Welcome back to part three of this Accounting Crunch series. This series is about debits and credits, double-entry accounting and T-accounts.
I recommend reading the earlier articles if you haven’t already as they will help you understand T-accounts in this article. All three parts are related and work together to give you a strong foundation in accounting basics.
Part 1 goes through what debits and credits are and their importance in accounting.
Part 2 goes through the importance of double-entry accounting and how debits and credits affect different accounts.
To quickly recap the last two articles:
- When you debit an asset or expense account, you increase its value.
- When you debit a liability, equity or revenue account, you decrease its value.
- When you credit an asset or expense account, you reduce its value.
- When you credit a liability, equity or revenue account, you increase its value.
- When a company records a transaction, at least one account will always be debited, whilst at least one other will always be credited, hence the name “double-entry”. These entries show the movement of value around the business.
In this article, we’re going to be putting all that knowledge into practice by learning about T-accounts. We’re going to go through what they are and how they’re used in accounting.
What is a T-account?
A T-account is a visual way of displaying the transactions occurring within a single account.
Any transaction a business makes will need to be recorded in the company’s general ledger. The general ledger is divided up into individual accounts which categorise similar transaction types together.
The reason it’s called a T-account is simply that it is shaped like a T.
These diagrams can be used to map out transactions before they are posted into the company’s ledgers to ensure they are correct.
Due to its simplistic nature, T-accounts are also used as a learning tool to practice transactions and double-entry accounting.
T-accounts are common practice. They can be found drawn on a scrap piece of paper to templates made in accounting software.
A T-account has three sections. The top is the name of the account. The left-hand side is where you enter debits whilst the right-hand side is where you enter credits.
T-accounts are used to track debits and credits made to an account.
Each T-account will only display one account.
So, to show this, T-accounts are usually displayed in pairs to show the impact of a complete business transaction in your accounts.
How are T-accounts used in accounting?
In part 2, I mentioned how double-entry accounting can be an arduous process.
T-accounts help to visualise the process making it clear what is occurring with each transaction.
They are a useful tool for both newcomers to accounting and veteran accountants alike to quickly map out the correct way to record a transaction.
Complex entries might have impacts in multiple account. By breaking transactions down into a simple, digestible form, you can visualise which accounts are being debited and which are being credited.
This visual guide helps you ensure figures are being posted in the correct way, potentially reducing data entry errors.
T-accounts can display transactions from a specific time period such as a week or a month. By displaying multiple transactions over a time period rather than a single transaction, it allows people to see a picture of a company’s activities.
In this image, you can see a T-account which shows my bank account for the first week of March. Every day, I receive cash from my coffee sales shown in the debit column on the left. In the right column, the credits represent cash being spent either on inventory or operating costs.
Below is a simplified view of the full ledger account. When these transactions are posted to the company’s accounts, they will be displayed with more information:
You can see the specific date, the description of the transaction and a running balance beside the debits and credits.
The T-account is a quick way to work out the placement of debits/credits before it’s recorded in full detail to help avoid data entry errors. Although it may lack the detail which the ledger provides, it provides the main information, which is the amount it’s being debited/credited by.
Let’s run through several examples and put all the knowledge from the three Accounting Crunch articles to work.
In this section, I’m going to go through different types of transactions, and I’ll be using T-accounts to display the movement of value through the business. I will use my coffee shop to represent a business throughout these examples.
You should check out my other coffee shop related articles where I breakdown the Profit and Loss Report and Balance Sheet. We also have an Accounting Glossary which you should check out if you’re unfamiliar with any of the terms used!
Example 1 – Selling a coffee
I sell a cup of coffee to a customer for £2.50. What happens in the accounts?
As you can see, my bank account (an asset account) is debited £2.50, increasing its value. My income account (revenue account) is being credited £2.50, increasing its value, making the transaction balanced.
However, I also use some inventory when making the coffee:
The ingredients for the cup of coffee are recorded as inventory (asset account). They come from my store cupboard. My inventory is reduced each time I sell a coffee so I need to credit the inventory account by 50p, reducing its value. This is a double-entry, and the accounts are balanced.
Example 2 – Purchasing a coffee machine
My coffee shop purchases another coffee machine for £700. However, I sign an agreement to pay for the machine next month. So what happens to the accounts?
As I’ve received the coffee machine, I’ve gained £700 worth of fixed assets (this account has been debited).
I’ve agreed to pay for the coffee machine next month so my accounts payable is increased (credited) by £700. Accounts payable is a liability account, keeping track of bills I still have to pay in future.
A month passes and I pay for the coffee machine.
My bank account is credited £700 (reducing its value) as I’m now paying for the coffee machine.
With the outstanding bill paid, accounts payable account is debited by £700, reducing its value and showing that I no longer owe this amount.
Example 3 – Paying rent
I need to pay £2000 for renting the unit space for my coffee shop. I pay the rent on time, on the day that it is due. So what happens to the accounts?
Rent is classed as an operating cost as it’s a standard cost required to run my business. Operating costs are a type of expense so it is debited by £2000.
To pay the rent, I’ve used cash, so my bank account (an asset account) is credited by £2000.
Next month I can’t afford to pay the rent. I agree with the landlord that I can pay it back the following month in addition to that month’s rent. So for this month:
A month passes and I pay for the rent.
As I owe both this month and last month’s rent, I have to pay £4000. My bank account is credited £4000, whilst the accounts payable account is debited £2000 and rent is debited £2000. Therefore, both debits and credits are equal in this transaction.
Example 4: Rent prepaid for a quarter
In this example, I need to pay rent for the next quarter in advance for my coffee shop’s unit space.
In January, I pay £6000 in cash to the landlord, so my bank (asset) account is credited £6000.
I now have three month’s worth of rent paid for, so my prepayments (prepaid rent) account is debited £6000.
Every month £2000 is credited from this account, reducing the asset as I make use of the property.
The £2000 credit each month to the Prepayment account is balanced by the £2000 debit to the rent expense account:
Phew! That last example was a complex one. It really shows how useful it is to try to draw out transactions in T-accounts before they are committed to the company records.
Where accounting meets business reality – what’s it all for?
When learning the accounting process, from debits and credits to double-entry, it’s easy to get lost in the process and miss the big picture.
What is this all for? Is this worth understanding if you aren’t an accountant?
Whether you are an accountant or a decision-maker the language of business finance is rooted in accounting. Whatever your role is in the business, it’s worth grasping the basics of this language.
Every transaction a company makes, whether it’s selling coffee, taking out a loan or purchasing an asset, has a debit and a credit. This ensures a complete record of financial events is tracked and can be accurately represented by financial reports.
The key financial reports, your cash flow, profit & loss and balance sheet are an organised representation of these fundamental accounting records. They are built from the ground up by these debits and credits. It’s these reports that you’ll be analysing to aid your decision-making process.
A single transaction will have impacts across all reports due to the way debits and credits work. So grasping these basics helps you delve into these reports and understand the financial story they tell.
Brixx, our financial forecasting tool, helps you with this process further. The software handles all the accounting work. When you enter any forecast activity, the double-entry process is completed for you, saving you time and giving you confidence in the numbers. It means you can spend more time analysing the results.
A free, no-obligation trial, means that you can try out Brixx and see for yourself how easy financial forecasting software should be… try it out for free today!