VOLUME 1
Chapter 5 - Return to reality
"Following the stock market crash of 1929, the Securities and Exchange Commission (SEC) required all publicly traded companies to publish annual financial statements, audited by independent accounting firms, based on a set of accounting standards that the profession had initially established itself."
Robert Eccles et al. ‘The ValueReporting Revolution’ (2000)
Most people seem to enjoy using these simulation models for a while, but I have noticed that sooner or later a certain restlessness creeps in. Those moving pipes and changing levels of water start to appear divorced from financial reality, and so we now need to relate them to normal business terms. It is time for you to load Model 103.
Figure 5.1: Model 103 - A simple set of accounts
This business is the same fruit-selling operation as the one in Figure 4.2 but I have now added a table of numbers on the right-hand side which displays the financial accounts for this business. In the case of the Sales and Receipts pipes, the first column presents us with the amount that has flowed along the pipe each day, the second column shows us the cumulative total of the flow since the beginning of the year and the third column identifies the cumulative total of the flow over all the years since the business was started.
That is true for the Sales and Receipts pipes, but matters are different for the values of the boxes that are listed in the Balance Sheet and in the sections below it. In the Balance Sheet itself, the boxes are all ‘Closing’ period values. As before, the word ‘Opening’ simply means the level in a box at the beginning of the period, while the word ‘Closing’ refers to the level at the end. In the case of the first column, Opening and Closing therefore refer to the levels at the beginning and end of today, while for the second column, Opening means the level at the start of the year and Closing means the level at the end of today. For the third column, the Opening values are all zero (the business had not yet been formed) while the Closing values are also at the end of today. So these definitions will cause all the Closing values and the Balance Sheet data to be the same in all three columns.
You can Start the model as you did in Chapter 1 by choosing a Speed and then setting a Sales rate and a Receipts delay. Once the model starts, the accounting numbers are displayed on the right-hand side. You may find it helpful to Pause the simulation at some point and to look over these numbers, following the simple arithmetic that has been used and relating this to the layout of the diagram.
The slider called History continues to be available in this model, and if you move this you will see in the boxes what the values were in previous days.
Figure 5.2: A recent business history
In Figure 5.2 you can see from the Undistributed Profits box that Sales have been running steadily and building up to a level of accumulated profit of £1,750k (=£1,750,000) while Debtors are constant at £1,120k and the Bank Account shows a recent increase to a level of £630k (these fruit-sellers are hard workers and deserve their forthcoming early retirement). Your own values will of course be different to these and so the crucial point here is to explore this model several times, pausing and re-starting the animation while you familiarise yourself with the diagram and the accompanying table of numbers.
While the diagram and table of numbers remained fairly simple, this may be a good time to summarise some fundamental accounting principles (Figure 5.3).
Double entry
A pipe always starts at one place on the diagram and ends at another place that is also on the diagram: it never leads off the diagram. Whenever a value flows through the pipe, it decreases the level where it starts and it simultaneously increases the level where it ends by the same amount.Assets
These are the boxes with positive blue amounts in them.Liabilities
These are the boxes with negative red amounts in themThe balance sheet always balances
If the blue boxes are regarded as positive numbers and the red boxes as negative numbers, then the level of all the boxes together always adds up to zero. This is because at the outset there was nothing in any of the boxes at all, and since then every time a value flows through a pipe, it creates an equal and opposite positive and negative amount at each end.
Figure 5.3: Some fundamental accounting principles
If you have been using these animated business models while you have been reading the chapters of this book so far, then these accounting principles will by now seem intuitively obvious to you. When you use a model, you can see that there are no pipes which lead off the diagram; and if you reset it and restart it a few times it will be self-evident that the rate at which the positive blue balances build up must always be the same as the rate at which the negative red balances are created.
What is all the fuss about then? Why does it take so many years to become an accountant? These are deep and unfathomable mysteries, so we must persevere in our search for simplicity. But before we can do so I am afraid that there is some more rather confusing accounting terminology that needs to be explained.
Instead of saying “A pipe always ends at one place on the diagram and starts at another place that is also on the diagram”, accountants tend to say “A double-entry transaction debits one account and credits another”. That is to say, accountants use the word ‘credit’ to describe the start of a pipe and ‘debit’ to describe its end. That is simply a convention that we can easily remember and it creates no particular problem for us. If you seek an aide-memoire, it suffices to remember that ‘c’ comes before ‘d’ in the alphabet.
However, the words Credit and Debit are also used by accountants to refer to a red level or a blue level in a box, respectively. A ‘debit account’ is a blue box and a ‘credit account’ is a red box. The reasoning behind this is as follows. If you “debit” an account, that is the same as activating the pipe that leads into it and there is therefore a financial flow into that box, causing its level to become more blue; whereas if you “credit” an account that is the same as triggering the pipe that leads out of it and there is therefore a financial flow out of that box, causing its level to become more red.
To recap: a debit transaction refers to the end of a pipe and a debit balance is a blue level, while a credit transaction describes the start of a pipe and a credit balance is a red level. Now it might be thought confusing enough that the words credit and debit are each used with these two quite distinct meanings, but to the layman it is even worse than this, because the natural meaning of these words appears to have been reversed. After all, surely if I have a credit balance at the bank, that is money that I own and therefore a blue quantity, and likewise a debit balance means that I am – literally – “in the red”?
The answer is yes, you are in the red, and if you were drawing up your own accounts that is precisely what you would see. But the accounts that the bank sends to you are not your own accounts: they are the bank’s accounts (see the Viewpoint paragraph in Figure 3.1). When you have money in the bank, the bank is aware that it owes this money back to you, and so from the bank’s perspective it is a liability – or in accounting parlance, a creditor. Likewise, when you have borrowed money from the bank then the bank records that you are holding on to one of its assets, which makes you a debtor.
Since we have all been receiving bank statements for many years, we have therefore come to believe that “to be in credit” is a good thing. It is: but if we generated our own accounts instead of referring to the statements sent by the bank, we would by now have learnt to say that “to be in debit” is a good thing instead. If you bear this historical accident in mind it will accelerate your understanding of future chapters.
