Understanding Business Accounting For Dummies, 2nd Edition (19 page)

Using
debits and credits
is a marvellous technique for making sure that both sides of exchanges are recorded and for keeping both sides of the accounting equation in balance. The recording of every transaction requires the same value for the debits on one side and the credits on the other side. Just think back to maths class in your schooldays: What you have on one side of the equal sign (in this case, in the accounting equation) must equal what you have on the other side of the equal sign.

See Table 2-1 for how debits and credits work in the balance sheet accounts of a business.

Table 2-1 The Rules of Debits and Credits

Changes In Assets In Liabilities and Owners' Equities

Increases Debit Credit

Decreases Credit Debit

Note:
Sales revenue and expense accounts, which are not listed in Table 2-1, also follow debit and credit rules. A revenue item increases owners' equity (thus is a credit), and an expense item decreases owners' equity (thus is a debit).

As a business manager, you don't need to know all the mechanics and technical aspects of using debits and credits. Here's what you do need to know:

The basic premise of the accounting equation:
Assets equal the sources of the assets and the claims on the assets. That is, the total of assets on the one side should equal the sum of total liabilities and total owners' equity on the other side.

The important difference between liabilities and owners' equity accounts:
Liabilities need to be paid off at definite due dates in the future. Owners' equity has no such claims for definite payments at definite dates. As such, these two accounts must be kept separate.

Balanced books don't necessarily mean correct balances:
If debits equal credits, the entry for the transaction is correct as far as recording equal amounts on both sides of the transaction. However, even if the debits equal the credits, other errors are possible. The bookkeeper may have recorded the debits and credits in a wrong account, or may have entered wrong amounts, or may have missed recording an entry altogether. Having balanced books simply means that the total of accounts with debit balances equals the total of accounts with credit balances. The important thing is whether the books (the accounts) have
correct
balances, which depends on whether all transactions and other developments have been recorded and accounted for correctly.

Juggling the Books to Conceal Embezzlement and Fraud

Fraud
is a catch-all term; we're using the term in its broadest sense to include any type of dishonest, unethical, immoral, or illegal practice. Our concern here is with the effects of fraud on a business's accounting records, not with the broader social and criminal aspects of fraud - which are very serious, of course, but which are outside the scope of this book.

A business should capture and record faithfully all transactions in its accounting records. Having said this, we have to admit that some business activities are deliberately
not
accounted for or are accounted for in a way that disguises their true nature. For example,
money laundering
involves taking money from illegal sources (such as drug dealing) and passing it through a business to make it look legitimate - to give the money a false identity. This money can hardly be recorded as ‘revenue from drug sales' in the accounts of the business.

Fraud occurs in large corporations and in one-owner/manager-controlled small businesses - and every size business in between. Some types of fraud are more common in small businesses, including
sales skimming
(not recording all sales revenue, to deflate the taxable income of the business and its owner) and the recording of personal expenses through the business (to make these expenses deductible for income tax). Some kinds of fraud are committed mainly by large businesses, including paying bribes to public officials and entering into illegal conspiracies to fix prices or divide the market. The purchasing managers in any size business can be tempted to accept kickbacks and under-the-table payoffs from vendors and suppliers.

We should mention another problem that puts accountants in the hot seat: In many situations, two or more businesses are controlled by the same person or the same group of investors. Revenue and expenses can be arbitrarily shifted among the different business entities under common control. For one person to have a controlling ownership interest in two or more businesses is perfectly legal, and such an arrangement often makes good business sense. For example, a retail business rents a building from a property business, and the same person is the majority owner of both businesses. The problem arises when that person arbitrarily sets the monthly rent to shift profit between the two businesses; a high rent generates more profit for the property business and lower profit for the retail business. This kind of manoeuvre may even be perfectly legal, but it raises a fundamental accounting issue.

Readers of financial statements are entitled to assume that all activities between the business and the other parties it deals with are based on what's called
arm's-length bargaining
,
meaning that the business and the other parties have a purely business relationship.
When that's not the case, the financial report should - but usually doesn't - use the term
related parties
to describe persons and organisations who are not at arm's length with the business. According to financial reporting standards, your accountant should advise you, the business manager, to disclose any substantial related-party transactions in your external financial statements.