Welcome to the Finance Storyteller series!
In this video I am going to discuss the concept of T-accounting
in relation to recording sales transactions.
T-accounting, or making T-accounts, is a very helpful way
of visually representing accounting entries.
You can use it to sketch out the accounting for of all kinds of transactions, from straightforward
standard transactions to highly complex and rare ones.
Let's take a look!
In recording a sales transaction, you tend to make use of 4 main accounts: inventory,
receivables, cost of goods sold, and revenue.
The first two, inventory and receivables, are accounts on the balance sheet.
The last two, cost of goods sold and revenue, are accounts in the income statement.
On purpose, I am only showing you 4 accounts, there are obviously many more accounts on
the balance sheet as well as on the income statement,
but these are out of scope in this example.
A balance sheet is a picture at a point in time of what you own and what you owe.
An income statement is an overview of the revenues and expenses during a period (like
a month, quarter or year).
Please note that not every company and not every accounting textbook will use the same
terms: for example receivables are often called accounts receivable or debtors, revenue is
often called sales or turnover, and the income statement is sometimes called
the profit and loss statement.
The financial terminology that a company uses also depends on its business model: if you
sell services, you would talk about cost of services sold instead of cost of goods sold.
At the start of the period, we have $100 worth of inventory.
This is either the cost of what we made it for (materials and labour) or what we paid
for it when we purchased it from an external supplier.
Before a sales transaction takes place, a lot of things have happened: your sales people
have gone out and praised the features and benefits of your products, the customer has
received a quotation, you have negotiated a contract with them, and they have sent you
a purchase order.
For the financial statements, things start to get interesting once you issue an invoice
to the customer.
Invoicing to the customer generates a debit in accounts receivable (you create an asset,
a claim to future cash), and a credit in revenues.
This is called double entry bookkeeping, and is represented with the solid line between
the two T-accounts.
When you send an invoice to the customer, you have to do some work in return.
For an invoice to count as revenue, goods have to be delivered
or a service has to be rendered.
The shipment transaction in this example is a credit to inventory, you no longer have
the goods in your possession in your warehouse, and financially speaking
you no longer own the asset.
The debit of the journal entry goes to the Cost Of Goods Sold or COGS account in the
income statement.
If at the end of the period, we now add up the opening balance and the two transactions
(sending the invoice, and shipping the goods), we get to the ending balances of the four
accounts we used: inventory is now $0, receivables is $150 (this is money still to be collected),
cost of goods sold is $100, and revenue $150.
The difference between revenue and cost of goods sold is a positive $50, we have sold
the inventory to the customer at a price that is higher than
what we made or bought the goods for.
You could call that margin, or more specifically gross margin.
If the sum of the credits in your income statement is bigger than the sum of your debits in the
income statement, which is the case in this example, then you generate a profit.
We can also express margin as a percentage of revenue:
$50 margin on $150 of revenue is 33%.
Here's a little bonus for you.
Let's assume a company wants to mislead its shareholders, by pretending things are going
better than they really are.
The company decides to issue fake invoices to artificially inflate its revenue and profitability.
How would that work in terms of journal entries,
and how would an accountant or auditor detect it?
If you overstate revenues by issuing fake invoices, then revenue would be $175 instead
of $150, and receivables would go up accordingly.
There are two ways this overstatement could be detected.
First of all, fake invoices lead to fake receivables that will never be collected.
Auditors always look carefully at the outstanding accounts receivable balance, and could ask
for balance confirmations from the customers mentioned on the invoice, as well as ask for
an aging analysis of how old the open invoices are.
Second way to detect the overstatement is analyzing the margin trend, and finding out
what the drivers are for an increase or decrease.
Historically, the margin was at 33% of revenue, and due to the fake invoices the margin has
now gone up to 43%, with no valid business reason.
If you issue fake invoices, you do not have a shipment transaction against it, therefore
your margin percentage goes up disproportionally.
I hope this was helpful.
Thank you for watching!
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