books’. Bookkeeping

is now a redundant word; it would be better called ‘record keeping’, or even better ‘capturing what is going on’.

We have seen that the systematic recording of transactions and economic events of a firm (which we call

bookkeeping even though the paper books have largely disappeared and been digitised) is essential to

accounting. Without it there would be no record of the economic and business activities of a firm in a firm’s

accounting system. We have also seen that the way these activities of firms are recorded by way of double-entry

accounting is an historical ‘accident’. It made sense in the days of quills and paper. Yet it frames the way we

record transactions today. And more importantly, the whole way of looking at business, that is the business

model, underpinning accounting remains the same in our digital age. This way of looking at business, which we

will look at in the rest of this chapter, has proved to be a powerful way of looking at the economic and business

realities of firms for many years. You may possibly find it a powerful way for you to look at business as well. In

studying accounting there are a few key things we need to understand. We will now look at some of these in the

next section.

1.3 Two sides to everything

There is a great difference between knowing and understanding: you can know a lot about something and not

really understand it.

Charles F. Kettering

There are a few key ideas underlying accounting that you need to understand. You do not need to simply

memorise them and be able to reproduce them (perhaps in an exam at university) and then forget about them.

You actually need to understand them. You need to personally engage and connect with these ideas. You need

to connect these key ideas about business that underpin accounting with your prior knowledge and previous

experience. In other words, these are ideas and concepts you need to make sense of for yourself. No-one else

can do this for you; you have to do it for yourself. This section is designed to support you in dointo dog this.

Take the time to reflect on the ideas and concepts discussed in this section. Think about them and search for

what they mean to you. In fact, these ideas and concepts could potentially transform the way you look at what

business is all about. As we start to do this, let us first look at journals and ledgers which are the key ‘building-

blocks’ of accounting.

Journals and ledgers

Accounting uses two types of books: journals and ledgers. A journal contains the daily transactions of a firm,

such as its sales to customers, purchases from suppliers and many other types of transactions and economic

events of a firm that keep happening in a constant stream each day. These are entered into a firm’s journals as

they occur each day. The English word journal comes from the French word ‘jour’ (or day) which was derived

from the original Latin word diurnalis, meaning daily. Also, the word ‘journalist’ has been used for those who

write for newspapers since the late 1600s, referring originally to those who wrote for newspapers which were

published daily.

In my teens I worked as a copy boy at the Sydney Morning Herald, a major daily newspaper in Sydney. A copy

boy was essentially an internal messenger within the offices of the newspaper, taking photos and pieces of paper

(‘copy’) from one part of the office to another. At the time I was thinking about perhaps becoming a journalist.

However, I was struck at how journalists started each day with a blank piece of paper and had to write stories

and meet strict deadlines every day. This seemed like a most demanding life. I eventually decided on a career in

investment banking instead of journalism.

So the journal is a great long list of transactions recorded as they occur each day. The ledger contains these

same transactions but arranged not in the order in which they occur each day but in individual accounts, being

such as various types of assets, liabilities, equity, revenue and expenses. The word ledger means something that

lies down or is laid down, having been adapted from the Dutch word logger. It originally referred to a book that

usually stayed in one place because it was heavy and difficult to move and was also constantly being used. So a

ledger basically means a book lying permanently in one place. The ledgers are at the heart of a firm’s

accounting system. It is where a firm’s key accounting information lies. In this sense, ledger now refers to the

data that lies permanently in one place in our computer.

The bookkeeper (or accounting clerk) enters a firm’s transactions into the journals, transfers them (or posts

them) to the ledgers (which is usually done automatically by computers these days) and looks after a firm’s

financial records or ‘books’ up to the trial balance stage. The trial balance is a worksheet where the balances of

each of the ledgers (one for each account) are listed in two columns (debits and credits). The total of each

column in the trial balance should be the same (or, in other words, should balance). It is called a trial balance

because it is a tool to help detect errors in the accounts: a ‘trial’ or ‘initial’ attempt to balance the accounts in the

ledger and this gives us an opportunity to fix up any errors that have caused the various ledger accounts to not

balance. However, there are many potential data entry errors in the accounts that would not be picked up by a

trial balance: for example, simply transposing (or swapping) a debit and credit entry for a transaction or posting

a journal entry to the wrong ledger account.

The bookkeeper (or accounting clerk) brings the books to the trial balance stage. An accountant would prepare

the financial statements using the trial balance and ledgers prepared by the bookkeeper. In the days when

bookkeeping involved physical paper books, transactions were first entered into the journal and then carefully

posted (or transferred) into the ledger. With the widespread use of computers, transactions are now entered only

once and they are automatically (and digitally) posted in the various accounts in a firm’s ledger. Indeed, the

words ‘journal’ and ‘ledger’ are being used less and less as we no longer see bookkeeping as involving keeping

a daily journal or journals of various transactions and a separate series of accounts for a range of different

aspects of a firm’s business. We are now recording transactions digitally into a series of accounts and we can

look at this ‘raw data’ in all sorts of different ways. HoweverNevertheless, financial records are entered into a

firm’s’ accounts based on a number of key ideas and concepts (including the ideas of journals and ledgers) that

influence the way we view these transactions and thus the economic and business realities of the firms they

represent.

Proprietorship

In accounting, not only do we record the same transaction twice into two different types of ‘books’; that is, first

into the journal and then into the ledger. Also, and much more importantly, we recognise that every transaction

of a firm has a dual aspect, just as a coin has two sides (heads and tails) or there are two sides to a piece of paper

or, usually, two sides to any argument. The key idea underlying double-entry accounting is an awareness of a

proprietor or owner of a firm who is separate and distinct from the firm itself. This is the entity concept in

accounting where the economic and business activities of a firm are kept completely separate from those of the

firm’s owners. Indeed, Subsequently, this idea has been reflected in our legal system as we have created the idea

of companies that have a separate legal identity and existence to that of their owners. However, this entity

concept in accounting applies to any type of firm (including sole traders and partnerships) regardless of whether

the particular type of firm involved has a separate legal identity from its owners or not.

The realisation that a firm can be seen to be separate from the proprietors or owners of a firm introduces a

duality (or a ‘two-sided’ nature) to all transactions of a firm. This is because all transactions involving a firm

will affect not only the firm itself but also the wealth or interests of the firm’s proprietors or owners as well.

This is true of each and every transaction or economic event affecting a firm. That’s right, every single one.

Double-entry accounting simply reflects this view or way of looking at business reality. As we will see, for

every transaction of a firm there will always be two opposite and equal components: the heads and tails of every

transaction, if you like. These two sides or aspects to every transaction are called debits and credits.

The word ‘debit’ comes from the Latin word ‘debere’ which means ‘to owe’. Indeed, the related Latin word

‘debitum’ means ‘debt’. The word ‘credit’ comes from the Latin word ‘credere’ which means ‘to believe’ or ‘to

entrust’. The practice has developed to put debits on the left-hand side and credits on the right-hand side of a

ledger account. For all their capacity today, computers still have no idea about their left or right. For this reason,

computers use positive numbers for debits and negative numbers for credits. So as we include items in our

various ledger accounts we do not refer to increasing or decreasing an account. Rather, we refer to ‘debiting’ or

‘crediting’ an account which will each result in either increases or decreases in accounts depending on the type

of account being debited or credited.

The underlying duality of transactions as a result of the proprietorship or entity concept can be seen when we

debit an asset account to record an increase in the an asset of a firm. We debit the an asset account because

when a firm receives an asset it owes an obligation to its equity owners to manage that asset well and provide a

return on it for their benefit. This is a firm’s obligation to its owners. It is what it ‘owes’ its equity owners.

There is the sense that a firm is obligated to its owners for its assets which it must have gained from them. Also,

when we increase either an equity or liability account we credit the equity or liability account. We do this

because equity investors (or in the case of liabilities, debt investors) have entrusted a firm with something of

value to them. They have only done this because they believe in the firm.

Trust underpins all of business. We saw the importance of this in the global financial crisis (GFC) in 2008.

When banks stopped trusting each other because they could not assess the risks in each other’s businesses they

stopped lending to each other. As a result, the whole financial and economic system seriously faltered affecting

billions of people world-wide (including you and me). Double entry accounting is based on the mutual

obligations that arise exist between a firm and those who entrust resources to the firm other parties (principally

its equity owners) with which it transacts. In this way, each transaction has two-sides to it, a duality, a balance;

indeed, a trust relationship that underpins all of business. For trust to exist in business we need someone to trust,

who will be obligated to us in equal measure to our trust. Trust is not unlimited in business. We need a degree of

trust but within careful limits. An effect of this duality of all transactions will be that there will always be an

equilibrium or balance between these two aspects of debits and credits of every transaction or economic event of

a firm.

Accounting equation

The idea that the equity owners of firms are separate to the firm itself is expressed in the fundamental

accounting equation that we will see underpins all accounting:

Equity = Assets - Liabilities

What this relationship means is that if the assets of a firm are increased then the equity interests of the owners of

a firm are also increased; and if the liabilities of a firm are increased, the equity interests of the owners of a firm

are reduced. Or more precisely, if the difference between a firm’s assets and liabilities are increased then the

equity interests of the owners of a firm are increased; and if they are decreased, the equity interests of the

owners of a firm are decreased. This is simply a model or way of viewing the world of business. It is a

simplification of all the complexity and diversity of business.

This fundamental accounting equation is often expressed as:

Assets = Equity + Liabilities

The idea of proprietorship and of a firm being a separate entity to its owners leads to all transactions of a firm

having two aspects to them. This duality has the effect of preserving the fundamental accounting equation

throughout a firm’s accounts. The way of looking at transactions or other economic events of firms is consistent

with the business model (or way of viewing business reality) embedded in the discipline of accounting. This

business model is neatly summarised and expressed as the fundamental accounting equation. In this way, as we

record transactions and other economic events in the accounts of a firm each will fit neatly into and support our

overall business model or view of the firm.

Double-entry accounting is not a method simply designed as a check on the mechanical accuracy of the entry of

transactions into a firm’s accounts. That is a commonly-held misconception about accounting. Rather, the

ability to use the fact that the debits and credits of a firm’s transactions should always balance to check the

accuracy of data entry into a firm’s accounts is a by-product of double-entry accounting, not the reason for it.

Instead, double-entry accounting is a way of looking at business. As it has turned out it is a very powerful way

of looking at business reality. This is why the ideas and concepts of accounting have become so pervasive and

central to the way we understand business for centuries, right up to in the 21st century. And though you may not

yet know this, it is the reason why you are finding yourself studying accounting (and reading this book) today.

We can see that, at its heart, double entry accounting is a way of looking at business. It is a way of perceiving

and making sense of the economic and business realities of firms. A key idea underlying this view of business is

that the owners of a firm are completely distinct and separate from the firm they own. This means a firm is

‘debited’ with assets because it owes an obligation to its equity investors for all the assets it controls and which

are the means of generating future value to repay that obligation. It also means a firm is ‘credited’ with equity

and liabilities because someone outside the firm has entrusted the firm with resources, believing trusted or

believed the firm will repay them in the future.

In this section we have seen there are two key ‘books’ in accounting, namely journals and ledgers; and that in

our digital age these two separate sets of books rarely exist. We have also seen the key ideas of proprietorship

and of the fundamental accounting equation that together underpin accounting. These central ideas of

accounting reflect a way of viewing the economic and business realities of firms. In turn, this view of reality

underpins the way transactions are recorded in a firm’s accounts. Accounting records and measures the

economic and business realities of a firm in a way that reflects a particular view of business. It is a powerful

way of viewing business but is not the only way we can view business. Understanding accounting can be a

powerful way to transform the way we actually see and think about the day-to-day realities of business. This is

possibly why so many people who end up running our businesses as chief executive officers, as other senior

managers or as directors know at least something about accounting.

1.4 Five elements of accounting

It is a little known fact that truth cannot be memorised.

Barry Long

The key ideas underlying accounting of proprietorship and the entity concept of a firm leads us to view a firm as

having five key elements: Assets, Liabilities, Equity, Revenue and Expenses. Assets are those aspects of a firm

we expect will provide future economic benefits to a firm; that is we expect will add value to a firm in the

future. For example, Coffee Supreme (a coffee business based in Wellington in New Zealand with operations

throughout New Zealand and in Melbourne, Australia) owns a number of small silver delivery vans. These

delivery vans are assets because they are expected to provide future economic benefits to Coffee Supreme by

transporting its products to customers (who are mainly coffee shops) in the future.

Liabilities are those aspects of a firm we expect will use up future economic benefits of a firm; that is we expect

will take away value from a firm in the future. For example, Coffee Supreme may have promised to pay

$50,000 in two months to a firm in Brazil that has recently supplied it with raw coffee beans. This is a liability

because we expect this will involve using up future economic benefits of Coffee Supreme, with $50,000 moving

out of Coffee Supreme’s bank account in two months.

Equity is often referred to as a ‘left over’ concept: what is ‘left over’ for the owners of a firm after liabilities are

deducted from assets. This view of Equity does miss the point somewhat. The concept of Equity is grounded in

the concept of proprietorship and of a firm being a separate entity to its owners. It is the ‘other side of the coin’

to a firm’s assets and liabilities. Assets and liabilities represent the value of a firm. Equity represents the value

of the interest of its owners in the firm. Based on our view of business reality underlying accounting, Equity

will always equal Assets less Liabilities as summarised and expressed in our fundamental accounting equation.

But Equity is not in essence a residual item. Equity has its own conceptual ‘reality’ in our view of the economic

and business realities of a firm that informs the discipline of accounting. It is because Equity does have its own

separate conceptual ‘reality’ in the way we view business in accounting that all transactions of a firm

conceptually have a dual nature, affecting both its equity and also its assets and liabilities.

Measure of value

Assets, Liabilities and Equity are the three elements that provide a measure of the value of a firm and of the

interests of its equity owners, or in other words the financial position of a firm (and of its equity owners) at a

given point in time. Value is a central concept in all of our lives and we have a wide range of opinions and

views about what is important, or valuable, or worthwhile in life. So accounting enters right into this issue of

what we value in business. Indeed, accounting seeks to put a precise dollar figure on the value of a firm; or at

least to give us information to help us make our own estimates or judgements of value. This is useful in business

(well, actually essential) because we all firms transact with others people in markets using dollars to measure

the value being exchanged.

Firms transact in product markets with customers, in input markets with suppliers and in capital markets with

equity and debt investors. All exchanges of value between a firm and other participants in these markets are

made in precise dollar terms. For this reason, quantifying value into hard, harsh monetary terms is unavoidable

in our market-based economy. If nothing else, it focuses our minds sharply on what is of value in our lives, and

in particular in our business lives and experiences. The view of the value of a firm in a firm’s accounts is built

up from each and every one of the transactions recorded in its accounts. This is where the value of a firm as

expressed in its assets and liabilities (and also the value of the interests of a firm’s equity investors as expressed

in its equity) come from. They do not come from anywhere else.

Changes in value

A firm’s value is changing day-by-day and moment-by-moment as a result of its business activities and of

changes in the markets in which it operates and in the world around it. As anyone who has been involved in

business knows, firms never stay still. Business is always ‘on the move’. The realities of business are always

shifting and changing and affecting the value of a firm (and the value of the interests of its equity investors) at

different points in time. It is just the same as in life. Life is dynamic, ever-changing. Nothing ever stands still,

just as we take in each breath. Life is ‘on the move’. It does not stand still for us. We quickly, quickly ‘get old’.

We just do not realise this when we are young. We can almost think the world ‘stands still’ for us in the moment

of time in which we find ourselves.

We can think our lives, our world, will go on forever just as it is. But it does not. Neither does business. The

value of a firm, as expressed and measured by a firm’s assets and liabilities, is not standing still. It is constantly

‘on the move’ and changing. In the dual nature of our view of business reality, the value of the interests of

equity investors in a firm is also constantly changing. Indeed, the two are inextricably linked: the value of a firm

and the value of the interests of equity investors in a firm.

Revenue and expenses

Now we come to something important about the way we view business reality in accounting. We usually do not

keep adjusting our firm’s equity day-by-day or moment-by-moment for changes in the value of a firm. Instead,

what we do is have temporary accounts of Revenue and Expenses to hold the various additions or reductions in

our equity. Every so often, perhaps monthly, six-monthly or yearly, we empty out these temporary Revenue and

Expense accounts and calculate the net effect of our firm’s transactions for a period on the value of the interests

of our equity investors in a firm. We call this a firm’s ‘profit’ if there is an increase in value and a ‘loss’ if there

is a decrease in value. We then transfer this profit or loss to a firm’s equity at the end of a period. We then start

the next period with zero amounts in our Revenue and Expenses accounts.

Revenue are additions to equity as a result of increases to assets or reductions in liabilities of a firm, (but not

except those changes to assets and liabilities that relate to transactions between a firm and its equity owners).

For example, revenue would include sales by Coffee Supreme of fresh roasted coffee to Chocolate Dayz Cafe, a

café at Days Bay on Wellington harbour in New Zealand. If Chocolate Dayz Café paid for this coffee in cash

then this would increase an asset (that is, cash) of Coffee Supreme by the same amount. Revenue would not

include an increase in cash (an asset) if shareholders in Coffee Supreme paid cash to the company to buy new

shares in the company. Rather, in such a case equity would be changed immediately.

Expenses are reductions to equity as a result of decreases to assets or increases in liabilities of a firm (but not ,

except those changes to assets and liabilities relating to transactions between a firm and its equity owners). For

example, expenses would include the cost of electricity used to power the coffee grinders and roasters in Coffee

Supreme’s manufacturing operations in Hopper Street, Wellington. Expenses would not include a reduction in

cash (an asset) as a result of Coffee Supreme paying a dividend to its shareholders.

Revenue and Expenses relate to something the firm has done to create or destroy value during a period of time.

The reason we do not include transactions between a firm and its equity owners as revenue or expenses is

because these transactions transfer value between the equity investors and the firm; they do not create or

destroy value for equity investors. For example, if equity investors buy new shares in a company then they will

pay the firm some cash (increasing the value of the interests of equity owners in the firm; but reducing their own

personal cash by the same amount); or if a company pays its equity investors a dividend on their shares then the

firm will pay some cash to its equity investors (decreasing the value of the interests of equity owners in the firm;

and increasing their personal cash by the same amount).

As a general rule, you cannot create value by simply moving things around from one pocket to the next; life,

and business, is meant to be easy, but not that easy. Revenue increases the value of the interests of our equity

investors in a firm (that is, increases a firm’s equity) and expenses reduce the value of the interests of our equity

investors in a firm (that is, reduces a firm’s equity). If a firm’s revenue is greater than its expenses during a

period the firm has added (or, perhaps magically ‘created’) value for its equity investors. If a firm’s expenses

are greater than its revenue during a period, then the firm has reduced (or, perhaps less magically ‘destroyed’)

value for its equity investors.

Extended accounting equation

The relationship of the five elements of accounting can be viewed as:

Assets = Equity + (Revenue – Expenses) + Liabilities

Or (if we ‘add’ Expenses to each side)

Assets + Expenses = Equity + Revenue + Liabilities

This is often called the extended fundamental accounting equation because it includes changes in value over a

period (Revenue and Expenses) as well as measures of value at a point in time (Assets, Equity and Liabilities).

Understanding the extended fundamental accounting equation is essential to understanding what accounting is

about. It is also a necessary first step in our journey to beinging able to potentially use accounting information to

help us connect to the economic and business realities of firms. In this section, we have looked at the five

elements of accounting: Assets, Liabilities, Equity, Revenue and Expenses. These five elements or ideas

underpin the view of business that accounting can give us. Accounting captures those aspects of a firm that will

support this view of business reality. A key part of this view of reality are precise dollar measures of value at

particular points in time (Assets, Liabilities and Equity) and precise dollar measures of changes in value during

particular periods of time (Revenue and Expenses).

Conclusion

In this chapter we have seen that a firm’s accounts are not themselves the economic and business realities of

firms. Each firm experiences its own economic and business realities quite independently of what gets recorded

in its accounts. Accounting involves recording in a firm’s accounts some aspects of what is going on in a firm.

The way this is done has developed over many yearscenturies. Embedded in the approaches used in accounting

is a particular view of business reality. Over time this view of reality has proved to be a powerful one. It has

resulted in a profession of accounting that has an insatiable appetite for university graduates from around the

world, in many ways regardless of where we are in the economic cycle. It has also resulted in many of those in

senior management and board positions of firms having backgrounds in accounting.

These powerful ideas sit in behind and are the reason for the way we include in a firm’s accounts aspects of its a

firm’s economic and business realities in its accounts. This is what we have looked at in this chapter. It has been

perhaps your first introduction to these powerful ideas and ways of viewing business. In the next chapter, we

will see that when firms provide their accounting information to people generally outside their firm there are a

lot of rules with which they need to comply. Yes, a lot of rules. We will now have a look at understanding the

rules of this ‘game’ called accounting.

Questions

Question 1-1

Why do we have double-entry accounting? Why do we put in everything twice? Why not just once?

Question 1-2

For your firm, identify three Assets, three Liabilities and three items of Equity. Describe what each item means

to you (you may find some footnotes in your firm’s financial statements may help you to make more sense of

these items). Put on your blog your answer to this question and comment on the answers to this question of at

least three other people. Include links to your blog and also to your comments in other people’s blogs.

References

Foulke, RA 1968, Practical financial statement analysis, 6th edn, McGraw-Hill, New York.