Today we're going to apply our knowledge of debits and credits. I'll show you how this translates into recording actual
example transactions. We're going to use
T-accounts in the beginning and move on to journal entries afterwards. Let's get to it.
(upbeat music) In a previous video, link is up here, we covered the theory
of debits and credits. If you didn't watch that video yet, I recommend that you do because otherwise what
we're about to cover here is not going to make much sense. Okay, so today we're going
to prepare journal entries for some example transactions. So basically we're going
to take some activities of a business and turn them into data. We call this bookkeeping. It's often mixed up with
accounting, but it's not the same. Bookkeeping is only a part of the overall accounting process, and it covers these two steps. Step is one is to collect
and sort all source documents for each financial transaction. Source documents are the evidence that the financial transaction occurred. It includes things like
receipts and invoices. Step two is to record and
post the relevant data from each source document. Here's the thing though. To record any transaction, it must be analyzed to
answer two questions, which accounts are affected? There are only six main account groups we need to worry about,
assets, dividends, expenses, liabilities, equity,
and revenue, ADEX LER. And question number two,
did accounts go up or down? We also know that to
record any transaction you always need at least two accounts. One will be debited, and
one will be credited. That's called double-entry bookkeeping. And the total debits for
each transaction we create must equal total credits. All right, so enough with the theory. Let's actually do this. Remember Claudio? We followed his Italian
beach business in this video, and now it's time to
record the transactions that happened during this day. Let's start with Claudio
leaving his home in the morning. He left with 100 euros in his pockets. This is his private money that he invested to start the business. Let's record this transaction. Which accounts are affected? Assets, that's resources
the company owns and uses. He left with 100 euros in cash. Cash is an asset, so
yes, assets are affected. Dividends, that's a
distribution of profits of the business to the owners. That doesn't happen here. Liabilities, that's
something we owe to others. At this point, Claudio doesn't
owe anything to anyone, so liabilities aren't affected. Equity, this is money
owners paid into the company or profits that the business generated that were not distributed to owners. Claudio put in his own
money into the business, so we know that equity is affected. Revenue and expenses are
accounts in the income statement. He didn't earn anything or incur
any expenses at this point, so these don't apply. So we can deduct this transaction will affect
only assets and equity. Second question, did
accounts go up or down? Let's see. Claudio put cash into the business, so the cash account increases, right? At the same time, by putting
money into the company, equity increases as well. So both accounts go up. That's weird, right? Let's use some T-accounts
to figure this out. T-accounts are what accountants use to visualize a transaction. Each T represents one account. In our case, we need two Ts, one for cash and one for paid-in capital. Each T has two sides,
a left side for debits and a right side for credits. In order to figure out the debits and credits for the transaction, we're going to use our
secret weapon, ADEX LER, accountants don't expect
low earning rates. Cash is an asset. It's the A in ADEX. ADEX is our shortcut to remember debits. These accounts increase with debits and decrease with credits. We already determined
that cash is increasing. Therefore, to increase
cash, we debit the account. Hundred euros go to the debit
side of the cash account. The golden rule in accounting is that total debits
must equal total credits. With that in mind, we can easily determine that the second account, paid-in capital, will be credited for 100 euros. Or to be on the safe side,
we use ADEX LER again. Paid-in capital is an equity account. It's represented by the E in LER. LER is the shortcut to remember credits. These accounts increase with credits and decrease with debits. Since equity is increasing,
it needs a credit for 100. That's it. Both sides of the
transaction are in balance. We recorded our first transaction. Let's move on to the next one. After Claudio left his home, he went to the manufacturer of the plates. There he bought 100 of the colorful plates with his 100 euros in cash. Let's run through the steps
to record this transaction. He spent his cash, so we
know assets will be affected. With his cash, he purchased inventory, the plates he's going to sell
to tourists later, right? Inventory is an asset too. Therefore, this transaction
affects two asset accounts. The second question was to determine if accounts go up or down. Well, he spent his cash, so his cash account will decrease, right? At the same time, in exchange
for cash, he got the plates, so inventory will increase. Here we have our two
accounts, cash and inventory. On the cash account, we already see the
first transaction we did on the debit side. Now we already know from
ADEX LER that cash belongs to the A in ADEX, which stands for debits. These account decrease with credits. Cash is decreasing, so we
know we need to credit it. 100 euros go to the credit
side of the account. Where does the debit
for this transaction go? We said inventory, right, which is also an asset
account represented by ADEX. Inventory is increasing,
so it needs a debit. 100 euros go into the debit
side of the inventory account. That's it. We are in balance. Another transaction recorded. Next one. With his 100 colorful plates,
Claudio went to the beach and started selling them to tourists. Usually we would record the
individual sales separately, but to save time and because
it's kind of repetitive, let's just record the sales
of the whole day in one go. There are actually two transactions
we need to account for. I'll show you what I mean. Let's start with the
first part, his sales. He sold 100 plates for five euros each, so that's 500 euros in total. How do we account for that? Which accounts are affected? We need at least two. We know the tourists
paid cash for the plates, so cash is definitely affected. We also know that when a
business is selling goods or services, it creates sales or revenue. That's the other account we need. Now, which one is going up or down? Well, cash is going up because he collects
that from the tourists. Therefore, cash will be debited. And we can safely assume that the credit will
need to go to revenue. With ADEX LER, we can confirm that. The R in LER stands for revenue. So we know it's a credit. Credits increase with credits, which means our assumption was correct. Instead of T-accounts, let's
now do a journal entry. This is what bookkeepers will use to transform the transaction into data that can be processed. Years ago, that was actually
written manually in a book, but nowadays we use
accounting software for that. A journal entry looks like this. It will include the date. That's the date the transaction occurred. Then it has one line for each account that was affected by the transaction. To the right are the
columns for the amounts, one for debits and one for credits. Sometimes we will also see the
abbreviations Dr for debits and Cr for credits. Usually some description for the transaction will be added too. We will just add some text
here below the accounts. So let's create the journal
for Claudio's sales. First the date, let's say
that was August 15th, 2019 for Augusto in Italy, high season for any beach business. Then the accounts, I usually
start with the debits. Claudio received cash,
so we write that down and put in 500 euros in
the debit column for it. The credit goes to revenues. We put the 500 euros in the credit column. Last, we add a short
description, and that's it. That's how this
transaction would look like as a journal entry. But we're not done yet. There is another part of this transaction that may not be so obvious at first and that we didn't account for yet. Do you know what that is? His inventory. So far, we only recorded the sales part, but while his cash was
increasing by selling the plates, his inventory was decreasing as well but not by the same amount. This is where it can get a bit complicated because there are different methods how inventory can be valued. There is first in, first out, or FIFO, weighted average cost, and
last in, first out, or LIFO. But that's for another video. Basically, we need to still account for the cost of goods sold, or COGS, so let's create the
journal entry for that. First the date, same
day, August 15th, 2019, then the accounts. Claudio incurs cost of
goods sold, or COGS, because he didn't get the plates for free. COGS are expenses. Expenses are the EX in
ADEX, and therefore, debits. They increase with the debit. So we need to debit expenses. We already know that
Claudio's inventory decreased. Inventory is an asset. Assets are debits. Debits decrease with a credit. Now for the amount. Remember, the plates were
100 euros for 100 pieces. Since they're all sold,
that's Claudio's COGS. So the journal entry is
a debit of 100 to COGS and a credit of 100 to inventory. So those were the transactions of his day. Let's just quickly wrap
this up by creating the P&L and the balance sheet for Claudio based on these transactions. This way we can see
how these accounts roll into the financial statements. First, I'll just visualize all
transactions with T-accounts. We used cash, paid-in equity,
inventory, revenue, and COGS. These were our transactions. Claudio leaving his home
with 100 euros in cash, that goes to cash in equity. Then Claudio goes to the
manufacturer and buys the plates. That goes to inventory and cash. Finally, Claudio successfully
sells all his plates. That goes to cash and revenue and also to COGS and inventory. Then we calculate the closing balances or totals for the accounts. It needs to add up the debits and credits on each side of the T. Then we deduct the total
credits from debits or vice versa for the credits accounts. Cash has 600 debits minus 100 for credits. This results in a debit
closing balance of 500. Paid-in equity has a credit
closing balance of 100. Inventory is zero. Revenue has a credit balance of 500 and COGS a debit balance of 100. Let's create Claudio's P&L. The P&L includes revenues and expenses. Therefore, we just need the
T-accounts for revenue and COGS. The closing balances
for these accounts flow into our simplified P&L, and we calculate a net profit of 400. Next, the balance sheet. Only the accounts for cash and
paid-in equity are relevant because the closing balance
in inventory is zero. Cash is an asset and goes to the debit
side of the balance sheet. Paid-in equity goes to the credit side. In our introduction video to accounting, we said that net profit is
the link between the P&L and the balance sheet. So the net profit of 400 from the P&L flows into retained earnings on the credit side of the balance sheet. This way everything is
balanced like it should. I hope this video was helpful to apply the theory
behind debits and credits to record actual transactions. Always remember accountants
don't expect low earning rates, ADEX LER, and you're going to be fine. If you enjoyed this video,
give it a thumb's up, and if you want to improve your
skills, consider subscribing. And don't forget to hit that bell so you don't miss any new videos. Thank you for watching. See you in the next video.
(upbeat music)
