Hello I'm professor Brian Bouche. Welcome back. This is the video you've all been waiting for we're gonna talk about debits and credits. Now I have to admit that there is somewhat of a disagreement in the accounting faculty world about whether we should still be teaching debits and credits. I am firmly in the camp where I believe that debits and credits are a very useful and powerful tool for learning and teaching accounting. Plus they still use them to this day. If I had to figure out some kind of complicated transaction and financial statement, the first thing I would do would be break out the debits and credits to help me crack the problem that I'm trying to solve. So, hopefully you'll find them useful too. If nothing else, you're joining an exclusive fraternity of people around the world that can speak in the world of debits and credits. Let's get started. As a starting point I have to say that the most interesting thing about bookkeeping is that it's the only word in the English language with three consecutive sets of double letters, oo, kk, ee. Beyond that, I'm not sure it's that interesting. But these three fundamental bookkeeping equations I'm gonna show you, are incredibly powerful tools for both learning accounting and then ultimately understanding the information that you're gonna read in financial statements. The first equation we've seen before. Assets equals liabilities plus stockholder's equity, the balance sheet equation. We're also going to introduce the equation that the sum of the debits has to equal the sum of the credits. And at the beginning balance of an account plus increases minus decreases has to equal the ending balance in an account. These three equations must balance at all times. And this will come in handy because many times we'll be missing one piece of information, but we'll have everything else. And then we can use one of these equations to figure out the piece of information that we're missing. We're going to recognize that the balance sheet equation can be preserve through the use of debits and credits. So instead of having to constantly go back and recalculate the balance sheet equation, instead, all we have to do is make sure our debits equal our credits, and we know that the balance sheet equation is preserved. So what are these magical things called debits and credits? A debit is defined as a left side entry, and a credit is defined as a right side entry. Doesn't credit mean good? Credit my account. Credit card. Credit to society. All sounds good to me. >> And doesn't debit mean bad? Debit card. Debit my account. Debit to society. I hate the word, debit. PS, debit and credit have gotten those connotations in the real world. But in the accounting world, debit simply means left, credit simply means right. Sometimes debits are good, sometimes they're bad. Sometimes credits are good, sometimes they're bad. All they mean is left and right. Don't ask me why we abbreviate debit as DR. It's probably something the British came up with centuries ago and we've always done it that way. But that's the way we do it so get use to it. Now lets take a look at how debits and credits can be used to preserve the balance sheet equation. So here's the balance sheet equation again and in prior videos remember we did a more complex complete balance sheet equation, where we split the stockholders' equity into contributed capital, retained earnings, and then revenues and expenses. >> Where are dividends? In a prior video, you had dividends in this complete balance sheet equation. I bet you think we aren't even watching the videos we don't participate in. Nice catch. I did drop dividends from this equation. One reason is that I was running out of space on the slide, as you can see. But the more important reason is, we're gonna not treat dividends as a separate account going forward. We'll create separate accounts for revenues and expenses but we're just going to treat dividends as a reduction in retained earnings. The problem with this equation is that we have the negative expenses at the end. As we saw in a couple videos ago, it can get confusing with working with expenses in this case. Because with any increase in expense would be an increase in a negative number on the right side of the equation which would make it go down, and it's very confusing. To solve this problem, we're going to move expenses to the other side. Now we have assets plus expenses equals liabilities plus contributed capital plus retained earnings plus revenue. And it's all positive numbers. Then we are going to call everything on the left debits and everything on the right credits. There are a number of rules of debits and credits that we have to keep in mind and follow if we want the debits and credits to stand in for the balance sheet equation. First is that every transaction must have at least one debit and at least one credit, which makes sense, because if we want our debits to equal credits, we have to have at least one on each side in a transaction. Debits must equal credits for all transactions. And as long as that's the case, we'll know that the balance sheet equation will stay in balance. No negative numbers are allowed. So you're going to debit a positive number or credit a positive number. You're never going to debit a negative number or credit a negative number. And as you can see in the balance sheet equation above, now that it's rearranged, we don't need to deal with negative numbers for debits and credits. Now we're gonna talk about accounts and account balances. And in case you ever wondered, the reason why this is called accounting is because we put everything in these accounts, which are areas where we keep track of similar types of transactions. Every account has a normal balance. That's the type of balance, either debit or credit, that the account carries under normal circumstances. We're gonna represent accounts in something called a T Account, which is gonna show all the changes in the account value. We're gonna put debits on the left side of the T and credits on the right side of the T, and we're gonna do that because debit means left and credit means right. The difference between the sum of the debits and the sum of the credits, at any point in time will give us a balance for the account. Then the change in account balance equation is the one we saw before. Beginning balance in account plus increases minus decreases has to equal the ending balance, where we're gonna use debits and credits to stand in for the increases and decreases. I was wondering why I wasn't getting any questions. Wake up. It's gonna get more interesting, I'm gonna do some examples now. Okay, let's take a look at how this works in more detail. Assets and expenses are going to have a normal balance that's a debit, which means it's gonna sit on the left side of the T-account. For example, let's look at an asset like a Accounts receivable. Remember this is the money owed to us by customers based on sales we've made in the past. It's an asset, because it's money we'll collect in the future. Notice I put a little(A) to denote that this is an asset account. The beginning balance sits on the left side of the T account because it's a debit balance account. Then let's say during the period, we make new sales of a hundred. New sales on account increase accounts receivable, increase the amount of cash that our customers owe us, and we're going to increase the account through a each debit entry. We increase a debit account with a debit entry. Then when we collect cash from customers, it reduces accounts receivable. The customers don't owe us the cash anymore because they paid us. So the account has to go down. We reduce accounts receivable with a credit. We reduce a debit balance account with a credit entry. Then at the end of the period we draw a line, add up the debits, subtract the sum of the credits, and we get an ending balance, in this case of 1,020, which sits on the debit side. Because again, it's a debit balance account. So does debit mean good? I mean, new sales are good, right? Or does credit mean good? Cash collections are good, right? I am so confused. >> Don't think of debits and credits as good and bad. Debits simply means left entry, credits simply means right entry. Debits will sometimes increase account, debits will sometimes decrease an account. It all depends on the type of account it is. So, hang on for more examples, but just keep in mind, debit and credit is not good and bad. It's just left and right. Now, let's look at accounts that have a normal balance on the credit side. Liabilities, stockholders' equity, and revenue have normal balances that are credits which sit on the right side of the T-account. If we look at an example of a liability like accounts payable, this is money that we owe our suppliers based on on raw materials that we've received in the past. Put a little (L) to indicate it's a liability because we have an obligation to pay those suppliers in the future. At the beginning of the period, we owe our suppliers a thousand dollars. That beginning balance sits on the credit side, because it's a credit balance account. During the year, we pay $80 to our suppliers that reduces the liability, reduces the obligation. We reduce a liability with a debit, so a debit entry reduces a credit balance account. Also during the year we go out and purchase new inventory. We purchase it on accounts, so we owe our suppliers $100. That's gonna increase the liability accounts payable. We increase the liability with credit, a credit entry increases a credit balance account. The end of the period we draw a line, add up the credits, subtract the sum of the debits, get an ending balance of 1,020, which sits on the credit side, or right side, because it is a credit balance account. >> I think I've got it! Debit means increase for a debit account and decrease for a credit account. And credit means increase for a credit account and decrease for a debit account. Or, is it the other way around? >> No, you're exactly right. Debits increase a debit balance account and decrease a credit balance account. Credits increase a credit balance account and decrease a debit balance account. Did I say that right? I think so. Anyway, let's just go on. One way to represent this graphically is through something we call the Super T-account. If you think of the whole balance sheet as a big T-account with assets on the left and liabilities and stockholders' equity on the right. Then what you can see is, all the individual asset accounts are gonna be increased by debits because they're on the left side of this Super T. All the individual liability, contributed capital, and retained earnings accounts Are gonna be increased through credits because they sit on the right hand side of the super t. And where it gets a little tricky is revenues and expenses. Remember revenues and expenses live within retained earnings. Revenues increase. Net income, which means, they increase retainers. Revenues have a credit balance. They're increased by credits, which in turn, increases retainers. Expenses are reductions in net income and hence, reductions in retained earnings. So expenses have a debit balance, because a debit to an expense represents a reduction in retained earnings. I mean there's not much intuition to this. This is just something you're gonna wanna memorize until it becomes second nature. Dude, can I get a tattoo of this on my arm? >> Yeah, you could but maybe a less drastic step would be to just print out the slide or maybe write it on your hand with an ink pen. But I do think it is a good idea to keep a cheat sheet handy to help remind you which accounts are debit balance accounts. And which accounts are credit balance accounts until you have it memorized. We're gonna follow a very systematic approach in analyzing transactions to figure out how to represent them as journal entries. Journal entries are what we're gonna use to show a transaction in this debt and credit format. So there is three questions we have to think about. First what specific asset, liability, stockholders' equity, revenue or expense accounts does a given transaction effect. Does the transaction increase or decrease the affected accounts? And then should the accounts be debited or credited, and here we can look back to something like our super T account as a cheat sheet to figure out whether we debit or credit to increase or decrease the accounts. Then we can put it in the journal entry format, which is our shorthand for what happened in the transaction. We start with the debit account, we use the abbreviation Dr for debit. The name of the account and the dollar amount. Then we list the credits after that. We indent the credits, put a Cr for the abbreviation, the names of the accounts credited and the dollar amount. The key thing to remember is always list your debits first, then list your credits and then always indent your credits. Okay, this is really important. Raise your right hand and repeat after me. I do solemnly swear that I will always list my debits first. >> I do solemnly swear that I will always list debits first, >> That I will always list credits second, >> That I will always list credits second, >> And that I will always indent my credits. And then I will always indent my credits. >> Did I just ask you to swear an oath about debits and credits? I think I'm maybe getting a little loopy here. So, why don't we go ahead and stop the video at this point. We'll pick it up in the next video with the series of four examples to help pull together everything we've talked about so far, and then we'll practice doing some journal entries. I'll see you then. See you next video
