Lesson 1 of 9
Two sides of one event
Every exchange changes two things at once. A record that captures only one of them is a list, and a list cannot tell you whether you made money.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Every business event that is worth recording changes at least two things, because something was given and something was received.
- A cash book records only the cash side, so it cannot say what is owed, what is owned, or whether a year was profitable.
- Double entry records both sides of every event, which makes the books self-checking rather than merely complete.
A transaction is an exchange. One party gives something and receives something, and both of those are facts about the business at the same instant.
That sounds obvious and it has a consequence that is not. If you write down only what you received, you have described half an event, and half an event cannot be added up into anything meaningful.
One event, two effects
- 1Materials arrivethe business now owns $30,000 of paper and cloth
- 2An obligation arrives with themthe business now owes the supplier $30,000
The company this course follows
Fen Street Bindery is an invented business that binds books to order. It begins on 1 January with nothing at all: no cash, no equipment, no customers and no obligations.
Its first year is the worked example in all nine lessons of this course. Every figure is round and invented so it can be checked by hand, and the same numbers carry forward from lesson to lesson.
Four events, and what each one changes
The third row is worth pausing on. Buying the machine did not make the business richer or poorer. It converted one asset into another: $48,000 of cash became $48,000 of equipment. Nothing was earned and nothing was spent in the sense that matters to profit.
The fourth row is the same shape and is easy to get wrong. Paying rent twelve months ahead is not an expense on the day it is paid. It buys twelve months of occupancy, which is an asset that gets used up over those twelve months.
What a cash book cannot do
Suppose the bindery kept only a record of money in and money out. At 31 December it would know its bank balance exactly and would still not know:
- how much customers owe it, because the sale on credit never touched cash;
- how much it owes suppliers, for the same reason;
- what it owns, because the machine is just a payment in a list;
- whether the year made a profit, because a payment for next year's rent looks identical to a payment for this year's wages.
Every one of those questions needs the other side of the event, and the other side is exactly what a cash book throws away.
The test for whether something is a transaction
Two conditions. There has to be an event, not an intention, and its effect has to be measurable in money.
Signing an agreement to buy materials next month is not yet a transaction, because nothing has been given or received. Hiring a skilled binder is not a transaction either, however valuable that person is, because the value cannot be measured in money.
That second condition is the source of a limitation this course will keep returning to. A set of books records only what can be priced. The reputation, the customer relationships and the skill of the staff are real, they are often the most valuable things the business has, and no ledger has ever contained them.
Check yourself
A business pays $48,000 cash for a machine. What happened to what it owns in total?
- It fell by $48,000
- It did not change, because cash became equipment
- It rose by $48,000
Show the answer
Answer: B.
One asset was exchanged for another of equal value. Nothing was earned and nothing consumed, so the total of what the business owns is unchanged.Why can a cash book not tell you whether a year was profitable?
- Cash books contain errors
- It cannot distinguish a payment that buys something future from a cost of this year, and it never records credit sales at all
- Profit is not a real concept
Show the answer
Answer: B.
Rent paid for next year and wages paid for this year look identical in a cash book, and a sale on credit does not appear until the money arrives.A bindery hires a highly skilled binder. Is that a transaction to be recorded?
- Yes, at the value the person adds
- No, because nothing has yet been given or received and the value cannot be measured in money
- Yes, at the annual salary
Show the answer
Answer: B.
A set of books records measurable exchanges. The skill is real and valuable and unrecordable, which is a permanent limitation of accounts rather than a flaw in this example.Sources
- This lesson is taught from first principles. No external source is cited, because no claim here depends on one.
What this leaves out
- Fen Street Bindery is invented and so is every figure in this course. No real company is described.
- The events chosen are deliberately simple. Real businesses face sales taxes, payroll deductions, returns, discounts and foreign currency, none of which appear here.
- Recording only what can be priced is a genuine limitation of all accounting, not a simplification made for this course.
- Nothing here is advice about any security.