Learn the Basics of Accounting in 15 Minutes: T Accounts, Debits & Credits
Today we are going to discuss understanding accounting. And I'm going to give you an example of deferred income. Because I get a lot of questions from undergraduates and graduates at the University, where they have a lot of questions about how it works. They don't understand debits and credits. And they really always seem to have issues with deferred income or deferred expense, so I'm going to do this. This going to be quick, but if you just listen to this video, you're going to understand how accounting works.
The first thing I always believe in starting off at the very beginning. Where did accounting start?
Accounting started back in 1495, by an Italian, he's a monk or a friar. His name was Luca Pacioli. And what Luca did was, he lived in Venice at the time. And Venice back in 1495, was actually the center of the world as far as business was concerned. And here's a picture of Luca for you, you could see he's a monk or a priest. And because he lived in Venice, and it was the center of the world, commerce, everything was coming through Venice, all the spices, and gold and all kinds of stuff. And they would be shipped throughout the Mediterranean and throughout the known world at that time.
And what Luca did was, he realized that there was a need for some type of bookkeeping, and he actually wrote a book. And here's a nice picture I have for you of Venice, what it looked like, in the 13th and 15th century. And see it was actually the trading capital of the world back then. And he wrote a book. And the reason he wrote this book was that there at the time, the complexity of business was growing more and more. And as the businesses grew, they needed to access to capital. And there was a lot...Banking was big, also in Venice at the time. But the bankers were reluctant to lend money because they didn't really understand if the merchants were making money or losing money because sometimes their books weren't in order.
And back then, if your books weren't in order, you could actually...you'd be thrown into debtors’ prison, or you could even be put to death. So, it was a very, very serious offense. Now, not only were the bankers reluctant to loan the money but also merchants were reluctant because if their books didn't balance, if there was some kind of sloppy bookkeeping, well, I mean, it could be the death penalty, or you could spend your life debtor's prison. Obviously, we don't do that anymore. But there was a real need to have a sound bookkeeping method.
And what Luca did was he wrote a book. It was called "Summa Arithmetica." Now, this book didn't only talk about bookkeeping, it was like 800 pages long. And it discussed all kinds of stuff like measurements, geometry. Only about 30 pages of this book was devoted to bookkeeping. But the main thing that happened if you remember your history, what was going on in the 1500s? Okay, that's when the printing press was invented. So, this book that Pacioli wrote was mass produced, and sent throughout the world and translated into different languages. And even though it discussed, like I said, all kinds of stuff, calculus and everything, there was 30 pages in there devoted to accounting. And what happened was, the banker said, "Hey, this is a great system." And the merchant said, "Hey, it's a great system, I'm not going to have my head chopped off when my book doesn't balance."
And this is how his system works. Now, the main thing I always tell accounting student is you have to understand that debit means left and credit means right. That's all it means. Because people like debits credits, it's just left and right. That's all you have to know. And what he did, what Luca did was he set up a T account. Okay. And trust me, what he wrote, in 1500s is still used today. It's still used every single day in the world today, this was one of the greatest inventions ever. It changed the world, it changed everything.
And all he did was you could see here is over here, I have assets, liabilities, income, revenue, expenses and equity. And like I told you, an asset, if you want to increase it well, you have to debit it, which just means what? Left, right? It increases, it increases it, if you put it on the left, and it decreases if you put it on the right, credit means right.
Now liabilities, though, if you want to increase a liability, well, if increasing it, you have to credit it. And decreasing, you have to debit it.
And for income and revenue, you have to credit it to increase it and debit to decrease, expenses are credit and debit again. And equity again, if you want to increase it you credit it. Now, this may sound a little confusing but just say to yourself, keep saying to yourself, "Okay. Debit means left; credit means right. Debit means left credit means right."
Now, here we have these T accounts, which is basically a T here, see the T? And I just said if you want to increase an asset what do you do? You debit it. Right? So, debit is plus, if you want to decrease it, it's minus. So, if you have an asset, like let's say cash, and you want to increase it, what do you do? Well, you have to debit it, which means put it on the left, because this is what Luca set up.
Now, assets equal liabilities plus owner's equity, if you have accounting, this is just a simpler formula. This has to balance and just like it had to balance into 1500s, it has to balance now in the 21st century.
Now, liabilities, we just said what? If you want to increase a liability, you have to credit it. What is credit mean? Right. So, it's going to be the right side of the T count. If you want to reduce it, you debit it.
Now, equity, owner's equity. If you want to increase it your credit, if you want to decrease it, you debit. Now, this is where it gets a little bit tricky. And you're going to have to...owner's equity is comprised of what? It's comprised of paid-in capital and retained earnings.
What's retained earnings comprised of? Well, it's the summary of expenses, revenues, and dividends.
Now, you have to understand this stuff. I wish someone told me this when I was an undergraduate, and just showed me this and just focus on this page because this is accounting. And if you understand this, you can understand more than 99% of the people out there. Okay. This first box here is basically telling you how you increase and decrease assets, liabilities, income expenses and equity. Now, this here is basically just taking this information and plug it in, in the T accounts. Okay? What Pacioli basically devised in 1500s. And if you use this system, this system balance...everything always balances. Right? Everything's a formula, assets equals liabilities plus owners' eq.
Okay, so let's say you have a liability account, and you want to increase it. We just went over and we said what do you have to do in a liability account to increase it? You have to credit it. Right? So, we go here, we see I want to increase it, because I have a bill for let's say, my internet. Well, I'm going to credit it. Here's the T account, and I'm going to record an expense. Now, I want to increase expenses. How do you increase an expense? Increase expense, you debit it. Right? It balances. And then when you pay it, you're going to use cash in the bank, you're going to have to reduce your asset, you're going to credit it, and you're going to reduce the liability. So how do you reduce a liability? You debit it.
Okay, everything works that way.
Now, here, we're going to go into a quick example so you can apply. But the main thing is just focus on what Luca wrote on the last page, just read it until you understand it. Okay? Once you understand that you're going to understand accounting.
Now, let's assume that you want to purchase...we're back in, you know, 1495, 300 pounds of spices per month from a Venice spice dealer. Okay, the price for 300 pounds of spices per month would be $1,000 each month. However, the spice dealer demands a $3,000 payment in order to guarantee the spices for the next month. What would be the entry to record this transaction?
Here's what the entry would be. Okay. So, let's say we want to...this is from the spice dealer. Okay. He wants to...you gave him $3,000. Right? And what do you want to do...what does he want to do with the £3,000? He wants to increase an asset. Well, how do we increase an asset? We debit it. Right? Debit it.
And he has $3,000 that he received, but he hasn't earned it. Right? Because spices have not shipped, so it's deferred income. Deferred income is a liability because you have a liability to provide $3,000 worth of spices. Right? So, we want to increase a liability. How do you increase a liability? Let's see how what Pacioli wrote. He wrote to increase a liability you credit it. Right? So, we're going to credit it. So, this should balance. Right?
Let's see, does it balance? Cash is 3000 because we got the cash and deferred income because we haven't...we owe...we have to...we haven't earned this $3,000. Right? If the contract's cancelled, we got to give the money back. So, it's a liability. Right? We have the money, but we haven't earned it. Now, what would be the entry after one month?
Well, now, hey, we earned some money. Right? So, we want to reduce this liability by $1,000. And we want to say, "Hey, we made $1,000." Well, how do you make...how do you record $1,000? You want to record $1,000. So, we want to increase income from spice sales. Right? Well, let's look at what he wrote.
Okay. So, revenue went up so we want to credit it. Right? Let's check over here. Revenue went up, increase, you credit it, and we want to decrease the liability, you debit it. Right? Let's go back. It works out.
So, the main thing from this video is that accounting was invented in the 1500s, by an Italian monk, Luca Pacioli. And the system, he set up with debits and credits, the financial statements, the balance sheets, the income statement was all written in his book. And that book, because of the printing press was published and sent around the world. And the reason it was so important, because just like now, accounting is critical, accounting is the language of business. Okay? If someone asks you if you know a foreign language, you can always say yes, if you understand accounting.
And that system was so important, because people like I said, they would they could lose their lives if their books didn't balance, or they'd be put in debtors’ prison, or have their hand chopped off. It was, you know, it was even now it's very important that books make sense. And if they don't, there could be tremendous consequences. So that's one of the reasons this system was so infallible because it worked. Okay? And there's little refinements, but basically, the same thing we do now was done in the 1500s.Return to Video Gallery