Recording Transactions

Background

We've covered the fact that with financial transactions, two accounts (at least) are impacted. So what types of accounts are there?

Question

What types of accounts are there? Name an example for each. Are the balances in each of them normally debits or credits?

Answer

1. Assets are things we own and are normally debits. Cash is an example.
2. Liabilities are things we owe and are normally credits. Accounts Payable is an example. 
3. Equity is the net value of the business and is normally a credit. Owner's Equity is an example.
4. Income is cash and other consideration we receive in the course of business and is normally a credit. Sales is an example.
5. Expense is what is paid out in cash and other consideration in order to make income and is normally a debit. Salaries is an example. 

Analysis

We've discussed in prior entries about a merchant selling a cow for gold (i.e. cash). Let's talk about some transactions that are a normal part of business and examine the types of accounts that are impacted.

So let's start with that cow we keep talking about. We own it - it's ours. We call something like that an asset. Assets are things we own.

Along with the cow, things we own include cash (gold, silver, money, etc), land, buildings, inventory, and more.

Assets are normally debit balances - and so debits will increase assets and credits will decrease them.

Let's make a little story out of this. Let's say the only thing in the world we own is the cow and we're walking to the market town to sell milk.

Ok - we get to town late. We need to get a room for the night but the innkeeper only wants cash. We say we'll pay him when we sell milk tomorrow. The innkeeper agrees, and so we now owe the innkeeper money. That is a liability. Liabilities are things we owe, such as loans and debts.

Liabilities are normally credit balances - and so credits will increase liabilities and debits will decrease them.

Along with the debt to the innkeeper, we might also owe money to the tax collector, to a landlord, or to others.

At the same time, we now also record an Expense - money or value that we pay in order to make income. Other types of expenses include salaries, utilities, taxes, and more.

Expenses are normally debit balances - and so debits will increase expenses and credits will decrease them.

So let's now talk about what we're worth. Before going to town, we were worth one cow (for ease, let's say the cow is worth $100). And let's also say that we have to pay $1 per night at the inn. So after one night in the inn, we're now worth $99. Our equity is what we own less what we owe. Equity is Assets less Liabilities.

Equity accounts are normally credit balances - and so credits will increase liabilities and debits will decrease them.

We find a butter maker and we sell some milk to them. We get some money (let's say $2) so that is an increase in cash and so a debit. We also record Income. Income is money that we earn.

Income is normally a credit balance - and so credits increase income and debits decrease them.

Vocabulary used:

For more information check out these links (comment to add your favourite link):

Where might you have come from?

Fact-orials Index

Accounting Principles

• Double Entry Accounting

Where might we go?

Accounting Principles:

• Cash vs Accrual Accounting
• Comparability of Transactions

The Start of Accounting

Background

With the creation of counting numbers, people had an easy way to keep track of different numbers of things. For instance, they could count what they owned...

Question

Why did accounting start? What's the purpose of it?

Answer

Accounting started right around the time numbers were created. The purpose of accounting is to organize financial transaction data.

Analysis

With the development of counting numbers, people could start to keep track of the numbers of things that they owned. But more importantly, they could keep track of historic transactions. How many calves were born last year as compared to the year before? How much did I get per head of cattle from this trader versus that merchant.

This then is the primary purpose of accounting - to keep track of financial transactions and also to track financial position. This kind of information enables the users of it to make better financial decisions. For instance, is it better to trade a dairy cow for 10 egg laying hens or to decline the trade? Knowing the value of the milk coming from the cow as compared to the value of the eggs from the hens would be a great thing to know - and it's accounting that keeps track of this kind of information.

Because we don't want to destroy information in accounting, we don't subtract. Instead we try to only add information. 

For instance, let's say we're tracking the number of cows and chickens we have. We'll start with 10 cows and 0 chickens.

Cows = 10
Chickens = 0

Along comes that trader we talked about before and we decide that 1 cow for 10 chickens is a good trade. If we were to simply track the numbers of things we have, we might say this:

Cows = 9
Chickens = 10

which is true but it doesn't tell us how we got here. It'd better to have the ability to show the different transactions. Perhaps this way:

Cows:

Starting Number = 10
Given to Trader = 1
Ending Number = 9

Chickens:

Starting Number = 0
Received from Trader = 10
Ending Number = 10

In accounting-speak, the tracking of each individual thing is done within an "account". In the above example, we have two accounts: cows, and chickens.

We keep track of the transactions of each account in a "journal" for each account (there is also something called the General Journal - transactions are initially reported there, then transferred to the individual journals). 

To help better keep clear transactions that increase and those that decrease an account, there'll be more space along the journal to show the transaction type. For instance, for the Cow account, it might look like this:



As we get more and more into the making of accounts and the different types, there are going to be a couple of things that make keeping track of information even easier.

The first is that, to make tracking transactions easier, accountants use something called a T Account - which is simply a T shaped way to track transactions. The Cow account would look like this:

               Cow
          ________
Start: 10   |
                 |   1 Given to Trader
                 |
         ____|_____
End:    9

(to show the end of a period of time where we sum up the results, we put the lower horizontal bar across. While it's open, that lower bar is left off and so it looks like a T and not a capital I.)

The other thing we'll do is not refer to things "increasing" and "decreasing" because sometimes one side of the T account will increase an account and sometimes it's the other side that will do it. Therefore, accountants refer to the left side of the T account as the Debit side and the right side as the Credit side.

Vocabulary used:

For more information check out these links (comment to add your favourite link):

Where might you have come from?

Fact-orials Index

The Start of Everything - the Fact-orials Table of Contents

Numbers:

• Counting/Natural Numbers

Where might we go?

Accounting Principals

• Double Entry Accounting