Accounting as the foundation of personal and business finance by Toby York

A Level and BTEC Business courses contain accounting requirements that are daunting, if not overwhelming. The learning specifications are broad in scope and technical in detail. Common language is used in uncommon ways, and as everybody knows, accounting is just a bit boring.

All of these things are true––except accounting is not boring––it’s beautiful and exciting. What’s more, teaching accounting can be a joyful experience and does not require wading through countless textbooks or brushing up on Accounting for Dummies. Effort is needed, but focusing on the right things in the right order can make this pleasurable too.

My hope is that you will feel more confident and inspired to teach this timeless, amazing subject that affects all our lives in so many ways.

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The beauty of double-entry bookkeeping

Arguably, the three most important social technologies in the history of human civilisation are literacy, numeracy, and accounting. Surprisingly, accounting probably predates the others. Schmandt-Besserat (1991) suggests that accounting did not arise from the increasing complexity of economies, but has been present in all but the most rudimentary societies for about 10,000 years. In her wonderful book, Before writing, she explains that small clay objects served as accounting tokens in pre-history and reflected an archaic mode of “concrete” counting before the invention of abstract numbers.

Today, accounting is based on the relatively modern system described in a fifteenth century school book of business and business mathematics by Luca Pacioli, Summa de arithmetica, geometria, proportioni et proportionalita, (Summary of arithmetic, geometry, proportions and proportionality). Pacioli sets out instructions for recording transactions using two entries of equal amount: a debit and a credit, which we call double-entry bookkeeping.
“Maestro Luca” was a renaissance man, Franciscan friar, close friend and teacher to Leonardo da Vinci, a doctor of divinity, faculty member on various universities, public lecturer and mathematician. His interests included art, architecture, statistics, calligraphy, chess, magic, and business, and closest to his heart, education.

At this time in northern Italy, political leaders valued bookkeeping as an essential form of knowledge and believed that it was required for maintaining order and the solvency of their states (Soll, 2014, p50). There were many comprehensive merchant schools providing a syllabus not very different to what is taught in business schools today. Pacioli was a teacher in the merchant schools for 30 years before writing Summa. Sangster and Scataglinibelghitar (2010) give a fascinating account of his approach to teaching:
“…he guided them in what was ‘best’ and explained why it was important that they do as he suggests. This was not ‘spoon-feeding’: his students still had to think. He continually challenged them by setting problems to solve that required insight, understanding, and a thorough appreciation of the flexibility of the various (mainly mathematical) tools they had been taught to use. In doing so, he used problems devised by other teachers but he developed new understanding and new solutions to these problems and placed the problems in a commercial or legal setting, thereby maximizing their relevance to his students.”

Over the past 500 years double-entry bookkeeping has become a powerful financial technology used by all organisations of every size and complexity throughout the world. Some commentators have suggested that its very existence enabled the rise of capitalism.

Admittedly, there is a quotidian mundaneness to it. It’s a mechanical, repetitive process that meticulously records every economic event to which an entity is a party. In any minute of every day across the world trillions of transactions are being recorded using double-entries. From the corner shop to the largest global corporations, manual and computerised systems are capturing the minutiae of investments, sales, purchases, and adjustments. It’s bureaucratic and functional, but the overall endeavour is a remarkable and massive achievement of data collection and information organisation.
 

Exploring the elements

Double-entry bookkeeping isn’t the whole story. Periodically, an entity’s transactions are manipulated and summarised by accountants, usually honestly, to tell a financial story––an account––that reveals, explains and analyses aspects of the entity’s financial performance and condition.

The financial story is built upon a conceptual framework that organises transactions within five foundational “elements”: assets, liabilities, equity, income and expenses. This is what gives accounting its elegance––the financial accounts of every entity, regardless of size or complexity, are prepared using just five elements.

There is heated debate among accountants and differences in practice but the fundamental nature of the five elements is broadly settled. The most effective introduction to accounting therefore starts by exploring them in turn.

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Elements 1, 2 and 3: assets, liabilities and equity

We ask students to say what they see in this picture.

This may be a long conversation and adapted into a homework exercise.

 

Ultimately, it reveals the nature and scope of assets that are recognised within financial statements and highlights differences between such “recognised assets” and vernacular definitions of ”assets in the world”. It’s always a revealing and rewarding conversation.

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We then ask students to imagine that they are starting a business which needs assets of 50,000. We write 50,000 in the asset box (see the diagram).

 

 

We ask where the funds for the business might come from, which provides the answer “from lenders”. We write 30,000 in the first orange box to show a bank loan and we label the box “liabilities”.

The remaining answer is “also from owners and investors“. We write 20,000 in the other orange box and label it equity.

We summarise by stating that liabilities and equity of 50,000 are the sources of funds which provide the cash of 50,000 which is available for the entity to use. The result is a balance sheet, or statement of financial position, showing the sources and uses of funds.

Incidentally, notice that we said 50,000 rather than £50,000 or €50,000. There is a valuable learning point, often missed, that only assets are valuable––for example, cash is valuable so cash is always an asset. Liabilities and equity are never valuable and are not cash, but they are expressed in monetary amounts. We differentiate between money (an asset) and monetised amounts.

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A good question to ask at this point is “what’s the value of this enterprise?”. The answer, of course, depends on point of view.

 

You might be inclined to say that the business is worth £20,000 and this is true, but only from the point of view of investors. The valuable thing is actually ”investment in equity”—an asset in the investor’s butterfly.

Ambiguity over point of view is common throughout accounting education, but especially so when explaining the nature of equity, even among the accounting profession and its regulators. It’s also a cause of much confusion among students.

What about from the lender’s point of view? The value of the entity is the loan of £30,000, which is an asset in the lender’s butterfly.

The enterprise value, if defined as equity and debt finance, is £50,000.

From the entity’s point of view, the purest answer is to say that the entity is worth nothing. The value of assets is equal to the sources of funding for those assets, which gives us the accounting equation:

Assets = Liabilities + Equity

So, depending on perspective, it can be argued that the entity value presented on the balance sheet is nil, £20,000, £30,000 or £50,000. This is not evasive or misleading, but a self-evident truth that reflects the purpose and nature of accounting.

We develop another conversation to make explicit the nature of profit (income less expenses) and its relationship to the balance sheet (or statement of financial position).  

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We imagine a new business that does not require inventory, for example a consultancy. This time we describe duality at the transactional and elemental levels—a hint at double-entries. For the bank loan we say “cash increases by £30,000 and bank loan increases by £30,000”.

Notice that nothing moves between the elements: cash increases / loan increases. Asset and liability appear at the same instant, reflecting the duality of a singular transaction.

For the equity transaction we say “cash increases by £20,000 and share capital increases by £20,000”.  

Elements 4 and 5: income and expenses

The story continues. A consultant in the business takes a taxi ride to a client’s premises to provide some advice while the taxi waits. The client pays the consultant £700 in cash for the work done. The taxi takes the consultant back to her office and she pays the driver £300 in cash.

The accounting equation is immutable, so it must be possible to record this transaction using only the three visible elements: assets, liabilities and equity.

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In working through the solution, we deal with cash first as the movements are more readily understood. Cash increases by £700 when the client pays and then decreases by £300 as the driver is paid.

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What about the balancing entries?

The first step is to facilitate the answer that a profit of £400 has been generated. Some students will want to record a change in liabilities, but the bank loan does not change whether or not the business generates profits.

The answer is that profit increases equity: the entity’s obligations to the ownership interests. Profit is “generated equity”. In workshops, even with experienced lawyers and entrepreneurs, this can be their “a-ha” moment. We highlight the importance of profit by drawing a purple box around it.

The accounting framework now balances and we can all breathe again.

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The final step is important, and in classes we progress slowly, using it as an opportunity to explore the natures of income and expenses, which are widely misunderstood.

We reveal income and expenses by “double-clicking” the purple profit box, a bit like a folder on a computer. Income and expenses tell the specific story of how generated equity changed during the period.

Some students are inclined to place income on the green side as that is where the “valuable things are”. We remind them that only assets are valuable and in this transaction the value is the increase of cash by £700.

We seek to reframe with a question, “What was the source of that value?”. Income was the source of funds and like all sources, it sits on the orange/credit side of the framework. Income is not valuable––income is activity that generates value.

Some students will suggest that expenses have decreased, as they reduce profit. It’s helpful to emphasis that an “adding / subtracting” mindset can be confusing, and it is better to think in terms of “increasing / decreasing”. The business had more travelling, so expenses increase, just as it had more bank loan when it received cash from the lender.

We use verbs to describe income, “consulting”, and the taxi ride as “travelling” to support the idea that income and expenses are activities.

Income is activity that creates value, expenses are activities that deplete value. Income increases the value of generated equity, expenses decrease the value of generated equity.

Organising and structuring knowledge

There is more to the Colour Accounting Learning System than is possible to outline in this introductory article, but I hope it provides evidence that dwelling in the conceptual framework not only makes accounting education accessible and rewarding, but also provides students with an organising mechanism making it easier for them to understand, contextualise and adapt their knowledge.

There can be few areas in education that have such a simple and singular system to teach, and if more than 500 years of past performance are any indication of future developments, once learned can be held by students for the rest of their lives without fear of obsolescence. This is one reason that teaching accounting is a privilege and a pleasure.

This article by Toby York first appeared in the Journal of the Economics, Business and Enterprise Association.

Toby York qualified as an accountant more than 30 years ago and has spent the best part of two decades teaching at Middlesex University Business School, and also in schools and corporations. A few years ago he stumbled across the “Colour Accounting Learning System”. This article is an outline of that approach and draws on the work of Peter Frampton and Mark Robilliard of the Accounting Literacy Foundation.

Resources and further reading

Accounting Cafe
A community of enthusiastic accounting educators creating resources for engaging and active lessons. Lots of ideas, downloads and accredited training courses in the use of the “Colour Accounting Learning System”. accountingcafe.org/schools

Accounting Literacy Foundation
An advocacy group promoting accounting literacy as an essential life skill and providing access to accounting literacy education. accountingliteracy.org

Colour Accounting BaSIS Framework™
The BaSIS Framework™ may be reproduced, amended and distributed under the terms of the Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International Public License: give credit to Wealthvox Limited and share your work on the same basis.

Colour Accounting Educators
The education site of Wealthvox, the owners of the “Colour Accounting Learning System”. educators.coloraccounting.com

The Joy of Accounting, Peter Frampton and Mark Robilliard
A book by the creators of the “Colour Accounting Learning System” with detailed and extensive examples and practical applications. True to its name, it is a joyful read.

References

Sangster, A. and Scataglinibelghitar, G. (2010) Luca Pacioli: The father of accounting education. Accounting Education, Vol 19, No .4, 423–438.

Schmandt-Besserat, D. (1991) Before Writing Volume 1, from counting to cuneiform. Austin, Texas: University of Texas Press.

Soll, J. (2014) The Reckoning: Financial accountability and the making and breaking of nations. Great Britain: Allen Lane.

York, T. (2021) The benefits of concept mapping in accounting education. Accounting Cafe. Available at: https://accountingcafe.org/wp-content/uploads/2021/05/Concept-mapping-in-accounting-education-DRAFT-v02.pdf (Accessed 21 May 2021).

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