Yesterday, we learned about the balance sheet, and how it keeps track of a company's assets, liabilities, and owners' equity. We also set up a hypothetical balance sheet for DailyKos, secured a loan from Markos, and bought a server.
The balance sheet is a tool used to present the financial status of a company at a single point in time. Today, we're going to learn what debits (DR), credits (CR) and the General Ledger (GL) are. Wait, come back! Debits and credits are easy, if you think about them in the right way.
Recall from yesterday, our ending balance sheet:
Balance Sheet for DailyKos |
Assets |
Liabilities |
$8,000 cash
$2,000 server |
$10,000 Markos loan |
Owner's Equity |
0 |
$10,000 |
$10,000 |
Before we get started on debits and credits, I have a correction from yesterday. It was brought up in the comments by
absdoggy that the Markos loan is not an arms-length transaction, so it shouldn't be treated like a regular loan. So, what's an
arms-length transaction? Wiki simplified, it is a transaction where both parties are on equal footing, and are relatively independent actors. Since Markos is both the lender and effectively the business, this transactions doesn't pass the "arms-length" test. Likewise, loans from family members aren't arms-length. If there's a side-agreement (like a bribe), that also isn't arms-length. So, in this case how do we account for the loan? Well, we consider the loan an equity item called "paid-in capital." So our balance sheet should really look like this:
Balance Sheet for DailyKos |
Assets |
Liabilities |
$8,000 cash
$2,000 server |
0 |
Owner's Equity |
$10,000 Markos paid in capital |
$10,000 |
$10,000 |
But let's do put a regular loan on the balance sheet. Let's say DailyKos needs more cash for the business, so they go to a bank and get a loan for another $10,000 (ha, like that would happen in these times). Our balance sheet will now look like this:
Balance Sheet for DailyKos |
Assets |
Liabilities |
$18,000 cash
$2,000 server |
$10,000 bank loan |
Owner's Equity |
$10,000 Markos paid in capital |
$20,000 |
$20,000 |
And now we've got $18,000 of cash left in DailyKos' bank account. But the balance sheet doesn't really tell us how that money got there. We need a way to track all the transactions of DailyKos. That's where debits, credits, and the general ledger come in. This next part is a little bit conceptual, so put on your outside-the-box thinking hat, or smoke a bowl, or do whatever you need to do.
Okay. First off, think of debit as "left" and credit as "right." Assets have a debit balance, and liabilities and equity have a credit balance. In other words, assets go on the left, liabilities and equity go on the right. As you can see, our balance sheet is already structured this way. But let's structure each "account" this way, too. Think of cash like this:
This is called a T account, because of it's shape (which doesn't look so T-ish using HTML tables, but meh...). When we got the $10,000 from Markos, we
debited the cash account. Debiting an asset account increases it. So let's add that entry to the T account:
Then we bought that server, meaning cash went out. In this case, we credit (think right) the cash account $2,000:
Then we got that second loan from the bank for $10,000, so we add another debit (think left) of 10,000:
Cash |
0 |
2,000 |
10,000 |
|
10,000 |
|
Now, we can see all the entries that changed the amount of money sitting in our cash account. We do the same thing for our other accounts. Our initial paid-in capital account had an initial 0 balance. Since it is a credit account (it's on the right of the balance sheet), it starts with the 0 on the credit side:
But then we got that money from Markos, so we need to credit the paid in capital account. We credit an equity account to increase it, because equity account (along with liabilities) have a credit balance.
And that's it for that account. The other transactions we've talked about are pretty straight-forward in their T account implementations. The big disadvantage of the T accounts is that while you can see how the money is moving around, you don't know when or why, and you can't tell which debits correspond to which credits. That where the
general ledger comes into play. The general ledger (or GL) is a journal that captures details of every transaction. It is generally in the form of a spreadsheet, with the main pieces of information being the date of the transaction, a narration of what the transaction is, the accounts involved, and by how much they are debited or credited. Each record of a transaction is called a
journal entry. Let's go ahead and record our initial paid-in capital loan from Markos. The journal entry would look something like this:
General Ledger for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/12/2011 |
Initial Loan from Markos |
|
|
|
Cash |
$10,000 |
|
|
Paid-In Capital |
|
$10,000 |
As you can see, the cash account got debited the amount of cash DailyKos got. Also, the paid-in capital account got credited by the amount Markos loaned DailyKos. Each journal entry will have the same amount debited as credited. This keeps our overall balance sheet, well, in balance. It's kinda how the balance sheet got its name.
At this point or way before, someone is bound to ask "Why is 'Debit' abbreviated 'Dr' instead of 'De' or 'Db' or something?" I have yet to hear a good answer. I think it's just something accountants do to piss us off. We just have to go with it.
So, I'm going to go ahead and record our other transactions in the GL:
General Ledger for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/12/2011 |
Initial Loan from Markos |
|
|
|
Cash |
$10,000 |
|
|
Paid-In Capital |
|
$10,000 |
9/12/2011 |
Bought a server |
|
|
|
Equipment |
$2,000 |
|
|
Cash |
|
$2,000 |
9/13/2011 |
Loan from the bank |
|
|
|
Cash |
$10,000 |
|
|
Bank Loans |
|
$10,000 |
With me so far? This is a good point to stop and take questions. This is a system, and you really need to understand it to move on. It's not something you can skip over and catch up later. And again, I appologize for my sucky teaching abilities. I'm neither a teacher, nor an accountant. Also, I know that none of this is particularly interesting or relevant to a political blog. It will become moreso as we move on, but we have to learn the basics first. I promise this will be the most boring piece of the series.
Here, I'll try to give you something interesting. Above, we reclassified the Markos loan to being equity, rather than a true liability loan. There is a reason for this. If DailyKos were to go bankrupt, there is a pecking order of who gets the rights to the assets under DailyKos' control. Liabilities get first dibs because equity is essentially the residual stake in the company - what's left after liabilities are subtracted from assets. Banks loaning a business money want the first shot at assets. This is a pretty fair deal. In return, the banks get a fixed rate of interest, so their upside is limited, but the upside for equity is unlimited. If DailyKos does super awesome and makes millions, the banks still only receive their 8% interest on the amount of the loan, plus repayment of principle, while the equity people wind up with the rest of that big stack of money. We'll go into more detail later.
In the next installment, we'll look at another key financial report: the income statement. While the balance sheet shows a snapshot of a company's finances, the income statement shows activity over a period of time. We'll touch on depreciation and interest, and show how a company can make accounting assumptions that can be used to manipulate their financial documents. It will be fun times.
...and for you CPAs out there, please correct me where I'm wrong, and help in the comments. I appreciate your help.