Last week, in this column I continued sharing my finance cheat sheet with the set of mnemonics I used to teach myself accounting.
This week, we continue. But first, we remember:
Debit means left.
Credit means right.
Asset accounts are left (debit) accounts and Capital accounts are right (credit) accounts. We remember this by spelling and counting:
Remember, Assets = Capital and Capital = Debt plus Equity. So debt and equity are both right accounts. At the beginning of every year, each account begins with the actual amount in the account at the end of the previous year. Positive amounts belong on the same side: left for left accounts, right for right accounts. Negative amounts belong on the opposite side.
To record increases or positive changes in an account, record the amount on the same side. To decrease an account, record an entry on the opposite side.
It’s very important to remember that after the beginning balances are created, every entry on the left side of an account is matched by entries totaling that amount on the right sides of some other account. That is why it’s called double entry bookkeeping. Also, accountants like for things to match.
Now, we remember that the income statement really explains changes in equity, a right account. Since revenue (sales) increase equity, it is a right account, Expenses, which decrease sales is a left account.
The Accounting Sample
Going back to our sample from last week, we begin with 50,000 in cash using 100% equity. That means the cash account starts with a balance of 50,000 and so does the equity account. All other accounts have a zero balance.
Let’s say that, before we begin to operate, we use 40,000 to buy a car that we plan to sell and we pay cash, then we would record changes in both cash and inventory.
Remember, since the car is what we will sell, it is inventory, NOT fixed asset! Also remember that both cash and inventory are left accounts.
The 40,000 decreases assets. So that goes on the opposite side – on the right. The transaction increases inventory. Inventory is a left account – so the entry goes on the same side – left.
It is important to note here that these two entries, the left entry in inventory to record an increase of 40,000 in inventory is balance by a right entry of 40,000 in cash, which records the decrease in cash. So the entries balanced!
When accountants have manual or semi-manual (excel) systems, they actually simply total all left entries and all right entries in an accounting period just to do a quick check that all of the entries balanced.
Now, notice that we have no income statement accounts yet. But, at this point, we have a beginning balance sheet.
Always remember, at the beginning of a fiscal year, balance sheet accounts get carried over but income statements accounts begin with zero.
Now, we sell the car for 45,000. Many things happen. We get cash. We release inventory. But also, that is a sale! And that is revenue! And, with the principle of matching, we can now recognize the cost of sales. So that is four accounts that are affected!
In the income statement accounts, we have movements in Sales, a right account because it increases equity, a right account. We make a right entry of 45,000 in sales in order to show that sales for the year increased.
We also record a cost of sales using the principle of accounting that we record expenses that are related to sales. And once again, we see that accountants do really like things to match.
Now, cost of sales is an expense account. This account decreases equity, a right account, and is therefore a left account. Since we are recording an increase in costs (a left account) for the year, this is a left entry.
There are also movements in balance sheet accounts. All the balance sheet movements are in the left (asset) accounts.
We record an increase in cash of 45,000 since the car was paid for in cash. This increases the left account of cash and is therefore a left entry. Note that it balances the right entry of sales and shows that the sale was a cash transaction. We also show a decrease in inventory of 40,000. This is a right entry in the left account of inventory. This shows that we released a car worth 40,000 when we made a sale. This 40,000 left entry balances the right entry of cost of sales.
If we want to make our income statement now (without tax and interest or any other cost), it would look like this:
Sales: 45,000
Cost of Sales 40,000
Gross Profit: 5,000
Other Expenses: 0
Net Income 5,000
Our ending Balance Sheet would look like this
And we can see that, not only does the balance sheet balance but also the increase in equity is explained by net income.
Isn’t accounting fun???
Readers can email Maya at [email protected]. Or visit her site at http://integrations.tumblr.com. For academic publications, Maya uses her full name, Maria Elena Baltazar Herrera.
