You don’t have to be around accounting or accountants very long before you hear “debits and credits”. You may also have heard of journals and ledgers.
The original purposes of debits, credits, journal entries and ledgers (T-accounts) include:
- Speed in capturing data
- Accuracy in recording
- Accuracy in processing
- Ease in preparing reports
None of these original purposes is relevant today.
Data are captured immediately and accurately by electronic means, processed using software that rarely (never) makes arithmetic errors, and organized into reports by software that allows great flexibility in aggregating and summarizing data.
So why are you in a module labeled Debits and Credits?
Here’s the answer in a nutshell:
Debits and credits, along with journal entry and T-account notation to display them, are powerful tools for analyzing transactions and financial statements. They are powerful because, until artificial intelligence supplants them, human analysts are in the same position as an accountant in the middle ages: overwhelmed with data that must be internalized, manipulated, and analyzed to extract maximum information. The techniques of debits and credits, and related journal entry and T-account forms, were developed and refined over hundreds of years. It is not surprising, then, that they are great tools for the job.
Taken together, these techniques form a visual representation of the numbers and their relationships contained in the financial statements. That is, they help write things down in a good way.
The Power of Visualization – A Helpful Digression
To see the importance of representing quantities in a way that facilitates understanding, just try to do the following multiplication problem:
MMDLI times XXIV.
You might need this:
In case you don’t know how to use an abacus, here’s the answer:
(L with a bar over it is the symbol for fifty thousand, and X with a bar over it is the symbol for ten thousand.)
Even when we switch to the Arabic numbers with which we are familiar, there are ways of representing the problem that allow us to find the answer quickly and accurately. It may be some time since you solved a multiplication equation by hand, so follow this video and pay attention to how important it is to line the numbers up correctly:
Debits and Credits
In the same way that we utilize numerical position and operators to facilitate arithmetic problems, debits, credits, journal entries and T-accounts (ledgers) allow us to represent many types of financial information in ways that facilitate understanding and analysis. Because debits and credits are used in both T-accounts and journal entries, their value will be apparent when we show how useful T-accounts and journal entries as analytical aids.
Let’s begin by exploring the way debits and credits are used to work the Fundamental Identity.
Download to work through: Debits and Credits
Journal Entries
A journal entry is a visual representation of a transaction. It shows all the accounts affected by a transaction, the amounts involved, and whether the account is to be debited or credited. If you impose some discipline on your journal entry, you will soon be able to pick up a lot of information about the transaction very quickly. Here is all you do:
- Write all the debits first, then the credits.
- Indent both the account name and the amounts of the credits.
Here is a video that demonstrates how you use the worksheet:
T-accounts
A T-account is a visual representation of how an account evolves over time. It has a beginning balance (which may be zero) and an ending balance (which may also be zero), and shows the increases and decreases that caused the account to go from its beginning balance to its ending balance.
For example, information from ImmuCell Corporation’s 2016 Form 10-K can be used to structure the following visual of its Property, Plant & Equipment (PP&E) and related Accumulated Depreciation accounts:
To give you an idea of how this can be used, here is an early teaching video I made with the analysis. The point of this video is to give you an example of the usefulness of T-account and Journal Entry notation. You should not expect to follow the details unless you have significant experience in analyzing financial statements. (The Stan I mention is Stan Garstka, my co-author, long-time colleague and most committed adherent to the mission of the Yale School of Management.)
This video shows how far you can go with the skills we will build in the course. Full disclosure: You usually can’t nail things down as completely as we did with ImmuCell in the video. But the point is not perfect understanding, it is maximizing the information we can extract from financial statements. You can work on it an entire lifetime, and still be learning and increasing your skill. What we want to do is help you get the foundation that will form the solid base of your future efforts.