Chapter 21 - The Dynamics of Accounting

History and evolution | Evaluation and misunderstanding | The purpose of this chapter | The accounting cycle | The journal | The ledger | Number of journals and ledgers needed | The trial balance | Debits and credits | The balance sheet | The profit and loss statement | Balance sheet

History

Long before the birth of Christ, the Phoenician, Roman and Greek businessmen were devoting a definite period of each day to the time-consuming task of recording every transaction that affected their busi­ness on the pages of a simple record now called a journal. Sometime during the Middle Ages or before, the Italians discovered a more work­able system of accounting called "double entry" bookkeeping. In 1494 Luca Paciolo, an Italian monk, wrote the first publication of its kind describing the features and practices of accounting in "the Italian manner."

Evolution

Since those early days the rules and procedures derived from trial and error have been subjected to constant research, study, and change. As the need for more and more detailed recording systems grew, a body of accounting theory was created to explain and modify the exist­ing rules and procedures. Each additional rule, explanation or modi­fication of an existing principle brought with it an attendant annoyance and confusion to the untrained observer.

Evaluation and Misunderstanding

Since accounting principles and practices change as the need for greater detail or additional information regarding revenue, expenses, profits, production, auditing, cost and budget is requested, there is no basic or universal theory in accounting. This lack of exactitude and the constant additions, deletions, and interpretations of accounting principles require considerable academic training and experience in accounting that the average owner of a business is not willing to obtain.

In self-defense most of them regard figures and accounting as a "dry" subject. The operator of a small restaurant feels that there are too many more important managerial problems to resolve such as food purchasing, food preparation, sales promotion or service. They state, justifiably in some cases, "Cost of accounting fees is less than 1 percent of sales. I have major costs to consider such as food and labor which account for 70 percent of my total costs. Furthermore, even if I took time out to thoroughly understand accounting, a few months after I complete the study, new rules and interpretations will make most of what is learned valueless."

The fact that this attitude is prevalent is understandable. However, to proceed from this statement and unequivocally state that the atti­tude is proper is questionable. Without an adequate system of account­ing, how can questions be answered such as:

1.  What am I worth today?

2.  Did my operation make a profit or suffer a loss in the past six months?

3.  What did it cost to make each of the food items I sold?

4.  What did it cost to operate the various departments?

5.  Were the prices of various menu items correctly related to cost of those items in a manner designed to obtain a reasonable amount of profit and an increase in sales?

6.  Can my records provide a plan for the future, a budget of costs, revenue and income, and a financial check of the entire opera­tion?

7. Are my records sufficiently detailed to comply with the requirements of annual federal and state income tax regulations?

There are many other fundamental problems that accounting re­solves, such as investment of capital, coordination of facilities, execu­tive control, and labor-management disputes. Indeed it is difficult to conceive how a highly productive operation or civilized society can exist without a system of accounting.

This chapter will familiarize the new or prospective owners of restaurants with the terminology and use of accounting. Study after study has aptly demonstrated that one of the major causes for failure in the restaurant industry is a lack of familiarity and understanding of the terms and basic purposes of accounting. Effective, profitable management decisions cannot be made unless they are based on a system that furnishes the manager with all the operating facts related to the restaurant.

The Accounting Cycle

The first function of accounting is to accurately record all the trans­actions of a business. This recorded information is then classified into various accounts, evaluated, and summarized in the ledger. From the summary information a trial balance is determined and the two finan­cial statements—the income statement and the balance sheet—are prepared.

The Journal

The daily record of itemized business transactions is called a journal. The journal may be defined as a book that provides management with a chronological record of all business transactions. The purpose of the journal is to record all transactions as they occur, to classify these transactions so they may be posted to their proper account and to indicate whether a transaction increased or decreased the account involved.

The Ledger

A journal differs from a ledger in that it is a daily record of trans­actions whereas a ledger is a book containing all the accounts of the business. Any business that is transacted is first recorded in the journal and later posted to its proper account in the ledger. The purpose of the ledger is to classify and summarize all the business transactions in their proper accounts.

An account is a page or card of a ledger used to accumulate the business transactions which take place within a classification. A sepa­rate account is designed for each classification. For example, a restau­rant operator may have one account for food sales, another for payroll expense and accounts for other classifications such as rent, utilities, cash in bank, or food inventory. Every item listed on the balance sheet or profit and loss statements has its individual account.

Number of Journal and Ledgers Needed

The number of accounting books needed in any operation will vary according to the detail of management information needed and the volume and type of business transactions found in each enterprise. In a small restaurant the owner or part-time bookkeeper may need only one journal to record the transaction and only one ledger. In a large operation, on the other hand, because of the many business transactions that occur, one bookkeeper or one journal or ledger may not be enough to record the various transactions efficiently. In that case, various special journals and ledgers are used to provide more adequate records and summaries and to distribute the work load efficiently. The journal, for example, may be divided into three or four books: a cash receipts, cash disbursements, purchase, and a general journal.

As the name implies, the cash receipts journal is used to record all cash receipts; the cash disbursements journal, all disbursements of cash; the purchase journal, all purchases on credit; and the general journal, all business transactions that are not recorded in the special journals.

Similarly, the ledger may be divided into accounts payable, sales and expense, equipment, a general ledger, and so on.

The Trial Balance

The trial balance is a work sheet on which the accountant prepares a list of all the accounts in the ledger having a balance. The prepara­tion of the trial balance is one of the final steps in the procedure of preparing the financial statements. At the close of an accounting period the accountant determines the net balance in each account. Since open accounts will have either debit or credit balances, the list is prepared on a sheet of paper which has two columns. The name of each account is written on the left side of the work sheet and its balance is entered in the left hand column if it is a debit balance and in the right hand column if it is a credit balance.

All of the accounts in the ledger which have been used during the period and which have balances are listed. Since equal debits and credits are made in the ledger, the total of the debit column of the trial balance should be equal to the total of the credit column. When the columnar totals of the trial balance agree, the list of accounts is said to be "in balance" and is a presumptive test of accuracy.

The two purposes of the trial balance are to aid in the preparation of the balance sheet and the profit and loss statement and to serve as prima facie proof of the accuracy of the ledger. The proof is not infal­lible because it is possible to have a trial balance which is in balance even though errors have been made in the bookkeeping. For example, an entry may be made to the wrong account or one error in an account may be offset by another error yet the trial balance will still appear to be correct.

Debits and Credits

Perhaps the most confusing set of terms in the entire accounting field to the layman is debits and credits. Much of the confusion can be eliminated by understanding that these terms are merely technical symbols of addition and subtraction. By noting at the time the trans­action occurred whether the value of the individual account is increased or decreased, considerable time is saved later in summarizing each account.

The fundamental rule regarding debits and credits is that for each debit there must be a credit. The rule demonstrates the dual nature of any transaction by stating that for every addition there must have been a subtraction. For example, if a dollar is deposited in the bank, double entry bookkeeping requires that we record not only the addition of one dollar to the bank account but also the subtraction of one dollar from the cash register or whatever the source of the money.

To introduce the use of debit and credit terms at this time, note diagram below which shows two of the many ways an account can be shown in the ledger.

Cash on Hand
Date	Ref.	Explanation	Debit	Credit	Balance
9/30					800.00
10/1	J-l	Sales Receipts	600.00		1400.00
10/1	J-2	to Petty Cash		200.00	1200.00
10/1	J-4	to First National		800.00	400.00

Cash on Hand
Debit	Date	Ref.	Explanation	Credit	Balance
	9/30				800.00
600.00	10/1	J-l	Sales Receipts		1400.00
	10/1	J-2	to Petty Cash	200.00	1200.00
	10/1	J-4	to First National	800.00	400.00

Both accounts show that on October 1, three transactions affecting the asset account "Cash on Hand" were recorded in the journal on pages 1, 2 and 4 and then posted to the account. The effect of the debit entry of $600.00 is to increase the balance of the asset account to $1400.00. Conversely, the two credit entries, $200 and $800, reduce the balance to $400.00.

The following diagram demonstrates the use of debit and credit entries to indicate a decrease or increase in the value of any account.

	Any Asset Account			Any Liability Account
	debit increases	credit decreases		debit increases	credit decreases

Any Ownership Account			Any Expense Account			Any Sales or Income Account
debit increases	credit decreases		debit increases	credit decreases		debit increases	credit decreases

If possible, forget any previous associations or meanings of the terms debit and credit. To make the terms meaningful regard them as technical symbols of addition or subtraction. In every instance a debit is a left hand entry; a credit, a right hand entry. A debit is always a transposition of value and a credit a source of value. Stated simply, credit—the source of the value, and debit—what you did with the value.

For example, if $200 was removed from cash register and deposited in the bank, the source of the money is the register and the transposi­tion of the money is to the bank. Consequently, $200 should be credited to the account named Cash on Hand or Cash in Register and $200 debited to the account Cash in Bank. The net effect of posting the transactions to the ledger is to subtract the $200 from the Cash on Hand account and to add $200 to the Cash in Bank account.

In a similar fashion, if you purchased $100 of food on credit from a purveyor, the source of the food is the purveyor, the transposition of food is to the food inventory. Consequently, $100 is credited to the purveyor in the accounts payable ledger and $100 is debited to the asset account called Food Inventories.

If you paid cash for the food, the source of the food value is Cash on Hand. Therefore the asset account Cash on Hand is credited with $100 and Food Inventory is debited $100.

The Balance Sheet

This financial statement is an organized, classified list of assets, liabilities, and ownership interest. The balance sheet answers the question, "What am I worth today?" It provides its reader with an instan­taneous exposure—a single picture—of the financial condition of a business at the close of a particular business date.

To understand how the balance sheet shows the financial condition of a business, certain terms must be defined and clarified. An asset, for example, is an economic good which is owned by the business unit. It represents something which has a measurable monetary value. It may be a tangible asset such as the building or equipment or an intan­gible asset such as good will. Assets are further classified as current— those assets which will be utilized or consumed during the coming year, such as cash and food inventories—and fixed—those assets which will not be fully utilized or consumed during the year, such as land, buildings and heavy equipment.

A liability is a claim against the assets of the business. For example, if we purchased $100 of food on credit from a purveyor, the balance sheet will show $100 food inventory—a current asset—and $100 accounts payable, a liability or claim against this asset. Liabilities are also classified as current—short term or less than a year—and fixed, or long term liabilities, representing claims such as mortgages or long term notes payable that will not mature during the coming year.

The last section of the balance sheet shows the claims that the owners of the business have against the assets of the business. If the business is organized as an individual ownerhip, the ownership equity is represented by ownership capital and earned surplus. Partnership form of organization differs from single ownership interest in that the equity or claim of each partner is listed separately. A corporation on the other hand has its ownership claims listed as capital stock, classi­fied according to type of stock, such as common and preferred.

A balance sheet, therefore, classifies all the assets in one section— shows how many economic goods the business owns; the liabilities and ownership equity in the other section—shows the various claims against these assets. Note that since the whole of one section of any balance sheet represents the total of all the assets of the business and the whole of the remaining section represents the total claims against the assets, the two totals will always equal each other, for any two figures are equal to each other if they equal the same figure.

To demonstrate this equality, study the following transactions and trace them by their reference numbers to the balance sheet shown below.

1. John decides to invest $50,000 in a restaurant. He purchases land for $5,000, a building for $15,000, heavy equipment for $20,000, and deposits $10,000 in the bank.
2. He purchases various food items valued at $2,000 from several purveyors on credit.
3. He signs a five year note for $6,000 at 5% interest to purchase an air conditioner unit.

If these were the only business transactions that were made that day, at the close of the day the balance sheet would look like this:

Balance Sheet July 30, ____
Current Assets		Current Liabilities
(1) Cash in bank	10,000	(2) Accounts payable	2,000
(2) Food inventory	2,000
Fixed Assets		Long Term Liabilities
(1) Equipment	20,000	(3) Notes payable	6,000
(3) Air conditioner	6,000	Total Liabilities     8,000
(1) Building	15,000
(1) Land	5,000	(1) Capital	50,000
	58,000		58,000

The balance sheet shows that as of June 30, this restaurant was valued at $58,000. The business possessed $58,000 of assets. The balance sheet also shows the interest or claims against the total assets by the owner and by people not connected with the ownership of the business. In this instance, the owner contributed $50,000 to the busi­ness, the purveyors, $2,000 and the bank, $6,000, a total of $58,000 claims against the assets of the business. Since all the assets and claims are shown, the balance sheet is "in balance," $58,000 of assets equals $58,000 of liabilities and capital.

Profit and Loss Statement

This financial statement is a schedule which summarizes the revenue and expense transactions for the period between the date of the last balance sheet and the next balance sheet. The time elapsing between the two balance sheets is the period for which the profit and loss state­ment provides a summary of the various business transactions that occurred. The period may be monthly, quarterly, semi-annually, or annually. The purpose of the P & L statement is to present an analysis of the business changes that have taken place from one balance sheet to another and to summarize the revenue and expense transactions during that given period.

The general practice is to list first the various revenue items accord­ing to their relative importance, the more important revenue items being listed first. These revenue items are followed by a summary of the cost of raw materials purchased called "cost of goods sold." The deduction of cost of goods sold from the revenue or sales of goods is called the "gross profit" or "gross margin." A list of various expense items such as rent, utilities, and supplies follows the gross profit figure. These expenses are deducted from the gross profit figure to obtain the net revenue or profit for that period. If the period is for a full fiscal year, the result is called "net revenue" or "income before income taxes." After the tax charge has been deducted, the remainder, if there is a profit, is called "earned surplus" and transferred to the capital account on the balance sheet.

PROFIT AND LOSS STATEMENT
JULY 1 TO SEPTEMBER 30,

Sales
Food Sales                                50,000
Liquor Sales                              25,000
                  Total Sales              75,000

Cost of Goods Sold
Food                                         23,000
Liquor                                         7,500
                  Total                        30,500
Gross Profit                                44,500

Expenses:
Labor                                       15,000
Rent                                           3,500
Supplies                                         800
Utilities                                       1,800
Adm. & General                         7,500
Advertising                                 1,500
Miscellaneous                                400
Depreciation                               1,500
                  Total                        32,000

Net profit before income taxes   12,500

The balance sheet and profit and loss schedule are the two final financial statements in an accounting cycle. The balance sheet gives picture of the value of the restaurant; the profit and loss statement a summary of the revenue and expense transactions. The first is accu­rate only for the given date; the second is accurate for a given period.

The purpose of this chapter is to familiarize the owner of a food service operation with the basic fundamentals of accounting. You should know the principles and procedures used to arrive at a balance sheet and a profit and loss statement. You should know the purpose of a ledger, a journal, and terms such as debit and credit.

The attempt has been made to remove part of the "iron curtain" surrounding the accounting field. There are many methods of arriving at accurate information that will tell you what your business is worth and how you arrived at that particular financial position. There is no mystery to this problem. Basically, all accounting systems record the business transactions in one or more journals. The figures are later posted from the journals to the various accounts in the ledger or ledgers so that each account may be summarized. At the close of an accounting period a list is prepared showing the title and the net balance of each account. This is called a trial balance and is a pre­sumptive test of accuracy, for if equal debits and credits have been made in each transaction, the total of the debits should be equal to the total of the credits. After this schedule has been completed, the accounts are organized in statement form and the balance sheet and profit and loss statements are prepared.

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