Gennaro Cuofano's Blog, page 273

Accounting Made Simple | A Beginner’s Guide

This expanded post will give you a complete understanding of the financial accounting basics. From double-entry to accounting equation and financial statements. Read on!

What Is the Double-Entry System?

When humans lived in the savannah they lived in small groups, which would consist approximately of no more that few dozens of individuals. Through the millennia the human tribes evolved in groups that became larger and larger until they became societies.

Societies are characterized by large groups of people that interact on a daily basis. Those people are in some way associated with religion, culture, and commerce. While religion and culture evolved mainly by word of mouth, commerce instead needed to develop other (more complex) tools to thrive.

In fact, if a tiny society is comprised of few hundred merchants; and if we consider all the possible interactions that could happen between them, they would easily amount to millions of transactions.

Therefore, the sole word of mouth wasn’t effective for keeping track of all those transactions. That is where “writing” came handy. The ancient Mesopotamian merchants, thus, started to develop tools that would allow them to track all the goods exchanged.

This evolution continued up to Middle Ages Florence. At that time, Florence was a metropolis (we can compare it to modern New York) and commerce had boomed. In fact, merchants from all over the world flowed in Florence to buy and sell any sort of goods.

The commercial routes between Florence and Venice were quite trafficked. Not surprisingly Florentine merchants had to come up with a tracking system that would allow them to consistently keep up with the millions of transactions taking place in Florence.

Most probably the Florentine merchants initially came up with several systems for tracking those transactions. Thus there was no standard or consistency. Somehow by the fifteen century, a tracking system called “double-entry” (developed in Venice) took over and became the most used accounting system at that time.

In fact, the same Luca Pacioli (a mathematician and Franciscan Friar from Tuscany) formalized the double entry in his Summa de arithmetica, in 1494. In his work Luca Pacioli tells us that any business to be successful necessitates of three things:

Capital (cash or credit)
A good accountant
A good internal system.

For “capital,” Pacioli, intended mainly cash (he understood way before than Franklin that “cash was the king”), but also credit. In other words, Pacioli believed that trust was the pillar of any business.

He used the word credit because it comes from the Latin word “credo,” which really means, “trust.” The second and third aspects are crucial as well. In fact, a good accountant has to have a basic understanding of mathematics (very basic). And he has to be able to effectively use an internal system, which he calls double entry system. That system became the official system of the western world. And it is still in use today.

How does it work?

Double-Entry System in a Nutshell

The double entry is simply a tracking system. Each transaction is classified according to two entries (hence it is called double-entry): debit and credit. In short, like computers language is expressed in bits, which consist of a bunch of 0s and 1s, accounting language is expressed in debits and credits.

What do those terms mean? Debit comes from the Latin “debitum,”which simply means, “What is owed.” Credit instead comes from the Latin “creditus” that can be translated as “having been loaned.”

But what is owed or loaned? The only good exchanged in the accounting world is money. Therefore, when we say debit and credit it always refers to assigning a $ amount to the goods or services sold or bought by the organization.

Therefore each time a transaction needs to be recorded in the accounting journal (so-called General Ledger) the money needs to be debited to an account while credited by another account. In this way the transaction balances.

Before you can record your first transactions, you must have a basic understanding of the main financial statements: balance sheet and income statement.

Financial Statements in a Nutshell

As we saw the main premise of accounting is to keep track of a bunch of transactions taking place in a certain period of time. For some reason, the double entry system prevailed.

This system says that each time you record a transaction you must debit one account and credit another account. But what is an account? An account is simply a way of classifying different transactions. In fact, in bookkeeping exist five main accounts:

Asset
Liability
Equity
Revenue
Cost

In short, the assets are all those resources that the company has at its disposal to run the business in the short and long term. The liabilities instead are mainly the money borrowed to acquire those resources.

Not all the resources (assets) are acquired through debt (liability). In fact, you may invest some of your money into the business to buy the machinery or other stuff that will help you to run it.

In this case, the money you put into the business is called equity. That’s it.

For instance, if you open an ice-cream shop you will buy the machine (asset) by borrowing some money from the bank (liability) and by putting some of your money (equity).

Consequently, the value of your machinery (asset) will be equal to the borrowed money (liability) plus your own money (equity). From here the so-called accounting equation A = L + E.

Those three accounts (Assets, Liability, and Equity) comprise the so-called Balance Sheet. Thus, for any given instant of the life of your business, the balance sheet will tell you what is the $ amount of assets the company owns and how those assets have been acquired (Either through debt, also called liability or through equity, also called capital).

Consequently, the $ amount of liability and equity must balance with the $ amount of assets the company owns. Pretty straightforward! Isn’t it?

If you didn’t get it yet, don’t worry we are going to see some very useful practical examples. Knowing how much assets, liabilities and equity the company owns or owes at each instant, (in accounting lingo) is called “financial position.”

You can see how a balance sheet works in detail in this short video:

Balance Sheet Explained

On the other hand, we are still missing two accounts: revenue and cost.

The revenues are simply the money flowing into the business at any given period. The costs are all the expenses flowing out at any given period.

The costs can be broken down in several ways. By subtracting the costs to the revenues of the business you get what is called Net Profit/Loss; which in accounting jargon is also called “bottom line.”

Those two accounts together form the so-called “Income Statement.” Accountants use a lot of other names for it (Profit and Loss or Statement of comprehensive income), which all means the same thing.

Therefore, the main purpose of the income statement is to show how much money went in and out and if the balance was positive or negative. Keep in mind that “money” does not mean “cash.” in fact, often times accounting runs on an “accrual basis.”

It simply means that transactions are recorded in the income statement independently from cash disbursement. Cash basis, instead, means that transactions are recorded only when cash is passed hand to hand.

To have a detailed understanding of the income statement you can watch this short video:

Income Statement Explained

If you followed along so far, you should be able to get to the final step: recording transactions.

A World Without Accounting

We saw that the accounting equation’s main purpose is to keep things in balance. It makes perfect sense. In fact, in the real world, if you put $5 in your pocket you will still find $5 (unless you are a magician, which in the accounting world is called “fraudster”).

Things get a little bit trickier in accounting. Keep in mind that the double entry system has been designed to understand where the money came from. Imagine the case in which you have a $100 bill.

You put it in your pocket. After few weeks you take it out but you completely forgot where it came from. Did I borrow it from someone? Was it money I saved? Did anyone pay me for the work done?

You don’t have an idea!

While you can afford to let this happen in the real world, this must never happen in the business world. Companies often buy and sell hundreds of goods or services. This generates a huge volume of transactions. Thus, knowing where anything comes from it is crucial for three main reasons:

Internal control
Tax compliance
Performance measurement

First, as you can imagine companies without an efficient system that keeps track of all their transactions would not be able to know what happens within the organization. This can lead to frauds, bad management and so on.

Second, the government also requires companies to submit their tax returns. To do so businesses must keep track of all their transactions and know how to classify them.

Third, another branch of financial accounting (ratio analysis) is also crucial to understand how the business is managed from several perspectives.

Time to Master the Accounting Game

So far we saw that the accounting world uses two main documents (balance sheet and income statement) to answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

By answering the first question we can determine the financial position of the organization. By answering the second question we can understand if the assets we bought are generating profits.

Hence, we can determine if it is worth to go on with the venture. A third document is crucial to understand the business performance as well (the cash flow statement). Yet, if you master balance sheet and income statement you are on the right path to developing deeper business acumen.

The two questions above are crucial to understanding how to record transactions in the accounting books. Hence, we will do this exercise by thinking about situations that may present in your life. This time though each time you put a $100 bill in your pocket you have to answer to the two questions above. Let’s start then, action!

Your First Company: Broken Inc.

You are broke, 0$ in your pocket! But you have to pay the rent! It amounts to $500. The landlord is coming tomorrow. How do you fix this situation? Although you are a grown up, it is an emergency situation.

Thus, you put your pride aside and ask your parents. They love you of course. Therefore, they give you the money. We are going to assume that your right pants’ pocket is a venture. We will call it “Broken Inc.”

Broken Inc. has now one shareholder (yourself) and a bank (your parents). How do we record this transaction in the accounting world? Easy.

We have to answer the first question: how did we acquire that money? Since your parents gave them to you we will assume that you are proud enough to give them back, once you earn them.

Thus, we will consider $500 as a loan. According to the accounting equation, Assets are on the left side, while Liability and Equity on the right side:

To record transactions, accountants use a visual aid called T-Entry (nowadays it’s all done automatically by software. This may seem a good thing but often times it’s not. When folks don’t take the time to understand how accounting works from its foundation screw-ups are guaranteed in the long run):

As you can see on the left side we have debit and on the right side credit. This means that each time we want to show that our assets increased we just debit them (remember assets are on the left side of the accounting equation) and vice versa.

Instead, each time we want to show that our liability or equity increased we just credit them (remember that liability and equity are on the right side of the accounting equation) and vice versa. To recap:

To show an increase in assets we debit them. To show a decrease in assets we credit them:

To show an increase in liability or equity we credit them. To show a decrease in liability or equity we debit them:

We can now put things together:

Let’s record the transaction. Broken Inc. received $500. It is a loan. This means that now in Broken Inc. bank account (your pocket) there is $500. But it is a loan. In fact, they will be given back to the bank (your parents).

We will record the transaction in the following way:

Therefore, your pocket (which is your cash account) will be debited. Why? It is a short-term asset. On the other hand, we will credit the $500 to an account which I arbitrary called “Parents’ Loan.” Why? It is a liability.

In other words, we showed that your cash account increased by $500. But we know also why that happened. Your parents gave you the money. Hence, once you will go back in few weeks time and look at Broken Inc. balance sheet you will know where the $500 came from.

As you can see from the image above, the T-Entry is immediately translated on your balance sheet. In fact below the t-entry, the balance sheet (BS) shows that you have $500 in assets but also $500 in liability.

Thus even though, in the present, you have $500. You know that in the future you must return them back.

Remember those are virtual transactions. It means that they take place only in your accounting books. In reality, you have $500 and that’s it! But accounting is a little bit trickier that reality because it needs to answer the two questions we saw at the beginning of the paragraph.

Broken Inc. Is Temporary Unbroken

In Scene One your parents saved your rear. The landlord is knocking ad your door. He will ask for the rent. The only liquid money available will disappear in few minutes. For now, though you don’t worry too much.

You open the door and the landlord is already with his hand forward waiting for the $500. This means that you will put the hand in your right pants’ pocket. We will consider the rent’s money as an expense that Broken Inc. is incurring.

In fact, expenses are often connected with the assets. For such reason on our income statement, we will place them on the left side. On the other hand, we will place the income on the right side. In other words, our income statement will look like the following:

This implies two things:

To show an increase in expenses we will debit them (they are on the left side of the t-entry) and vice versa.
To show an increase in revenues we will credit them (they are on the right side of the t-entry).

Thus it will look like the following:

You have the insight to record the transaction now. Since you paid the rent to the landlord, this is a “rent expense.” yet to pay it you had to withdraw the money from Broken Inc. pocket account. Therefore:

As you can see in the upper part we recorded the transaction. We showed an increase in rent expense by debiting it and a decrease in Broken Inc. Pocket (asset) by crediting it.

On the below part you can see how your financial statements look like (balance-sheet + income statement are called so). Thus, the Income Statement (IS) shows a net loss of $500, while the balance sheet (BS) shows only $500 in liability.

There is something wrong here. Do you notice anything? Not yet? Let me give you an insight. It is not by chance that the “balance” sheet it is called so. In fact, it has always must balance. Always!

Therefore, when you see the asset side showing a different amount compared to the liability + equity side, something is wrong. In this case, nothing is wrong. We just missed a step.

In fact, to match the asset side with the liability & equity side of the balance sheet we have to connect it with the income statement. How?

We must report the losses in the equity section of the balance sheet. In fact, in accounting when you have a net loss on the income statement it will be also shown as “accumulated loss” on the balance sheet. Once we do so the BS will balance out:

As you can see the liability and equity cancel each other out. Therefore, eventually, your balance sheet will have $0 in total assets and $0 in liability plus equity (the parent’s loan cancels out with the accumulated losses, which makes the equity account negative).

Broken Ink. is in financial distress again. It is time for you to fix its finances since you are its greatest assets. It is time to earn some money!

Fixing the Finances of Broken Inc.  

You decide to pay back to money your parents gave you to pay the rent. Therefore, you look for a job and finally find it. You will be working as a waiter in a restaurant, earning a fixed salary of $1,000 per month.

Mr. Sal agrees to pay you in advance (he is very kind). Thus, you finally get the paycheck. The paycheck is going to be income for Broken Inc. Finally, you will not show a net loss. Thus, you record the transaction on Broken Inc. accounting books:

As you can see in the upper part we recorded the t-entry. In short, we debited Broken Inc. pocket to show that the cash account increased by $1,000. Also, we credited the salary account to show that it increased by $1,000.

As you can see below the t-entry, the entry on the left (Broken Inc. pocket account) is translated on the balance sheet. The entry on the right (salary) is translated on the income statement.

Since the salary offset the rent expense you now have a net profit of $500. That net profit was also translated on the balance sheet as accumulated earnings. Neat!

Finally, Broken Inc. paid all its debts and it has a $500 surplus. Don’t you think it is time to pay back your parents’ loan?

Balancing Things Out

You proudly walk toward your parents’ house. In a week things have changed. You grew up and learned the lesson. It is time to repay your parents. You get in the house. Your mother is in the kitchen. She is cooking for you.

You sit at the dinner table and announce your parents that you found a job. Therefore, you give them back the $500 they borrowed you. Broken Ink is 100% yours now! You are your own master. Let’s see how to record the last transaction:

As you can see we debited the Parents’ Loan (liability) to show its decrease. On the other side, we credited the Broken Inc. Pocket account (asset) to show its decrease.

This transaction only affected the balance sheet. In fact, the left side of the t-entry zeroed out the loan. The right side of the t-entry resulted in a $500 decrease of the same account.

The income statement was unaffected. In short, Broken Inc. has $500 in cash, which are all yours, since those are accumulated earnings. Congratulations!

Summing up and Conclusions

Throughout this short manual, we saw that accounting was already used in ancient Mesopotamia. The double entry system though was developed in Venice but formalized for the first time by a Tuscan mathematician, Luca Pacioli.

In his work, Summa de Arithmetica, Pacioli delineated the three most important aspects of any business:

Capital (cash or credit)
A good accountant
A good internal system.

In addition, we saw that the two main documents that describe the situation of any business are the balance sheet and income statements. Together they form the so-called financial statements. Those two documents classify the accounting transactions under three main accounts:

Asset
Liability
Equity
Revenue
Cost

Assets, Liability, and Equity are shown under the balance sheet, which the main purpose is to show the financial position of the organization. The “balance” sheet is called so because the Asset side has always to match up with the Liability and Equity side.

From this premise we get the accounting equation A = L + E. thereafter, we have the income statement, which classifies the transactions in Income (or revenue) and Cost (or expense).

Its main purpose is to show whether the business has a net profit (total revenue are higher than total costs) or a net loss (total expenses higher that total revenues). Together those two statements answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

That’s all! You also learned how to record journal entries. If you want to practice some more you can watch those videos:

What is a double entry?
Accounting Entry – Part One
Accounting Entry – Part Two

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Financial Accounting Foundation | A Teenager’s Guide

This expanded post will give you a complete understanding of the financial accounting basics. From double-entry to accounting equation and financial statements. Read on!

What Is the Double-Entry System?

When humans lived in the savannah they lived in small groups, which would consist approximately of no more that few dozens of individuals. Through the millennia the human tribes evolved in groups that became larger and larger until they became societies.

Societies are characterized by large groups of people that interact on a daily basis. Those people are in some way associated with religion, culture, and commerce. While religion and culture evolved mainly by word of mouth, commerce instead needed to develop other (more complex) tools to thrive.

In fact, if a tiny society is comprised of few hundred merchants; and if we consider all the possible interactions that could happen between them, they would easily amount to millions of transactions.

Therefore, the sole word of mouth wasn’t effective for keeping track of all those transactions. That is where “writing” came handy. The ancient Mesopotamian merchants, thus, started to develop tools that would allow them to track all the goods exchanged.

This evolution continued up to Middle Ages Florence. At that time, Florence was a metropolis (we can compare it to modern New York) and commerce had boomed. In fact, merchants from all over the world flowed in Florence to buy and sell any sort of goods.

The commercial routes between Florence and Venice were quite trafficked. Not surprisingly Florentine merchants had to come up with a tracking system that would allow them to consistently keep up with the millions of transactions taking place in Florence.

Most probably the Florentine merchants initially came up with several systems for tracking those transactions. Thus there was no standard or consistency. Somehow by the fifteen century, a tracking system called “double-entry” (developed in Venice) took over and became the most used accounting system at that time.

In fact, the same Luca Pacioli (a mathematician and Franciscan Friar from Tuscany) formalized the double entry in his Summa de arithmetica, in 1494. In his work Luca Pacioli tells us that any business to be successful necessitates of three things:

Capital (cash or credit)
A good accountant
A good internal system.

For “capital,” Pacioli, intended mainly cash (he understood way before than Franklin that “cash was the king”), but also credit. In other words, Pacioli believed that trust was the pillar of any business.

He used the word credit because it comes from the Latin word “credo,” which really means, “trust.” The second and third aspects are crucial as well. In fact, a good accountant has to have a basic understanding of mathematics (very basic). And he has to be able to effectively use an internal system, which he calls double entry system. That system became the official system of the western world. And it is still in use today.

How does it work?

Double-Entry System in a Nutshell

The double entry is simply a tracking system. Each transaction is classified according to two entries (hence it is called double-entry): debit and credit. In short, like computers language is expressed in bits, which consist of a bunch of 0s and 1s, accounting language is expressed in debits and credits.

What do those terms mean? Debit comes from the Latin “debitum,”which simply means, “What is owed.” Credit instead comes from the Latin “creditus” that can be translated as “having been loaned.”

But what is owed or loaned? The only good exchanged in the accounting world is money. Therefore, when we say debit and credit it always refers to assigning a $ amount to the goods or services sold or bought by the organization.

Therefore each time a transaction needs to be recorded in the accounting journal (so-called General Ledger) the money needs to be debited to an account while credited by another account. In this way the transaction balances.

Before you can record your first transactions, you must have a basic understanding of the main financial statements: balance sheet and income statement.

Financial Statements in a Nutshell

As we saw the main premise of accounting is to keep track of a bunch of transactions taking place in a certain period of time. For some reason, the double entry system prevailed.

This system says that each time you record a transaction you must debit one account and credit another account. But what is an account? An account is simply a way of classifying different transactions. In fact, in bookkeeping exist five main accounts:

Asset
Liability
Equity
Revenue
Cost

In short, the assets are all those resources that the company has at its disposal to run the business in the short and long term. The liabilities instead are mainly the money borrowed to acquire those resources.

Not all the resources (assets) are acquired through debt (liability). In fact, you may invest some of your money into the business to buy the machinery or other stuff that will help you to run it.

In this case, the money you put into the business is called equity. That’s it.

For instance, if you open an ice-cream shop you will buy the machine (asset) by borrowing some money from the bank (liability) and by putting some of your money (equity).

Consequently, the value of your machinery (asset) will be equal to the borrowed money (liability) plus your own money (equity). From here the so-called accounting equation A = L + E.

Those three accounts (Assets, Liability, and Equity) comprise the so-called Balance Sheet. Thus, for any given instant of the life of your business, the balance sheet will tell you what is the $ amount of assets the company owns and how those assets have been acquired (Either through debt, also called liability or through equity, also called capital).

Consequently, the $ amount of liability and equity must balance with the $ amount of assets the company owns. Pretty straightforward! Isn’t it?

If you didn’t get it yet, don’t worry we are going to see some very useful practical examples. Knowing how much assets, liabilities and equity the company owns or owes at each instant, (in accounting lingo) is called “financial position.”

You can see how a balance sheet works in detail in this short video:

Balance Sheet Explained

On the other hand, we are still missing two accounts: revenue and cost.

The revenues are simply the money flowing into the business at any given period. The costs are all the expenses flowing out at any given period.

The costs can be broken down in several ways. By subtracting the costs to the revenues of the business you get what is called Net Profit/Loss; which in accounting jargon is also called “bottom line.”

Those two accounts together form the so-called “Income Statement.” Accountants use a lot of other names for it (Profit and Loss or Statement of comprehensive income), which all means the same thing.

Therefore, the main purpose of the income statement is to show how much money went in and out and if the balance was positive or negative. Keep in mind that “money” does not mean “cash.” in fact, often times accounting runs on an “accrual basis.”

It simply means that transactions are recorded in the income statement independently from cash disbursement. Cash basis, instead, means that transactions are recorded only when cash is passed hand to hand.

To have a detailed understanding of the income statement you can watch this short video:

Income Statement Explained

If you followed along so far, you should be able to get to the final step: recording transactions.

A World Without Accounting

We saw that the accounting equation’s main purpose is to keep things in balance. It makes perfect sense. In fact, in the real world, if you put $5 in your pocket you will still find $5 (unless you are a magician, which in the accounting world is called “fraudster”).

Things get a little bit trickier in accounting. Keep in mind that the double entry system has been designed to understand where the money came from. Imagine the case in which you have a $100 bill.

You put it in your pocket. After few weeks you take it out but you completely forgot where it came from. Did I borrow it from someone? Was it money I saved? Did anyone pay me for the work done?

You don’t have an idea!

While you can afford to let this happen in the real world, this must never happen in the business world. Companies often buy and sell hundreds of goods or services. This generates a huge volume of transactions. Thus, knowing where anything comes from it is crucial for three main reasons:

Internal control
Tax compliance
Performance measurement

First, as you can imagine companies without an efficient system that keeps track of all their transactions would not be able to know what happens within the organization. This can lead to frauds, bad management and so on.

Second, the government also requires companies to submit their tax returns. To do so businesses must keep track of all their transactions and know how to classify them.

Third, another branch of financial accounting (ratio analysis) is also crucial to understand how the business is managed from several perspectives.

Time to Master the Accounting Game

So far we saw that the accounting world uses two main documents (balance sheet and income statement) to answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

By answering the first question we can determine the financial position of the organization. By answering the second question we can understand if the assets we bought are generating profits.

Hence, we can determine if it is worth to go on with the venture. A third document is crucial to understand the business performance as well (the cash flow statement). Yet, if you master balance sheet and income statement you are on the right path to developing deeper business acumen.

The two questions above are crucial to understanding how to record transactions in the accounting books. Hence, we will do this exercise by thinking about situations that may present in your life. This time though each time you put a $100 bill in your pocket you have to answer to the two questions above. Let’s start then, action!

Your First Company: Broken Inc.

You are broke, 0$ in your pocket! But you have to pay the rent! It amounts to $500. The landlord is coming tomorrow. How do you fix this situation? Although you are a grown up, it is an emergency situation.

Thus, you put your pride aside and ask your parents. They love you of course. Therefore, they give you the money. We are going to assume that your right pants’ pocket is a venture. We will call it “Broken Inc.”

Broken Inc. has now one shareholder (yourself) and a bank (your parents). How do we record this transaction in the accounting world? Easy.

We have to answer the first question: how did we acquire that money? Since your parents gave them to you we will assume that you are proud enough to give them back, once you earn them.

Thus, we will consider $500 as a loan. According to the accounting equation, Assets are on the left side, while Liability and Equity on the right side:

To record transactions, accountants use a visual aid called T-Entry (nowadays it’s all done automatically by software. This may seem a good thing but often times it’s not. When folks don’t take the time to understand how accounting works from its foundation screw-ups are guaranteed in the long run):

As you can see on the left side we have debit and on the right side credit. This means that each time we want to show that our assets increased we just debit them (remember assets are on the left side of the accounting equation) and vice versa.

Instead, each time we want to show that our liability or equity increased we just credit them (remember that liability and equity are on the right side of the accounting equation) and vice versa. To recap:

To show an increase in assets we debit them. To show a decrease in assets we credit them:

To show an increase in liability or equity we credit them. To show a decrease in liability or equity we debit them:

We can now put things together:

Let’s record the transaction. Broken Inc. received $500. It is a loan. This means that now in Broken Inc. bank account (your pocket) there is $500. But it is a loan. In fact, they will be given back to the bank (your parents).

We will record the transaction in the following way:

Therefore, your pocket (which is your cash account) will be debited. Why? It is a short-term asset. On the other hand, we will credit the $500 to an account which I arbitrary called “Parents’ Loan.” Why? It is a liability.

In other words, we showed that your cash account increased by $500. But we know also why that happened. Your parents gave you the money. Hence, once you will go back in few weeks time and look at Broken Inc. balance sheet you will know where the $500 came from.

As you can see from the image above, the T-Entry is immediately translated on your balance sheet. In fact below the t-entry, the balance sheet (BS) shows that you have $500 in assets but also $500 in liability.

Thus even though, in the present, you have $500. You know that in the future you must return them back.

Remember those are virtual transactions. It means that they take place only in your accounting books. In reality, you have $500 and that’s it! But accounting is a little bit trickier that reality because it needs to answer the two questions we saw at the beginning of the paragraph.

Broken Inc. Is Temporary Unbroken

In Scene One your parents saved your rear. The landlord is knocking ad your door. He will ask for the rent. The only liquid money available will disappear in few minutes. For now, though you don’t worry too much.

You open the door and the landlord is already with his hand forward waiting for the $500. This means that you will put the hand in your right pants’ pocket. We will consider the rent’s money as an expense that Broken Inc. is incurring.

In fact, expenses are often connected with the assets. For such reason on our income statement, we will place them on the left side. On the other hand, we will place the income on the right side. In other words, our income statement will look like the following:

This implies two things:

To show an increase in expenses we will debit them (they are on the left side of the t-entry) and vice versa.
To show an increase in revenues we will credit them (they are on the right side of the t-entry).

Thus it will look like the following:

You have the insight to record the transaction now. Since you paid the rent to the landlord, this is a “rent expense.” yet to pay it you had to withdraw the money from Broken Inc. pocket account. Therefore:

As you can see in the upper part we recorded the transaction. We showed an increase in rent expense by debiting it and a decrease in Broken Inc. Pocket (asset) by crediting it.

On the below part you can see how your financial statements look like (balance-sheet + income statement are called so). Thus, the Income Statement (IS) shows a net loss of $500, while the balance sheet (BS) shows only $500 in liability.

There is something wrong here. Do you notice anything? Not yet? Let me give you an insight. It is not by chance that the “balance” sheet it is called so. In fact, it has always must balance. Always!

Therefore, when you see the asset side showing a different amount compared to the liability + equity side, something is wrong. In this case, nothing is wrong. We just missed a step.

In fact, to match the asset side with the liability & equity side of the balance sheet we have to connect it with the income statement. How?

We must report the losses in the equity section of the balance sheet. In fact, in accounting when you have a net loss on the income statement it will be also shown as “accumulated loss” on the balance sheet. Once we do so the BS will balance out:

As you can see the liability and equity cancel each other out. Therefore, eventually, your balance sheet will have $0 in total assets and $0 in liability plus equity (the parent’s loan cancels out with the accumulated losses, which makes the equity account negative).

Broken Ink. is in financial distress again. It is time for you to fix its finances since you are its greatest assets. It is time to earn some money!

Fixing the Finances of Broken Inc.  

You decide to pay back to money your parents gave you to pay the rent. Therefore, you look for a job and finally find it. You will be working as a waiter in a restaurant, earning a fixed salary of $1,000 per month.

Mr. Sal agrees to pay you in advance (he is very kind). Thus, you finally get the paycheck. The paycheck is going to be income for Broken Inc. Finally, you will not show a net loss. Thus, you record the transaction on Broken Inc. accounting books:

As you can see in the upper part we recorded the t-entry. In short, we debited Broken Inc. pocket to show that the cash account increased by $1,000. Also, we credited the salary account to show that it increased by $1,000.

As you can see below the t-entry, the entry on the left (Broken Inc. pocket account) is translated on the balance sheet. The entry on the right (salary) is translated on the income statement.

Since the salary offset the rent expense you now have a net profit of $500. That net profit was also translated on the balance sheet as accumulated earnings. Neat!

Finally, Broken Inc. paid all its debts and it has a $500 surplus. Don’t you think it is time to pay back your parents’ loan?

Balancing Things Out

You proudly walk toward your parents’ house. In a week things have changed. You grew up and learned the lesson. It is time to repay your parents. You get in the house. Your mother is in the kitchen. She is cooking for you.

You sit at the dinner table and announce your parents that you found a job. Therefore, you give them back the $500 they borrowed you. Broken Ink is 100% yours now! You are your own master. Let’s see how to record the last transaction:

As you can see we debited the Parents’ Loan (liability) to show its decrease. On the other side, we credited the Broken Inc. Pocket account (asset) to show its decrease.

This transaction only affected the balance sheet. In fact, the left side of the t-entry zeroed out the loan. The right side of the t-entry resulted in a $500 decrease of the same account.

The income statement was unaffected. In short, Broken Inc. has $500 in cash, which are all yours, since those are accumulated earnings. Congratulations!

Summing up and Conclusions

Throughout this short manual, we saw that accounting was already used in ancient Mesopotamia. The double entry system though was developed in Venice but formalized for the first time by a Tuscan mathematician, Luca Pacioli.

In his work, Summa de Arithmetica, Pacioli delineated the three most important aspects of any business:

Capital (cash or credit)
A good accountant
A good internal system.

In addition, we saw that the two main documents that describe the situation of any business are the balance sheet and income statements. Together they form the so-called financial statements. Those two documents classify the accounting transactions under three main accounts:

Asset
Liability
Equity
Revenue
Cost

Assets, Liability, and Equity are shown under the balance sheet, which the main purpose is to show the financial position of the organization. The “balance” sheet is called so because the Asset side has always to match up with the Liability and Equity side.

From this premise we get the accounting equation A = L + E. thereafter, we have the income statement, which classifies the transactions in Income (or revenue) and Cost (or expense).

Its main purpose is to show whether the business has a net profit (total revenue are higher than total costs) or a net loss (total expenses higher that total revenues). Together those two statements answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

That’s all! You also learned how to record journal entries. If you want to practice some more you can watch those videos:

What is a double entry?
Accounting Entry – Part One
Accounting Entry – Part Two

Gift for You

If you want to learn financial accounting and ratio analysis from scratch to professional level there is a coupon waiting for you. You can get the course on Udemy: Financial Analysis from scratch to Professional Level (worth $65) at an 85% discount! From the link Here.

Good luck with your career!

To be updated on the upcoming release and promotions for “The Flawless Investor” the book that will open up the doors of the investing world, click Here.

Financial Accounting Foundation | A Beginner’s Guide

This expanded post will give you a complete understanding of the financial accounting basics. From double-entry to accounting equation and financial statements. Read on!

What Is the Double-Entry System?

When humans lived in the savannah they lived in small groups, which would consist approximately of no more that few dozens of individuals. Through the millennia the human tribes evolved in groups that became larger and larger until they became societies.

Societies are characterized by large groups of people that interact on a daily basis. Those people are in some way associated with religion, culture, and commerce. While religion and culture evolved mainly by word of mouth, commerce instead needed to develop other (more complex) tools to thrive.

In fact, if a tiny society is comprised of few hundred merchants; and if we consider all the possible interactions that could happen between them, they would easily amount to millions of transactions.

Therefore, the sole word of mouth wasn’t effective for keeping track of all those transactions. That is where “writing” came handy. The ancient Mesopotamian merchants, thus, started to develop tools that would allow them to track all the goods exchanged.

This evolution continued up to Middle Ages Florence. At that time, Florence was a metropolis (we can compare it to modern New York) and commerce had boomed. In fact, merchants from all over the world flowed in Florence to buy and sell any sort of goods.

The commercial routes between Florence and Venice were quite trafficked. Not surprisingly Florentine merchants had to come up with a tracking system that would allow them to consistently keep up with the millions of transactions taking place in Florence.

Most probably the Florentine merchants initially came up with several systems for tracking those transactions. Thus there was no standard or consistency. Somehow by the fifteen century, a tracking system called “double-entry” (developed in Venice) took over and became the most used accounting system at that time.

In fact, the same Luca Pacioli (a mathematician and Franciscan Friar from Tuscany) formalized the double entry in his Summa de arithmetica, in 1494. In his work Luca Pacioli tells us that any business to be successful necessitates of three things:

Capital (cash or credit)
A good accountant
A good internal system.

For “capital,” Pacioli, intended mainly cash (he understood way before than Franklin that “cash was the king”), but also credit. In other words, Pacioli believed that trust was the pillar of any business.

He used the word credit because it comes from the Latin word “credo,” which really means, “trust.” The second and third aspects are crucial as well. In fact, a good accountant has to have a basic understanding of mathematics (very basic). And he has to be able to effectively use an internal system, which he calls double entry system. That system became the official system of the western world. And it is still in use today.

How does it work?

Double-Entry System in a Nutshell

The double entry is simply a tracking system. Each transaction is classified according to two entries (hence it is called double-entry): debit and credit. In short, like computers language is expressed in bits, which consist of a bunch of 0s and 1s, accounting language is expressed in debits and credits.

What do those terms mean? Debit comes from the Latin “debitum,”which simply means, “What is owed.” Credit instead comes from the Latin “creditus” that can be translated as “having been loaned.”

But what is owed or loaned? The only good exchanged in the accounting world is money. Therefore, when we say debit and credit it always refers to assigning a $ amount to the goods or services sold or bought by the organization.

Therefore each time a transaction needs to be recorded in the accounting journal (so-called General Ledger) the money needs to be debited to an account while credited by another account. In this way the transaction balances.

Before you can record your first transactions, you must have a basic understanding of the main financial statements: balance sheet and income statement.

Financial Statements in a Nutshell

As we saw the main premise of accounting is to keep track of a bunch of transactions taking place in a certain period of time. For some reason, the double entry system prevailed.

This system says that each time you record a transaction you must debit one account and credit another account. But what is an account? An account is simply a way of classifying different transactions. In fact, in bookkeeping exist five main accounts:

Asset
Liability
Equity
Revenue
Cost

In short, the assets are all those resources that the company has at its disposal to run the business in the short and long term. The liabilities instead are mainly the money borrowed to acquire those resources.

Not all the resources (assets) are acquired through debt (liability). In fact, you may invest some of your money into the business to buy the machinery or other stuff that will help you to run it.

In this case, the money you put into the business is called equity. That’s it.

For instance, if you open an ice-cream shop you will buy the machine (asset) by borrowing some money from the bank (liability) and by putting some of your money (equity).

Consequently, the value of your machinery (asset) will be equal to the borrowed money (liability) plus your own money (equity). From here the so-called accounting equation A = L + E.

Those three accounts (Assets, Liability, and Equity) comprise the so-called Balance Sheet. Thus, for any given instant of the life of your business, the balance sheet will tell you what is the $ amount of assets the company owns and how those assets have been acquired (Either through debt, also called liability or through equity, also called capital).

Consequently, the $ amount of liability and equity must balance with the $ amount of assets the company owns. Pretty straightforward! Isn’t it?

If you didn’t get it yet, don’t worry we are going to see some very useful practical examples. Knowing how much assets, liabilities and equity the company owns or owes at each instant, (in accounting lingo) is called “financial position.”

You can see how a balance sheet works in detail in this short video:

Balance Sheet Explained

On the other hand, we are still missing two accounts: revenue and cost.

The revenues are simply the money flowing into the business at any given period. The costs are all the expenses flowing out at any given period.

The costs can be broken down in several ways. By subtracting the costs to the revenues of the business you get what is called Net Profit/Loss; which in accounting jargon is also called “bottom line.”

Those two accounts together form the so-called “Income Statement.” Accountants use a lot of other names for it (Profit and Loss or Statement of comprehensive income), which all means the same thing.

Therefore, the main purpose of the income statement is to show how much money went in and out and if the balance was positive or negative. Keep in mind that “money” does not mean “cash.” in fact, often times accounting runs on an “accrual basis.”

It simply means that transactions are recorded in the income statement independently from cash disbursement. Cash basis, instead, means that transactions are recorded only when cash is passed hand to hand.

To have a detailed understanding of the income statement you can watch this short video:

Income Statement Explained

If you followed along so far, you should be able to get to the final step: recording transactions.

A World Without Accounting

We saw that the accounting equation’s main purpose is to keep things in balance. It makes perfect sense. In fact, in the real world, if you put $5 in your pocket you will still find $5 (unless you are a magician, which in the accounting world is called “fraudster”).

Things get a little bit trickier in accounting. Keep in mind that the double entry system has been designed to understand where the money came from. Imagine the case in which you have a $100 bill.

You put it in your pocket. After few weeks you take it out but you completely forgot where it came from. Did I borrow it from someone? Was it money I saved? Did anyone pay me for the work done?

You don’t have an idea!

While you can afford to let this happen in the real world, this must never happen in the business world. Companies often buy and sell hundreds of goods or services. This generates a huge volume of transactions. Thus, knowing where anything comes from it is crucial for three main reasons:

Internal control
Tax compliance
Performance measurement

First, as you can imagine companies without an efficient system that keeps track of all their transactions would not be able to know what happens within the organization. This can lead to frauds, bad management and so on.

Second, the government also requires companies to submit their tax returns. To do so businesses must keep track of all their transactions and know how to classify them.

Third, another branch of financial accounting (ratio analysis) is also crucial to understand how the business is managed from several perspectives.

Time to Master the Accounting Game

So far we saw that the accounting world uses two main documents (balance sheet and income statement) to answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

By answering the first question we can determine the financial position of the organization. By answering the second question we can understand if the assets we bought are generating profits.

Hence, we can determine if it is worth to go on with the venture. A third document is crucial to understand the business performance as well (the cash flow statement). Yet, if you master balance sheet and income statement you are on the right path to developing deeper business acumen.

The two questions above are crucial to understanding how to record transactions in the accounting books. Hence, we will do this exercise by thinking about situations that may present in your life. This time though each time you put a $100 bill in your pocket you have to answer to the two questions above. Let’s start then, action!

Your First Company: Broken Inc.

You are broke, 0$ in your pocket! But you have to pay the rent! It amounts to $500. The landlord is coming tomorrow. How do you fix this situation? Although you are a grown up, it is an emergency situation.

Thus, you put your pride aside and ask your parents. They love you of course. Therefore, they give you the money. We are going to assume that your right pants’ pocket is a venture. We will call it “Broken Inc.”

Broken Inc. has now one shareholder (yourself) and a bank (your parents). How do we record this transaction in the accounting world? Easy.

We have to answer the first question: how did we acquire that money? Since your parents gave them to you we will assume that you are proud enough to give them back, once you earn them.

Thus, we will consider $500 as a loan. According to the accounting equation, Assets are on the left side, while Liability and Equity on the right side:

To record transactions, accountants use a visual aid called T-Entry (nowadays it’s all done automatically by software. This may seem a good thing but often times it’s not. When folks don’t take the time to understand how accounting works from its foundation screw-ups are guaranteed in the long run):

As you can see on the left side we have debit and on the right side credit. This means that each time we want to show that our assets increased we just debit them (remember assets are on the left side of the accounting equation) and vice versa.

Instead, each time we want to show that our liability or equity increased we just credit them (remember that liability and equity are on the right side of the accounting equation) and vice versa. To recap:

To show an increase in assets we debit them. To show a decrease in assets we credit them:

To show an increase in liability or equity we credit them. To show a decrease in liability or equity we debit them:

We can now put things together:

Let’s record the transaction. Broken Inc. received $500. It is a loan. This means that now in Broken Inc. bank account (your pocket) there is $500. But it is a loan. In fact, they will be given back to the bank (your parents).

We will record the transaction in the following way:

Therefore, your pocket (which is your cash account) will be debited. Why? It is a short-term asset. On the other hand, we will credit the $500 to an account which I arbitrary called “Parents’ Loan.” Why? It is a liability.

In other words, we showed that your cash account increased by $500. But we know also why that happened. Your parents gave you the money. Hence, once you will go back in few weeks time and look at Broken Inc. balance sheet you will know where the $500 came from.

As you can see from the image above, the T-Entry is immediately translated on your balance sheet. In fact below the t-entry, the balance sheet (BS) shows that you have $500 in assets but also $500 in liability.

Thus even though, in the present, you have $500. You know that in the future you must return them back.

Remember those are virtual transactions. It means that they take place only in your accounting books. In reality, you have $500 and that’s it! But accounting is a little bit trickier that reality because it needs to answer the two questions we saw at the beginning of the paragraph.

Broken Inc. Is Temporary Unbroken

In Scene One your parents saved your rear. The landlord is knocking ad your door. He will ask for the rent. The only liquid money available will disappear in few minutes. For now, though you don’t worry too much.

You open the door and the landlord is already with his hand forward waiting for the $500. This means that you will put the hand in your right pants’ pocket. We will consider the rent’s money as an expense that Broken Inc. is incurring.

In fact, expenses are often connected with the assets. For such reason on our income statement, we will place them on the left side. On the other hand, we will place the income on the right side. In other words, our income statement will look like the following:

This implies two things:

To show an increase in expenses we will debit them (they are on the left side of the t-entry) and vice versa.
To show an increase in revenues we will credit them (they are on the right side of the t-entry).

Thus it will look like the following:

You have the insight to record the transaction now. Since you paid the rent to the landlord, this is a “rent expense.” yet to pay it you had to withdraw the money from Broken Inc. pocket account. Therefore:

As you can see in the upper part we recorded the transaction. We showed an increase in rent expense by debiting it and a decrease in Broken Inc. Pocket (asset) by crediting it.

On the below part you can see how your financial statements look like (balance-sheet + income statement are called so). Thus, the Income Statement (IS) shows a net loss of $500, while the balance sheet (BS) shows only $500 in liability.

There is something wrong here. Do you notice anything? Not yet? Let me give you an insight. It is not by chance that the “balance” sheet it is called so. In fact, it has always must balance. Always!

Therefore, when you see the asset side showing a different amount compared to the liability + equity side, something is wrong. In this case, nothing is wrong. We just missed a step.

In fact, to match the asset side with the liability & equity side of the balance sheet we have to connect it with the income statement. How?

We must report the losses in the equity section of the balance sheet. In fact, in accounting when you have a net loss on the income statement it will be also shown as “accumulated loss” on the balance sheet. Once we do so the BS will balance out:

As you can see the liability and equity cancel each other out. Therefore, eventually, your balance sheet will have $0 in total assets and $0 in liability plus equity (the parent’s loan cancels out with the accumulated losses, which makes the equity account negative).

Broken Ink. is in financial distress again. It is time for you to fix its finances since you are its greatest assets. It is time to earn some money!

Fixing the Finances of Broken Inc.  

You decide to pay back to money your parents gave you to pay the rent. Therefore, you look for a job and finally find it. You will be working as a waiter in a restaurant, earning a fixed salary of $1,000 per month.

Mr. Sal agrees to pay you in advance (he is very kind). Thus, you finally get the paycheck. The paycheck is going to be income for Broken Inc. Finally, you will not show a net loss. Thus, you record the transaction on Broken Inc. accounting books:

As you can see in the upper part we recorded the t-entry. In short, we debited Broken Inc. pocket to show that the cash account increased by $1,000. Also, we credited the salary account to show that it increased by $1,000.

As you can see below the t-entry, the entry on the left (Broken Inc. pocket account) is translated on the balance sheet. The entry on the right (salary) is translated on the income statement.

Since the salary offset the rent expense you now have a net profit of $500. That net profit was also translated on the balance sheet as accumulated earnings. Neat!

Finally, Broken Inc. paid all its debts and it has a $500 surplus. Don’t you think it is time to pay back your parents’ loan?

Balancing Things Out

You proudly walk toward your parents’ house. In a week things have changed. You grew up and learned the lesson. It is time to repay your parents. You get in the house. Your mother is in the kitchen. She is cooking for you.

You sit at the dinner table and announce your parents that you found a job. Therefore, you give them back the $500 they borrowed you. Broken Ink is 100% yours now! You are your own master. Let’s see how to record the last transaction:

As you can see we debited the Parents’ Loan (liability) to show its decrease. On the other side, we credited the Broken Inc. Pocket account (asset) to show its decrease.

This transaction only affected the balance sheet. In fact, the left side of the t-entry zeroed out the loan. The right side of the t-entry resulted in a $500 decrease of the same account.

The income statement was unaffected. In short, Broken Inc. has $500 in cash, which are all yours, since those are accumulated earnings. Congratulations!

Summing up and Conclusions

Throughout this short manual, we saw that accounting was already used in ancient Mesopotamia. The double entry system though was developed in Venice but formalized for the first time by a Tuscan mathematician, Luca Pacioli.

In his work, Summa de Arithmetica, Pacioli delineated the three most important aspects of any business:

Capital (cash or credit)
A good accountant
A good internal system.

In addition, we saw that the two main documents that describe the situation of any business are the balance sheet and income statements. Together they form the so-called financial statements. Those two documents classify the accounting transactions under three main accounts:

Asset
Liability
Equity
Revenue
Cost

Assets, Liability, and Equity are shown under the balance sheet, which the main purpose is to show the financial position of the organization. The “balance” sheet is called so because the Asset side has always to match up with the Liability and Equity side.

From this premise we get the accounting equation A = L + E. thereafter, we have the income statement, which classifies the transactions in Income (or revenue) and Cost (or expense).

Its main purpose is to show whether the business has a net profit (total revenue are higher than total costs) or a net loss (total expenses higher that total revenues). Together those two statements answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

That’s all! You also learned how to record journal entries. If you want to practice some more you can watch those videos:

What is a double entry?
Accounting Entry – Part One
Accounting Entry – Part Two

Gift for You

If you want to learn financial accounting and ratio analysis from scratch to professional level there is a coupon waiting for you. You can get the course on Udemy: Financial Analysis from scratch to Professional Level (worth $65) at an 85% discount! From the link Here.

Good luck with your career!

To be updated on the upcoming release and promotions for “The Flawless Investor” the book that will open up the doors of the investing world, click Here.

Accounting | A Beginner’s Guide

What Is the Double-Entry System?

When humans lived in the savannah they lived in small group, which would consist approximately of no more that few dozens individuals. Through the millennia the human tribes evolved in groups that became larger and larger, until they became societies.

Societies are characterized by large groups of people that interact on a daily basis. Those people are in some way associated by religion, culture and commerce. While religion and culture evolved mainly by word of mouth, commerce instead needed to develop other (more complex) tools to thrive.

In fact, if a tiny society is comprised of few hundred merchants; and if we consider all the possible interactions that could happen between them, they would easily amount to millions of transactions.

Therefore, the sole word of mouth wasn’t effective for keeping track of all those transactions. That is where “writing” came handy. The ancient Mesopotamian merchants, thus, started to develop tools that would allow them to track all the goods exchanged.

This evolution continued up to Middle Ages Florence. At that time, Florence was a metropolis (we can compare it to modern New York) and commerce had boomed. In fact, merchants from all over the world flowed in Florence to buy and sell any sort of goods.

The commercial routes between Florence and Venice were quite trafficked. Not surprisingly Florentine merchants had to come up with a tracking system that would allow them to consistently keep up with the millions of transactions taking place in Florence.

Most probably the Florentine merchants initially came up with several systems for tracking those transactions. Thus there was no standard or consistency. Somehow by the fifteen century a tracking system called “double-entry” (developed in Venice) took over and became the most used accounting system at that time.

In fact, the same Luca Pacioli (a mathematician and Franciscan Friar from Tuscany) formalized the double entry in his Summa de arithmetica, in 1494. In his work Luca Pacioli tells us that any business to be successful necessitates of three things:

Capital (cash or credit)
A good accountant
A good internal system.

For “capital,” Pacioli, intended mainly cash (he understood way before than Franklin that “cash was the king”), but also credit. In other words, Pacioli believed that trust was the pillar of any business.

He used the word credit because it comes from the Latin word “credo,” which really means, “trust.” The second and third aspects are crucial as well. In fact, a good accountant has to have basic understanding of mathematics (very basic). And he has to be able to effectively use an internal system, which he calls double entry system. That system became the official system of the western world. And it is still in use today.

How does it work?

Double-Entry System in a Nutshell

The double entry is simply a tracking system. Each transaction is classified according to two entries (hence it is called double-entry): debit and credit. In short, like computers language is expressed in bits, which consist of a bunch of 0s and 1s, accounting language is expressed in debits and credits.

What do those terms mean? Debit comes from the Latin “debitum,”which simply means, “What is owed.” Credit instead comes from the Latin “creditus” that can be translated as “having been loaned.”

But what is owed or loaned? The only good exchanged in the accounting world is money. Therefore, when we say debit and credit it always refers to assigning a $ amount to the goods or services sold or bought by the organization.

Therefore each time a transaction needs to be recorded in the accounting journal (so-called General Ledger) the money needs to be debited to an account while credited by another account. In this way the transaction balances.

Before you can record your first transactions, you must have a basic understanding of the main financial statements: balance sheet and income statement.

Financial Statements in a Nutshell

As we saw the main premise of accounting is to keep track of a bunch of transactions taking place in a certain period of time. For some reason, the double entry system prevailed.

This system says that each time you record a transaction you must debit one account and credit another account. But what is an account? An account is simply a way of classifying different transactions. In fact, in bookkeeping exist five main accounts:

Asset
Liability
Equity
Revenue
Cost

In short, the assets are all those resources that the company has at its disposal to run the business in the short and long term. The liabilities instead are mainly the money borrowed to acquire those resources.

Not all the resources (assets) are acquired through debt (liability). In fact, you may invest some of your money into the business to buy the machinery or other stuff that will help you to run it.

In this case, the money you put into the business is called equity. That’s it.

For instance, if you open an ice-cream shop you will buy the machine (asset) by borrowing some money from the bank (liability) and by putting some of your money (equity).

Consequently the value of your machinery (asset) will be equal to the borrowed money (liability) plus your own money (equity). From here the so-called accounting equation A = L + E.

Those three accounts (Assets, Liability and Equity) comprise the so-called Balance Sheet. Thus, for any given instant of the life of your business the balance sheet will tell you what is the $ amount of assets the company owns and how those assets have been acquired (Either through debt, also called liability or through equity, also called capital).

Consequently, the $ amount of liability and equity must balance with the $ amount of assets the company owns. Pretty straightforward! Isn’t it?

If you didn’t get it yet, don’t worry we are going to see some very useful practical examples. Knowing how much assets, liabilities and equity the company owns or owes at each instant, (in accounting lingo) is called “financial position.”

You can see how a balance sheet works in detail in this short video:

Balance Sheet Explained

On the other hand, we are still missing two accounts: revenue and cost.

The revenues are simply the money flowing into the business at any given period. The costs are all the expenses flowing out at any given period.

The costs can be broken down in several ways. By subtracting the costs to the revenues of the business you get what is called Net Profit/Loss; which in accounting jargon is also called “bottom line.”

Those two accounts together form the so-called “Income Statement.” Accountants use a lot of other names for it (Profit and Loss or Statement of comprehensive income), which all means the same thing.

Therefore, the main purpose of the income statement is to show how much money went in and out and if the balance was positive or negative. Keep in mind that “money” does not mean “cash.” in fact, often times accounting runs on an “accrual basis.”

It simply means that transactions are recorded in the income statement independently from cash disbursement. Cash basis, instead, means that transactions are recorded only when cash is passed hand in hand.

To have a detailed understanding of the income statement you can watch this short video:

Income Statement Explained

If you followed along so far, you should be able to get to the final step: recording transactions.

A World Without Accounting

We saw that the accounting equation’s main purpose is to keep things in balance. It makes perfect sense. In fact, in the real world, if you put $5 in your pocket you will still find $5 (unless you are a magician, which in the accounting world is called “fraudster”).

Things get a little bit trickier in accounting. Keep in mind that the double entry system has been designed to understand where the money came from. Imagine the case in which you have a $100 bill.

You put it in your pocket. After few weeks you take it out but you completely forgot where it came from. Did I borrow it from someone? Was it money I saved? Did anyone pay me for the work done?

You don’t have idea!

While you can afford to let this happen in the real world, this must never happen in the business world. Companies often buy and sell hundreds of goods or services. This generates a huge volume of transactions. Thus, knowing where anything comes from it is crucial for three main reasons:

Internal control
Tax compliance
Performance measurement

First, as you can imagine companies without an efficient system that keeps track of all their transactions would not be able to know what happens within the organization. This can lead to frauds, bad management and so on.

Second, the government also requires companies to submit their tax returns. To do so businesses must keep track of all their transactions and know how to classify them.

Third, another branch of financial accounting (ratio analysis) is also crucial to understand how the business is managed from several perspectives.

Time to Master the Accounting Game

So far we saw that the accounting world uses two main documents (balance sheet and income statement) to answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

By answering to the first question we can determine the financial position of the organization. By answering the second question we can understand if the assets we bought are generating profits.

Hence, we can determine if it is worth to go on with the venture. A third document is crucial to understand the business performance as well (the cash flow statement). Yet, if you master balance sheet and income statement you are on the right path to develop deeper business acumen.

The two questions above are crucial to understand how to record transactions in the accounting books. Hence, we will do this exercise by thinking about situations that may present in your life. This time though each time you put a $100 bill in your pocket you have to answer to the two questions above. Let’s start then, action!

Your First Company: Broken Inc.

You are broke, 0$ in your pocket! But you have to pay the rent! It amounts to $500. The landlord is coming tomorrow. How do you fix this situation? Although you are a grown up, it is an emergency situation.

Thus, you put your pride aside and ask to your parents. They love you of course. Therefore, they give you the money. We are going to assume that your right pants’ pocket is a venture. We will call it “Broken Inc.”

Broken Inc. has now one shareholder (yourself) and a bank (your parents). How do we record this transaction in the accounting world? Easy.

We have to answer the first question: how did we acquire that money? Since your parents gave them to you we will assume that you are proud enough to give them back, once you earn them.

Thus, we will consider $500 as a loan. According to the accounting equation Assets are on the left side, while Liability and Equity on the right side:

To record transactions, accountants use a visual aid called T-Entry (nowadays it’s all done automatically by software. This may seem a good thing but often times it’s not. When folks don’t take the time to understand how accounting works from its foundation screw-ups are guaranteed in the long run):

As you can see on the left side we have debit and on the right side credit. This means that each time we want to show that our assets increased we just debit them (remember assets are on the left side of the accounting equation) and vice versa.

Instead, each time we want to show that our liability or equity increased we just credit them (remember that liability and equity are on the right side of the accounting equation) and vice versa. To recap:

To show an increase in assets we debit them. To show a decrease in assets we credit them:

To show an increase in liability or equity we credit them. To show a decrease in liability or equity we debit them:

We can now put things together:

Let’s record the transaction. Broken Inc. received $500. It is a loan. This means that now in Broken Inc. bank account (your pocket) there is $500. But it is a loan. In fact, they will be given back to the bank (your parents).

We will record the transaction like the following way:

Therefore, your pocket (which is your cash account) will be debited. Why? It is a short-term asset. On the other hand, we will credit the $500 to an account which I arbitrary called “Parents’ Loan.” Why? It is a liability.

In other words, we showed that your cash account increased by $500. But we know also why that happened. Your parents gave you the money. Hence, once you will go back in few weeks time and look at Broken Inc. balance sheet you will know where the $500 came from.

As you can see from the image above, the T-Entry is immediately translated on your balance sheet. In fact below the t-entry the balance sheet (BS) shows that you have $500 in assets but also $500 in liability.

Thus even though, in the present you have $500. You know that in the future you must return them back.

Remember those are virtual transactions. It means that they take place only in your accounting books. In reality you have $500 and that’s it! But accounting is a little bit trickier that reality because it needs to answer the two questions we saw at the beginning of the paragraph.

Broken Inc. Is Temporary Unbroken

In Scene One your parents saved your rear. The landlord is knocking ad your door. He will ask for the rent. The only liquid money available will disappear in few minutes. For now though you don’t worry too much.

You open the door and the landlord is already with his hand forward waiting for the $500. This means that you will put the hand in your right pants’ pocket. We will consider the rent’s money as an expense that Broken Inc. is incurring.

In fact, expenses are often connected with the assets. For such reason on our income statement we will place them on the left side. On the other hand, we will place the income on the right side. In other words, our income statement will look like the following:

This implies two things:

To show an increase in expenses we will debit them (they are on the left side of the t-entry) and vice versa.
To show an increase in revenues we will credit them (they are on the right side of the t-entry).

Thus it will look like the following:

You have the insight to record the transaction now. Since you paid the rent to the landlord, this is a “rent expense.” yet to pay it you had to withdraw the money from Broken Inc. pocket account. Therefore:

As you can see in the upper part we recorded the transaction. We showed an increase in rent expense by debiting it and a decrease in Broken Inc. Pocket (asset) by crediting it.

On the below part you can see how your financial statements look like (balance-sheet + income statement are called so). Thus, the Income Statement (IS) shows a net loss of $500, while the balance sheet (BS) shows only $500 in liability.

There is something wrong here. Do you notice anything? Not yet? Let me give you an insight. It is not by chance that the “balance” sheet it is called so. In fact, it has always must balance. Always!

Therefore, when you see the asset side showing a different amount compared to the liability + equity side, something is wrong. In this case nothing is wrong. We just missed a step.

In fact, to match the asset side with the liability & equity side of the balance sheet we have to connect it with the income statement. How?

We must to report the losses in the equity section of the balance sheet. In fact, in accounting when you have a net loss on the income statement it will be also shown as “accumulated loss” on the balance sheet. Once we do so the BS will balance out:

As you can see the liability and equity cancel each other out. Therefore, eventually your balance sheet will have $0 in total assets and $0 in liability plus equity (the parent’s loan cancels out with the accumulated losses, which makes the equity account negative).

Broken Ink. is in financial distress again. It is time for you to fix its finances, since you are its greatest assets. It is time to earn some money!

Fixing the Finances of Broken Inc.  

You decide to pay back to money your parents gave you to pay the rent. Therefore, you look for a job and finally find it. You will be working as waiter in a restaurant, earning a fixed salary of $1,000 per month.

Mr. Sal agrees to pay you in advance (he is very kind). Thus, you finally get the paycheck. The paycheck is going to be income for Broken Inc. Finally you will not show a net loss. Thus, you record the transaction on Broken Inc. accounting books:

As you can see in the upper part we recorded the t-entry. In short, we debited Broken Inc. pocket to show that the cash account increased by $1,000. Also we credited the salary account to show that it increased by $1,000.

As you can see below the t-entry, the entry on the left (Broken Inc. pocket account) is translated on the balance sheet. The entry on the right (salary) is translated on the income statement.

Since the salary offset the rent expense you now have a net profit of $500. That net profit was also translated on the balance sheet as accumulated earnings. Neat!

Finally Broken Inc. paid all its debts and it has a $500 surplus. Don’t you think it is time to pay back your parents’ loan?

Balancing Things Out

You proudly walk toward your parents’ house. In a week things have changed. You grew up and learned the lesson. It is time to repay your parents. You get in the house. Your mother is in the kitchen. She is cooking for you.

You sit to the dinner table and announce your parents that you found a job. Therefore, you give them back the $500 they borrowed you. Broken Ink is 100% yours now! You are your own master. Let’s see how to record the last transaction:

As you can see we debited the Parents’ Loan (liability) to show its decrease. On the other side, we credited the Broken Inc. Pocket account (asset) to show its decrease.

This transaction only affected the balance sheet. In fact, the left side of the t-entry zeroed out the loan. The right side of the t-entry resulted in a $500 decrease of the same account.

The income statement was unaffected. In short, Broken Inc. has $500 in cash, which are all yours, since those are accumulated earnings. Congratulations!

Summing up and Conclusions

Throughout this short manual we saw that accounting was already used in ancient Mesopotamia. The double entry system, though was developed in Venice but formalized for the first time by a Tuscan mathematician, Luca Pacioli.

In his work, Summa de Arithmetica, Pacioli delineated the three most important aspects for any business:

Capital (cash or credit)
A good accountant
A good internal system.

In addition, we saw that the two main documents that describe the situation of any business are the balance sheet and income statements. Together they form the so-called financial statements. Those two documents classify the accounting transactions under three main accounts:

Asset
Liability
Equity
Revenue
Cost

Assets, Liability and Equity are shown under the balance sheet, which main purpose is to show the financial position of the organization. The “balance” sheet is called so because the Asset side has always to match up with the Liability and Equity side.

From this premise we get the accounting equation A = L + E. thereafter, we have the income statement, which classifies the transactions in Income (or revenue) and Cost (or expense).

Its main purpose is to show whether the business has a net profit (total revenue are higher than total costs) or a net loss (total expenses higher that total revenues). Together those two statements answer two main questions:

First, how much of my assets have been acquired through debt and capital?
Second, are my assets generating a net profit or a net loss?

That’s all! You also learned how to record journal entries. If you want to practice some more you can watch those videos:

What is double entry?
Accounting Entry – Part One
Accounting Entry – Part Two

Gift for You

If you want to learn financial accounting and ratio analysis from scratch to professional level there is a coupon awaiting for you. You can get the course on Udemy: Financial Analysis from scratch to Professional Level (worth $65) at an 85% discount! From the link Here.

Good luck with your career!

To be updated on the upcoming release and promotions for “The Flawless Investor” the book that will open up the doors of the investing world, click Here.

The New Wave of Entrepreneurship

There is a multi-trillion dollar economy opening up to technology faster than ever. It has been driven by trends that have changed the nature of how entrepreneurs will be characterized going forward; specifically, industry executives will be the next wave of in-demand startup CEOs.

In April of 2007, Apple changed everything with the launch of the iPhone. It is hard to imagine that it has only been 8 years since the release of the first truly pervasive smartphone, but there is no denying its impact has been world-changing.

Beyond the creation of a new dimension of industry-driven, by location-based, services (and with it, a myriad of billion dollar companies), an equally significant phenomenon emerged. By creating technology that was intuitive to the consumer masses, every person around the world started to embrace technology as more than just a work tool.

Lawyers, doctors, car mechanics and people from every sector of the economy not only had a tool for productivity, but a piece of technology in their pocket they embraced as an intimate part of their lives.

Furthermore, these new consumers could now point to a standard for usable technology. Cumbersome, enterprise legal software that won’t allow a lawyer to search cases from outside the office is no longer acceptable. For those outside of the Silicon Valley silo, conversations can be heard from construction workers sitting on a lunch break saying “Wouldn’t it be nice if there was an app to …”.

Unfortunately, these conversations are often too far away from Silicon Valley’s ears, which are still dominated by the talk of what will be the next WhatsApp or Instagram. Even so, a new breed of entrepreneur is emerging who see firsthand the challenges in their industry, and with that the opportunity to make a world-changing impact, and these entrepreneurs do not fit the founder archetype that many Silicon Valley investors look for.

Photos from http://www.ablogtowatch.com, http://securityaffairs.co, http://geniusapp.com, and http://www.rakenapp.com

Previous decades saw similar shifts in entrepreneur characterizations. The late 90s were about Harvard MBAs applying traditional management techniques to leverage brand new Internet technologies. The “aughts” brought on the “22 year-old Stanford Computer Science” graduate applying technology to a low hanging industry. Now, in this decade, we are seeing a new wave of entrepreneurship driven by industry executives with deep product backgrounds leveraging technology to disrupt a traditionally non-tech industry.

For the past 2 years I’ve had the opportunity to see this shift firsthand as the managing partner of Silicon Valley Software Group (SVSG), a firm of CTOs focused on helping companies with their technology strategy. SVSG has seen entrepreneurs ranging from movie producers, lead singers of platinum album rock bands, travel executives, and hedge fund managers all trying to figure out how to leverage their domain expertise through technology. After a number of similar engagements, a few observations have emerged:

In each venture, a product-focused entrepreneur saw the adoption of technology among their peers in a particular industry and, with that, the opportunity to create a product focused on that industry.
None of these entrepreneurs had notable tech experience.
Hardly ANY of these high profile individuals had relevant connections with the Silicon Valley community.

This last observation is of particular importance!

As tunnel-visioned as Silicon Valley might be, there is a reason that it has produced so many world-changing companies.

The combination of growth capital, multidisciplinary talent, and mentors sharing best practices around how to create hyper-growth businesses are often taken for granted by those who are part of the ecosystem.

However, the disconnect between Silicon Valley natives and outsiders is shocking. Many of the companies SVSG has come across have no ability to raise strategic capital at first because their businesses are too risky when considering common pitfalls they are more likely to fall into compared with their Valley peers. Concepts as commonplace as the lean startup methodology are welcomed as sage insight to these new entrepreneurs.

What is missing for these new founders is a bridge into Silicon Valley. To date, this has been stymied by a narrow mindset from the Silicon Valley community. However, the forces of capitalism will eventually prevail and these new entrepreneurs will find their own community to center around.

Keen investors will lead the herd and take advantage of existing markets ripe for change. Incubators and accelerators will emerge with a focus on entrepreneurs with deep industry experience. We are in a tech boom right now and there are countless ways to apply technology to industries that haven’t changed in decades. For those sitting in the corner office, the time has come to venture out, there are markets to disrupt.

Source: Toptal

Awaken the Accountant in You | Master the Accounting Basics in One-Hour

written by Gennaro Cuofano

Why This Manual?

Many associate accounting with math and give it up too fast. This is plain wrong. I wanted to show that you could learn the basics of accounting in no more than an hour of your time.

In addition, I did not want to publish a long (boring) academic book that very few were going to read. Quite the opposite, my aim was to create a manual, widely accessible, easy to understand (yet complete). From this attempt this short manual took shape.

What Can You Expect?

The assumption of this short manual is that you will read it thoughtfully until the end (at the end of the book you will find a nice gift!). In addition you will watch the short videos referenced in the book.

If you follow the instructions you can expect to have a deep understanding of the basic concepts of accounting. Therefore, you will master the double entry and the two main financial statements (balance sheet and income statement).

You will get the resources to practice on your own as well. Those expectations will be met at one condition: you give me one hour of your time.

This means that in the next hour you will be in a quite room, with no distraction. All you need is a piece of paper and pencil. Follow along… that’s all! Let’s start.

Click on the cover below to grab your free copy of the ebook:

The 4WMBA is one-year old! See giveaways and coupons available…

Just a year ago “The Four-Week MBA” started out with its first post and a series of youtube videos, intended to create a solid foundation of Financial Accounting. Why accounting? It is the language of business. Thus, it was a logical step to take. In the course of the year more than 3,500 students enrolled to the Finance Courses on Udemy. Many students were able to reach their career goals. Others used our courses to improve their understanding of the business world.

Thereafter The Four-Week MBA published over 50 articles on several topics, spacing from financial accounting, fundamental analysis, leadership, entrepreneurship, start-ups, management, investing and much more.

Our objective is to create “useful resources for both business professionals and entrepreneurs, which cannot be taught in a classroom.” We will continue to operate by following this principle.

We want to thank all our followers and subscriber and that is why we organized some interesting giveaways (unfortunately for now this is only for US residents):

You can also access the giveaways from the links below:

Financial Accounting
Fundamental Analysis
Portable Finance Guide
Fast Tenant’s Guide

If this is not enough we are offering all our courses for $10! See the links below:

Financial Analysis from scratch to Professional LevelFinancial Analysis from scratch to Professional Level
Awaken the Accountant in you
How to Become an Accountant from scratch!


How to Become a Financial Analyst from scratch! 

 

Don’t Be Fooled: Calculate the Real Cost of Employees and Consultants

The following post is offered by http://www.toptal.com to The Four-Week MBA community. 

REAL EMPLOYEE COST CALCULATOR
This calculator is based on the cost accounting methodology detailed in the article below.

Use the calculator below to compare the real costs of contractors vs. employees, based on their salaries and hourly rates.

Annual Comparison of Real Costs (cumulative by month)Consult…Employee123456789101112$0$50,000$100,000$150,000$200,000MonthsReal Cost (Cumulative)5Employee:78,770

Months
Consultant
Employee




1
14,560
15,754


2
29,120
31,508


3
43,680
47,262


4
58,240
63,016


5
72,800
78,770


6
87,360
94,524


7
101,920
110,278


8
116,480
126,032


9
131,040
141,786


10
145,600
157,540


11
160,160
173,294


12
174,720
189,048









Adjust hourly rates or annual compensation figures below to compute and compare real costs
* Real costs are roughly based on DCAA Cost Accounting Standards



Advanced


Don’t Be Fooled: How to Calculate Employee Costs vs. Consultant Costs
A typical flawed analysis

Andre’s gotten funding for his company and is looking to staff his development team. He needs top software engineering talent and he needs it fast. Andre was ready to bring on Roger, a freelance consultant who came highly recommended, but backed off upon learning that Roger’s rate was $70/hour. That seemed way too expensive After all, Andre reasoned, that’s equivalent to an annual salary of over $145K, based on a typical 2,080 work hours per year. In contrast, Andre is sure he can hire a great developer as an employee for $100K or less. So Andre decides to look for an employee to hire instead and save money.

Unfortunately, like all too many hiring managers, Andre’s financial analysis was overly simplistic and highly flawed as a result. The reality is that the costs per employee calculations when hiring are vastly different (and often greater) than those involved in bringing on a consultant, and the differences go way beyond annual salaries and hourly rates. Andre doesn’t realize it, but there’s a good chance he actually would have saved money by hiring the consultant.

It’s truly astounding how few business owners properly account for the real cost of their labor. In a product company, these errors can eat away at your bottom line. And in a services business, these errors can even result in spending more to provide a service than you’re charging for it.

But of course, this is not a new problem. Accordingly, tried and true methods do exist for more accurately calculating the real costs of your labor, enabling you to perform a sound financial analysis and make a more educated decision when faced with the “employee vs. consultant” dilemma. Here’s what you need to know:

It’s not so simple

Let’s assume that Andre finds an employee, Pete, for $95K/year. Evaluating costs on an hourly basis, Andre believes that Roger will cost him $70/hour, whereas Pete (using the standard 2,080 work hours per year) will only cost him around $45/hour.

That’s a significant savings.

Or is it?

Unfortunately for Andre, it’s not so simple when you take employee overhead costs into account. Let’s see why.

Most readers of this article will be quick to recognize that Andre has failed to factor in benefits. True. But even when it comes to benefits, things are not so simple. You may be factoring in health and dental insurance, 401K contributions, and other perks, but are you factoring in the cost of the employee’s annual vacation when calculating the cost of the hours that she is productively working for you?

Here’s a fairly typical list of the company-paid benefits that are directly attributable to each employee:

Insurance (medical, dental, life)
Annual Bonus / 401K Contribution
Payroll taxes (company paid portion)

So as a first step, let’s begin our cost per employee formula by factoring in these costs to better estimate Pete’s real cost to Andre’s company:

$95,000 Pete's Base Salary
15,000 Pete's Insurance (medical, dental, life) - company paid portion
2,500 Pete's Annual Bonus / Company 401K Contribution
8,000 Payroll taxes (company paid portion)
======== ===============================================================
$120,500 Better approximation of total annual cost (salary + benefits)

OK, that’s closer to accurate, but still a long way from representing Pete’s full cost to Andre’s company. Benefits are frankly only the tip of the iceberg when it comes to figuring out how much an employee is really costing your company.

Cost of employee benefits? You’re paying for more than benefits

Running a business can be exhilarating. It can be challenging. And it can be expensive. There’s the cost of office space. Phone systems. Computer equipment. Administrative staff. Payroll services. And on and on and on. And each of your employees benefits from all this infrastructure “for free”.

And while you don’t charge your employees for any of this infrastructure, they most certainly do benefit from it. That being the case, to the extent that each employee uses this infrastructure, a corresponding portion of the cost is really attributable to him or her.

Here’s a fairly typical list of company-paid infrastructure costs (often referred to as indirect costs):

Accounting fees
Advertising
Bank service charges and fees
Books
Check orders
Computer hardware
Computer software licenses
Computer software subscriptions and maintenance
Conferences and trade shows
Corporate graphics and web design
Corporate taxes (property, etc.)
Credit card processing fees
Delivery and postage
Digital certificates
Dues and subscriptions
Equipment
Filing fees
Furniture
Hosting services
Insurance (liability, workers comp, etc.)
Interview expenses
Legal fees
Meals and entertainment
Meeting expenses
Office supplies
Overhead staff (executive, administrative)
Printing services
Recruiting (advertising and fees)
Rent
Repair services
Training
Travel
Voice and data communications

While this is a long list of overhead indeed, it’s important to mention that it’s not even necessarily complete. Many companies will have their own peculiar sets of indirect costs that don’t fall within any of the categories listed above. Collectively, it’s these many indirect costs that can cause a company to inadvertently “lose money” on hiring its employees.

Factoring it all in

OK, so how does one distribute these costs across each of the company’s employees to better approximate their real cost?

An overly simplistic way of doing this calculation would be to just add up all indirect costs, divide by the number of employees, and then add that portion of the total to each employee’s annual compensation.

While this may seem perfectly reasonable at first blush (and it is certainly much better than not factoring in these costs at all!), one quickly realizes that it is still way over-simplifying the problem.

Consider this, for example: Not every employee uses the same portion of the corporate infrastructure. As an extreme example, the company janitor occupies a much smaller portion of the administrative staff’s time than the CTO does. So attributing equal portions of the cost of the administrative staff to the janitor and the CTO wouldn’t seem to make a whole lot of sense. Even in less drastic cases, the same holds true. A Senior Systems Architect is likely to be using more of the company’s infrastructure than an entry level programmer.

The question then becomes how to intelligently distribute the company’s indirect costs across all employees.The generally accepted practice is to use salary as an approximation of seniority, which in turns serves as an approximation of the portion of corporate infrastructure and resources used.

Here's a very simple example that helps demonstrate the point:

Annual Salaries:
Sue $75,000
Bob $50,000
Ted $25,000
===== ========
Total $150,000

Allocation of Indirect Expenses:
Sue 50% ($75,000 / $150,000)
Bob 33% ($50,000 / $150,000)
Ted 17% ($25,000 / $150,000)

But even this is still over-simplified.

Consider the fact that some employee’s salaries (COO, CFO, administrative staff, etc.) are actually part of the infrastructure costs. As you go further down this path, it becomes apparent that costs need to be “pooled” into different categories in order to properly distribute them. The basic idea is that indirect costs are pooled into three primary categories:

Fringe benefits. Items such as health care, retirement contributions, paid time off, workman’s compensation, and so on.
Overhead. Business expenses not attributable to a specific project. Examples include rent, computer equipment, office supplies, voice and data communication charges, hosting services, and so on.
General & Administrative (G&A). Expenses attributable to running your business in general such as salaries for corporate executives and administrative personnel, legal fees, accounting fees, and so on.

The resulting calculations rapidly become quite sophisticated. For example, these Cost Accounting Standards from the Defense Contract Audit Agency provide a glimpse into the resulting complexity. Using cost per employee formulas such as these, an “indirect rate” corresponding to each of the above three categories is calculated. These are then applied cumulatively to an employee’s salary to derive his or her actual cost to the company.

According to a recent Deltek report, the most common values for these rates were roughly as follows: Fringe 35%, Overhead 25%, G&A 18%.

Applying these rates cumulatively yields a cost multiplier of 1.99; i.e., (1 + 0.35) x (1 + 0.25) x (1 + 0.18). This means that each employee is typically costing the company roughly twice (1.99 times) their base salary.

These multipliers can vary widely, though, across different companies, or even within the same company from year-to-year. In the Government contracting domain, the 1.99 figure is roughly the median, with cost multiplier values most typically being in the range of 1.5 to 2.5.

Returning to our true cost of an employee example, Pete’s real hourly cost to Andre’s company isn’t $45/hour; we now see that it’s probably much closer to $90 per hour ($45 x 1.99). On an annualized basis, this means that Pete doesn’t cost the company $95K; rather, Pete roughly costs the company around $190K/year ($95K x 1.99)! Suddenly, this no longer seems like such a bargain.

Consultant salary calculator: The real cost of consultants

But wait, you’ll say, don’t we have to provide a consultant with some corporate infrastructure too? So isn’t Roger the consultant also really costing us more than his hourly rate?

Yes, indeed he is. An excellent point.

However, the amount of infrastructure that a consultant uses is significantly less than that of an employee (not to mention the fact that the consultant doesn’t receive any benefits from the company). As a result, the actual cost of a consultant is affected by G&A (General & Administrative) costs only; Fringe (i.e., benefits) and Overhead are irrelevant to the cost of a consultant.

So, in our example, we can more accurately estimate Roger’s real cost to Andre’s company as being around $83/hour (i.e., $70 x 1.18, based on the typical G&A rate of 18% quoted earlier). This would equate to an annualized cost of roughly $170K (again using the standard figure of 2,080 work hours per year).

An apples-to-apples comparison

Now that we’ve properly accounted for the true costs of Pete the employee and Roger the consultant, we can make more of an apples-to-apples financial comparison between their costs:

What Andre thought:

Andre thought that Pete the employee was only costing his company around $45/hour, whereas Roger the consultant would cost his company $70/hour.

The reality:

Pete the employee is really costing Andre’s company around $90/hour, whereas Roger the consultant would only cost his company around $83/hour.

And thus, we prove the old adage that things are not always as they seem.

Other things to consider

Here are a couple of other key points to consider:

Potential financial risks. There are additional potential financial risks with an employee that are less likely in the case of a consultant. A prime example is the fact that companies tend to make hire/fire decisions much more rapidly with consultants than with employees. It is not uncommon for under-performing employees to be kept on the payroll for multiple months, throughout various stages of probation, to minimize the potential for an employee-filed lawsuit. The resulting cost to the company can be quite substantial. In contrast, companies tend to dismiss consultants with minimal if any notice when in any way dissatisfied with their performance.
Recruiting fees affect the cost of all employees. One obvious savings with consultants is the avoidance of often hefty recruiting fees. What may be less obvious, though, is that each recruiting fee paid drives up the real cost of all employees. Since recruiting costs are including in overhead expenses, every recruiting expense that your company incurs increases your overhead costs, which in turn raises your overhead rate multiplier, which in turns drives up the effective cost of each and every one of your employees (i.e., since the overhead multiplier is used in calculating every employee’s real cost, the higher that multiplier is, the higher each employee’s real cost ends up being).

Concluding remarks

When making the in-house employee vs. consultant cost-based hiring decision, it’s critically important to properly account for all the hidden costs per employee and costs per consultant involved in order to make a sound business decision.

Every company and situation is different so there’s no “one size fits all” answer here. But an awareness of the factors and issues discussed in this article will help arm you to make the best financial decision for you and your team.

This article was written by Hyam Singer, Toptal’s VP of User Engagement.

Why the Financial Markets Are More Like a Drunken Firing Squad

Since the beginning of the financial markets, boom and bust have happened. From the Dutch Tulip Mania of 1637, when a bulb was priced more than a house, other bubbles followed: The Mississippi Bubble, The South-sea Bubble and so on.

We could go on for an entire page, listing all the bubbles happened in the last centuries.  You may think that at this point we learned many lessons from them. Did we? Of course we did not. In fact, one common pattern of all those bubbles is “this time is different.”

Yet it wasn’t. In their brilliant paper entitled “This time is different” Carmen M. Reinhart Kenneth S. Rogoff show us how defaults and crises happening throughout the centuries taught us some valuable lessons, which very few seem to have grasped.

The catch is that those defaults often happened with some years or decades apart, with the consequence of inducing market players and policy makers that “this time was different” but when the next crisis struck they eventually turned out to be as severe if not more than the previous ones.

But if that is the case what did we get wrong?

We Got It All Wrong

The main assumption made by many economists and investors is that financial markets follow what is called a normal distribution, also called Gaussian curve. In short, this kind of distribution tells you that events that move too far from the average are rare.

A tool to know how far values are spread out from the average, is the standard deviation, also expressed with the Greek letter, sigma (σ). In other words, a value, which has a sigma of five, is way more rare than a value that has a sigma of one.

The Gaussian curve though tells you that events of 5/10 sigma are so rare that you shouldn’t expect them to happen in million of years. But how is this possible if only in the last decades we saw financial market crashes – which were considered by most economists, in the magnitude of 10/20 sigma – happening time and time again?

The problem is that we got it all wrong. In fact, those events, which are deemed to be so improbable according to the Gaussian distribution, are not such if we make a different assumption: financial markets follow a different form of distribution, called Cauchy distribution. To understand this kind of distribution we will use an interesting analogy; that of a drunken squad shooting into a wall.

Financial Markets Are Like a Drunken Firing Squad

in the book “The Physics of Wall Street: A Brief History of Predicting the Unpredictable” James Owen Weatherall describes the Cauchy Distribution with the following analogy. Imagine a drunken squad about to shoot in the wall in front of them:

“If you make a notice of where each bullet hits the wall you can use this information to come up with a distribution that corresponds to the probability that any given bullet will hit any given part of the wall…The firing’s drunken squad bullets hit the middle part of the wall most of the time – more often, in fact that the normal distribution, would have predicted. But the bullets also hit very distant parts of the wall surprisingly often – much, much more often than the normal distribution would have predicted.“

In other words, this kind of distribution totally changes the probability of certain “rare events” to happen. In fact, according to David Hand, in his book “The Improbability Principle” a 5-sigma event that according to the Gaussian distribution has a 1 in 3.5 million years to happen, in the Cauchy distribution, it has a 1 in 16 probabilities to happen!

This means that not only market crashes are not rare events, but we should actually expect them to happen way more often that we usually have thought in the past!

Keeping this in mind you may want to be sure your retirement fund is not blindly exposed to financial markets.

Credit photo: http://www.stockunlimited.com

The Rise of the Nerdepreneurs | How a Bunch of Polymaths Are Taking over the World

Since centuries the world of science and entrepreneurship seemed very far apart. Almost like two planets orbiting in parallel, which would never gravitate around each other. Yet, especially in the last century, those orbits have slowly changed.

Technology, which is the byproduct of scientific progress, walks hand in hand with the creation of new business ventures. Therefore, if before, scientists and entrepreneurs were two distinct roles; nowadays it is more and more common to find those two roles encapsulated in the same persona.

In other words, we see more often the rise of “scientific-minded entrepreneur.”

The Rise of The “Nerdepreneurs”

Mark is in his dorm room, with a bunch of friends. He has just created a new website called Facemash. The aim of this platform is to rank the Campus’ girls, based on their attractiveness. Edoardo, Mark’s friend, enters the room. Suddenly Mark asks for Edoardo’s chess-ranking algorithm. Edoardo writes it down on Mark’s dorm room window. This is the beginning of Facebook!

Although this scene of the movie “The Social Network” is just a romanced version of the reality, nonetheless it makes a great point. Mark Zuckerberg, the guy behind Facebook was a computer geek. Persons, like Mark Zuckerberg, would, just few decades ago, have looked the farer from the entrepreneur’s stereotype. Although Mark Zuckerberg was still a student, he was acting with a scientific mind-set.

The World Wide Web Like the Hydra Monster

Hercules was in trouble. Due to the goddess Hera, he had temporary lost his mental and killed his own wife and kid. Once he recovered from Hera’s spell, Hercules asked help and forgiveness to the god Apollo.

Apollo in turn, subordinated Hercules’ penitence to twelve Labors, which were so difficult that any human being would have considered them impossible. Once completed those Labors, Hercules would be set free.

It was time to overcome the second Labor, which consisted of killing a monster, with nine heads, called Hydra. Hercules was accompanied in this adventure, by his nephew Iolaus, which was also his charioteer.

Hercules initially started to cut the Hydra’s heads with his sword; there was only one glitch; the Hydra’s heads regrew swiftly, making Hercules’ feat impossible. None had tamed that monster before, and Hercules was doomed.

Yet he had an idea. He called for help, his nephew Iolaus. While Hercules chopped the Hydra’s heads, Iolaus kept a fire torch to its neck, making it impossible to grow. Thus, Hercules took the opportunity; chopped and buried the last immortal head of the monster and so he won.

Throughout human history, knowledge had traveled from head to head; that was the only way we knew. It was possible to transfer knowledge through books, but those books had to be physically transported from human bodies to human bodies.

The World Wide Web changed all that. Once the information and knowledge was transferred to a computer, then it could be shared worldwide to other millions of machines.

In 1991 Tim Berners Lee gave birth to the first global hyperlinked information system. It was a revolution! Science, commerce and military already used some sort of web networks, but they were closed and limited. Instead in Berners Lee’s vision the web was supposed to be universal and “world wide.”

By 1996, the World Wide Web was like the Hydra’s monster. It was growing exponentially but none really knew what it was and how it would have evolved.

The “Polymaths’ Mob”

In this scenario, a young man, named Larry, was working on a research project, BackRub, for his Ph.D. The aim of this project was to understand the mathematical properties of the web. In other words, Larry wanted to link the content of the web, based on the citations they contained.

Like Hercules called Iolaus to help him tame the Hydra, so Larry Page called Sergey Brin to help him tame the World Wide Web. Through hard work the two young men came up with “PageRank,” named after Larry Page.

In other words, web pages were ranked based on the citations they contained and how many times they were cited by other web pages. In addition, these links were also ranked based on the importance and prestige of the linking and linked sources. This is how Google was born.

Facebook and Google are just two of the many other examples of the “Nerdepreneurship Phenomenon.” In short, while the “old school entrepreneurs,” like Ford, didn’t deem necessary to know anything, except having a bunch of polymaths answering to his questions. Now we are assisting to the rise of a the “polymaths’ mob.”

A New Religious Credo

What do they all have in common? The scientific mindset. Which can be summarized in few, but very powerful commandments.

These commandments form part of the new “Entrepreneurs’ religious beliefs.” Like any other religion, the worshipping of deities too drives this credo. From Richard Feynman, to Karl Popper, a new world order is taking over. Let’s see their main credos:

You shall have no other mind before the rational one (Biological Hacking.)

Don’t make assumptions. Test them (Let algorithms do the work.)

Be comfortable with not knowing (The Feynman Paradox)

Let your ideas be falsified (Popper’s Mindset)

Let the analogies out. Think from first principles (Musk’s Heuristic)

Share the article if you like it. If we hit a certain threshold of readers we will expand on the five commandments mentioned above.

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References

https://www.youtube.com/watch?v=BzZRr4KV59I

http://www.perseus.tufts.edu/Herakles/labors.html

http://www.perseus.tufts.edu/Herakles/hydra.html

https://www.youtube.com/watch?v=9hIQjrMHTv4

http://webfoundation.org/about/vision/history-of-the-web/