Welcome to the Finance Storyteller series!
In this video we are going to cover T-accounting in a special way, by looking at the balance sheet
as a family of t-accounts.
This helps to understand the context of accounting entries, and allows you to see the interdependencies.
The term T-account refers to the visual representation that we use while T-accounting: a big horizontal
line at the top, and a vertical line below that in the middle, like a capital letter T.
If you think about that visual structure of
the capital letter T, then you could consider the balance sheet as a prime example.
A balance sheet is a picture at a point in time of what you own (on the left-hand side)
and what you owe (on the right-hand side).
What we own is called assets.
What we owe is called liabilities.
If we fill in the balance sheet with an example of accounts and amounts, then these are some
of the terms you would often come across.
In assets: cash, accounts receivable (invoices sent to your customer that they have not paid yet),
inventory (goods that you hold to sell) and plant & equipment (fixed assets, buildings
and machines).
In liabilities: accounts payable (invoices sent to you by your supplier that you have
not paid yet), accrued liabilities (liabilities for which you have not received an invoice),
debt (borrowings), and equity (the book value of shareholder capital).
As the word balance sheet suggests, the sum of the assets has to equal the sum of the
liabilities and equity.
A very useful way to view your balance sheet, is to look at each of these asset and liability
accounts as their own T-account.
Cash, accounts receivable, inventory, and plant & equipment have a number on the left-hand
side of the T, as they are asset accounts.
Accounts payable, accrued liabilities, debt and equity have a number on the right-hand
side of the T, as they are liability accounts.
We can now start doing our T-accounting for movements on the balance sheet.
For illustration purposes, I will walk you through 5 balance sheet to balance sheet transactions.
On purpose, I am not involving any transactions that touch the income statement, as that would
greatly increase the scope and complexity of this example.
Our first transaction is a payment by the customer of the full accounts receivable balance.
This is recorded as a debit to cash, and a credit to accounts receivable.
The second transaction is the purchase of a new piece of equipment.
This is recorded as a debit to plant & equipment, and a credit to cash.
The third transaction is the delivery of new inventory to our warehouse.
We purchase new inventory, and our supplier sends us an invoice that we have to pay later.
This is recorded as a debit to inventory, and a credit to accounts payable.
Our inventory asset increases, and our accounts payable liability goes up by the same amount.
The fourth transaction is a reclass between accrued liabilities and accounts payable on
the liability side of the balance sheet.
We had a significant amount of outside services performed just before year end last year,
for which we had not received invoices yet.
At that point, we recorded the cost in the income statement as a debit, and the liability
on the balance sheet as a credit in accrued liabilities.
Now that we received the invoice from the supplier, we book a credit to accounts payable,
further increasing our balance of money that we owe to suppliers, and we book a debit to
accrued liabilities.
The last transaction in this example is paying down part of the loan we have with the bank.
We use some of our favorable cash position to pay down debt.
To record this, we credit cash as money is moving out of our account, and we debit debt.
The balance sheet has now become overly busy with these transactions, so it is time to
clean it up for the new upcoming year end by calculating the ending balances.
In cash, we had an opening balance of 20, a further debit of 80 when the accounts receivable
were paid, and outgoing amounts of 10 and 30.
If you sum this, you get to a debit ending balance of 60.
In accounts receivable, the opening balance of 80 was fully settled, so we have an ending
balance of 0.
In inventory, we had an opening balance of 40, received a delivery of 20, so we end with 60.
In plant & equipment, we started with 60 and added 10 in new equipment,
for an ending balance of 70.
In accounts payable, we had an opening credit balance of 30, which was further increased
by 30, to end at 60.
Accrued liabilities started with 10, and this amount was reclassed to accounts payable when
we received the invoice, so we end with a credit balance of 0.
In debt, we started with a credit balance of 70, paid down 30 of our outstanding balance,
so we end with an outstanding liability of 40.
Equity wasn't touched by any of the transactions in the example,
so it stays equal to the opening balance of 90.
Total assets are now 190, and total liabilities and equity is also 190, so our balance sheet
balances between left and right.
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.
I hope the idea of looking at the balance sheet as a family of t-accounts is helpful
for your conceptual understanding.
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