Alice has a cup. She loves it, and doesn't want to get rid of it. Belinda wants a cup just like it. She really wants one just like it, straight away, and she doesn't want to wait.

I ask Alice if I can borrow her cup for a month, on the understanding that she gets it back in identical condition. I'll pay her £1 for letting me do this.

I then sell the borrowed cup to Belinda for £10. That gives me a month to find a replacement cup for Alice. Luckily for me, Clare has one that she doesn't want, and she sells it to me for £7.

At the end of the month, I can give the used-to-belong-to-Clare cup to Alice. She's happy because, as promised, she's got a cup again. She's also got £1, for basically doing nothing.

Belinda is still happy; she's got the cup she wanted, for a fair price.

Clare is happy because she has got rid of the cup she didn't really want, for a fair price. She's now got £7 in her pocket, which she can spend on something else.

And of course I'm happy too. I've got £2 profit, which I can go spend on something else.

That's short-selling in a nutshell. Everyone ends up happy.

OK. The eagle-eyed among you are already crying foul. Alice didn't get "her" cup back; she got another one. When you're dealing in shares, not cups, this doesn't matter. Shares in public companies are all identical and can't be damaged. So this wheeze really does work.

But it only works for me if the price falls over the month. If the price rises, I may be forced to pay more to Clare to be able to fulfil my agreement with Alice. Ultimately, I could lose out. But the girls will still be happy. It's only me that loses out.

Another claim made by critics of short selling is that my intervention in the market forces the market price down. But they never explain how. And, having traded with Belinda, I'm a buyer in the market. Once my transaction with Clare is completed, I no longer have any exposure to cups at all. How does this manipulate the market any more than any other participant looking to buy or sell?

Oh. On no account try to repeat this analysis with one less girl and one less cup. That really is hazardous and, I'm told, not safe for work!

Filed under: Accounting 101, Capital markets, Economics with tags derivatives, market abuse, shares, short selling, stock lending
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Ritchie is as pleased as punch because one of his blog entries from last year has been included in a publication:

Page 27 is a case study. It’s this blog, by me.

You might like to answer the questions the authors raise:

1. Murphy comments on the different theories of accounting under IFRS and UK GAAP. What are the differences and why is IFRS deemed inappropriate for local authorities?

2. based upon the arguments by Murphy should we have different accounting systems? For local authorities? For different countries?

3. What approach is Murphy using when he addresses the question of accounting for local authorities?

4. Why do you think IFRS has been adopted for local authorities? Is it scientific or unscientific?

From blog to accounting theory.

Critics please note.

Indeed I do.  This reads not so much as an endorsement of Murphy's burblings but as a comprehension test.  In particular, question 3 is more about his approach than it is about whether his arguments are valid.  Question 3 could indeed be restated "Is Murphy's argument valid?"

The answer, invariably, is no.

No doubt Wiley think there's lots to discuss in this post, as there are in many of his posts.  But they're not agreeing with him here, far from it.

Filed under: Accounting 101, Other blogs with tags idiots, ifrs, public sector, pwned, richard murphy, uk gaap, wiley
4067No Comments »http%3A%2F%2Fwww.fcablog.org.uk%2F2010%2F09%2Ffrom-blog-to-accounting-theory-to-pwned%2FFrom+blog+to+Accounting+Theory+to+pwned2010-09-16+08%3A13%3A40Christie+Malryhttp%3A%2F%2Fwww.fcablog.org.uk%2F%3Fp%3D4067

Some time ago, I introduced you to the first concept of double-entry book-keeping. However it was so long ago, we should probably start again. So here we go:

The basic idea is that every double entry book-keeping transaction has two sides to it - a debit side and a credit side. These entries are always from the point of view of the business:

• A debit is either something the business owns or is something the business has expensed.
• A credit is either something the business owes or is something the business has earned.

It's easier to explain this by just doing it. So here's a description of a business, very simplified, and we'll look at the transactions that go along with it. Yes, I know, some of the numbers look a bit silly:

Sandra decides to go into business as a hairdresser, working from people's houses. On 1 July, she puts £1,000 into her business. She needs some special scissors, so she goes and buys some for £400 in cash. Although she has a good network of friends, she decides to take out an advertisement in the local paper, for which she pays £50, on account. On 20 July, she cuts A's hair for £40 cash. On 27 July, she cuts B's hair for £40. Because B is a particularly good friend, she lets her pay her the following week.

What are the transactions up to 31 July?

First of all, we need to identify the transactions. Here they are, highlighted:

Sandra decides to go into business as a hairdresser, working from people's houses. On 1 July, she puts £1,000 into her business [1]. She needs some special scissors, so she goes and buys some for £400 in cash [2]. Although she has a good network of friends, she decides to take out an advertisement in the local paper, for which she pays £50, on account [3]. On 20 July, she cuts A's hair for £40 cash [4]. On 27 July, she cuts B's hair for £40 [5]. Because B is a particularly good friend, she lets her pay her the following week.

Transaction 1

On 1 July, she puts £1,000 into her business

The business has acquired access to a new asset, £1,000 in cash. However at the same time it has a new obligation back to Sandra, its owner, because it got the money from her. The entry is as follows:

DR  Cash £1,000
    CR  Capital £1,000

Transaction 2

...she goes and buys some [scissors] for £400 in cash.

Because the scissors can be used again and again, they are not a business expense. They are an asset that the business can use. So we record the scissors as an asset, while reducing the cash balance accordingly.

DR  Fixed assets £400
    CR  Cash £400

Transaction 3

she decides to take out an advertisement in the local paper, for which she pays £50, on account

An advertisement, once published, is considered 'gone', and therefore is a business expense. Note that she hasn't paid in cash, so the other side of the transaction is to trade creditors. It's something that she'll need to pay in the future.

DR  Advertising expense £50
    CR  Trade creditors £50

Transaction 4

On 20 July, she cuts A's hair for £40 cash

This one is easy. It's income, for which she receives cash.

DR  Cash £40
    CR  Sales £40

Transaction 5

On 27 July, she cuts B's hair for £40. Because B is a particularly good friend, she lets her pay her the following week

This one is very similar to [4]. But note that she doesn't get paid until the following week. So the 'debit' leg of the transaction isn't cash, it is recorded as a trade debtor, someone that owes the business money.

DR  Trade debtors £40
    CR  Sales £40

And that's that. Please note that these transactions are grossly simplified for ease of comprehension. But hopefully they help to explain some basic transactions.

Please comment/ask questions if there's anything that's unclear.

Filed under: Accounting 101 with tags introduction to double entry book-keeping
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Double-entry book-keeping is the what underpins modern accounting. All good accountants can 'speak' it natively and are able to break a complex series of transactions down into debits and credits. But what is it, exactly?

Double-entry book-keeping was first popularised by an Italian, Luca Pacioli, who was a mate of Leonardo da Vinci's. Its genius is that it records a transaction twice. This is reminiscent of Newton's idea that every action has an equal and opposite reaction, but has a truly amazing side-effect. It allows you to double-check whether you have recorded entries properly. Because, if you have entered in a transaction with unbalanced entries, your resulting ledger will not balance. In a stroke, and several hundred years before the computer, Pacioli had hit upon a way to introduce in-built checking to accounting.

The equal and opposite sides are called 'debits' and 'credits' by accountants. Every transaction has debits and credits that, taken together, match. In other words, the sum of all the debits equals the sum of all the credits.

Here's where it gets a bit esoteric, but you'll just have to bear with me. A 'debit' is either something the business owns or is something the business has expensed. A 'credit' is either something the business owes or is something the business has earned. This allows you to construct some fairly complex situations.

Let's try out a transaction. Later on, we'll get into some really complicated stuff. Imagine an entrepreneur setting up a company with £1,000. What would the entry for this transaction look like?

After the transaction, the company has cash - of £1,000. So we know that this transaction will have a debit of £1,000. We also know that we have to find a credit of £1,000. It's not earnings, because the company hasn't done anything yet. So it must be something the company owes. And that's what it is - the company 'owes' the £1,000 back to the entrepreneur. We call that 'capital' to reflect the idea that the company can't distribute that money as a dividend; it's needed to protect the company's creditors (when it gets some).

In accounting convention, we would write the entry like this:

DR  Cash £1,000
    CR  Capital £1,000

That's all for now. More complicated transactions will follow in later lessons. Please ask questions if this isn't clear!

Filed under: Accounting 101 with tags double-entry book-keeping, introduction to double entry book-keeping, isaac newton, leonardo da vinci, luca pacioli
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BBC news reports on Royal Bank of Scotland's results this morning as follows:

Royal Bank of Scotland (RBS) has announced losses for 2009 of £3.6bn, after struggling with billions of pounds of bad loans.

The figure is lower than the £5bn loss many experts were expecting and is well below the £24bn it lost in 2008.

The UK taxpayer owns 84% of RBS after the government bailed out the bank at the end of 2008.

RBS is the second major UK bank to report 2009 results, after Barclays announced record profits of £11.6bn.

This is a pretty fat-headed commentary from the Beeb here. There are two kinds of loss at play here, which we'll call cashlike losses and non-cashlike losses. Needless to say, non-cashlike losses are much less 'serious' than cashlike losses.

Non-cashlike losses occur when a business has to write down an asset that it had bought with something other than cash. Usually these occur when a business buys another business with its own shares. Without getting too technical accountingwise, the acquiring business values everything it's paying over (usually a big load of its own highly-valued shares) and everything it can recognise in the acquired company. The difference between the two is called 'goodwill' and is stuck on the group balance sheet of the acquiring company. Why do we always get a balancing number? Because there are usually things that accounting standards don't let you recognise as an asset but which have value, such as acquired research projects, you usually get goodwill in a business purchase, and it's usually a positive number. And fairly often a big one.

Back to RBS. RBS, you'll recall, paid a vast amount for ABN Amro thanks to Sir Fred's frolic. Last year's loss was swelled by a writedown (we call it an 'impairment') of goodwill of £16 billion. It's bad, for sure, but it's not that bad. A lot of it is market downturn, so RBS has finally had to face up to Sir Fred overpaying for ABN Amro, but it did so with its own shares, which were inflated at the time.

The equivalent goodwill impairment figure for 2009 was a mere £363 million. The rest is due to cashlike losses. These are the bad guys. These are assets that the business expected to turn into cash but it has had to devalue. For example, loans that the bank has made to customers or businesses but which will now not be repaid. In 2008, RBS impaired £7.4 billion of loans. Yet in 2009, we learn that RBS impaired nearly £14 billion of loans - almost twice as bad.

The bank did substantially better on its trading activities - £3.8 billion of income compared to a loss of nearly £9 billion in 2008.

But to report all this as "a £3.6bn loss is better than a £24bn loss" is just plain silly.

Filed under: Accounting 101, Current issues with tags banks, bbc, goodwill, impairment, royal bank of scotland
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A few days back I got a call from someone needing some accounting advice. He was trying to draw up some accounts for a client with a lease arrangement. The accounting standard for leases requires that you spread the implicit interest under the lease over the lease term, approximately in proportion to the amount of capital remaining.

Now, this might sound complicated, but it's exactly like a mortgage. If you were to take out a repayment mortgage with a 25 year fixed interest rate, you would be quoted a fixed payment amount that would stay the same for all 300 payments. Your first payment would pay off a tiny portion of the mortgage itself, and the rest would cover interest. Your next payment would pay off a tiny amount more of the mortage and a slightly smaller amount of interest than before. And so on... until your final few payments, which would be mostly mortgage and almost no interest.

In the days of fast computers and spreadsheets, working this sort of thing out is trivial. But it wasn't always like this. So that's why some bright spark invented what is now known as the Rule of 78. It works as follows:

• Imagine a year's worth of payments.
• Number the first month 12, the second 11, the third 10, etc.
• Now you divide each month by 78. Why 78? Because 78 is the sum of each of the integers from 1 through 12.
• The resulting fractions are the amount of interest you repay with each monthly payment.

It's worth pointing out that the Rule of 78 is better for short loans than for longer ones. But it's quite handy if you're stuck on a desert island and are in need of drawing up a quick loan agreement. And there are those who think it would be a rather good name for a punk band.

Filed under: Accounting 101 with tags interest, leases, punk, rule of 78
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When people talk about accountants, one might think that all accountants are the same. Yet, the UK accountancy profession, uniquely, has several professional bodies in competition with each other.

There are six main accountancy bodies in the UK:

• The Institute of Chartered Accountants in England and Wales (ICAEW)
• The Association of Chartered Certified Accountants (ACCA)
• The Chartered Institute of Management Accountants (CIMA)
• The Chartered Institute of Public Finance and Accountancy (CIPFA)
• The Institute of Chartered Accountants of Scotland (ICAS)
• Chartered Accountants Ireland

The fierce competition between these bodies, in particular between the ICAEW and ACCA, has led to some features that are particular to the UK profession. In many parts of the world, accountants are synonymous with auditors. Not in the UK - our accountants have a long history of involvement with company management and public financial discipline. Also, membership of one of our institutes is not dependent on remaining in public audit - accountants can remain a member of a UK institute after leaving audit.

There are other, smaller, professional bodies in the UK. I'll get round to all the main bodies one by one, as well as the tiddlers, in future posts.

Filed under: Accounting 101, Institutes with tags acca, cai, cima, cipfa, icaew, icas
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