Tricks to Remember Debits and Credits

Debits and credits form the foundation of basic accounting. These terms help define double-entry accounting. As an accountant, every transaction you post involves debits and credits. Many people have trouble grasping the rules for debits and credits. Here are some tricks to understand debits and credits.

For free templates to understand debits and credits (and dozens of other accounting concepts), access the accountinged.com resource collection. Try this online academy free for 10 days.

The rules that stays the same

Debits and credits are confusing, because some rules change- and other don’t. So, let’s first consider two rules that never change…..

Debits are always on the left; credits are always on the right           

Total debits must always equal total credits

Period. End of story.

Now, that statement may sound strange. But it makes sense when you consider that most of the other rules about debits and credits change. The other rules change; depending on what type of account is involved.

T-Accounts

A key tool to understand these other debit and credit rules is to use t-accounts. Let’s use the cash account as an example. Draw a T. Write “cash” at the top, “debt” on the bottom left (just below the horizontal line) and “credit” on the right. Your t-account will look something like this:

                                               Cash

                   Debit                                               Credit

Again, head over to the accountinged.com free resources. You’ll find an excel template called “Basic accounting transactions and journal entries” that will explain t-accounts in detail.

T-accounts are great, because you can see impact of debits and credits.

The accounting equation (balance sheet equation)

Some accounts are increased with a debit, others with a credit. One way to keep this straight is to consider the accounting (or balance sheet) equation:

Assets = liabilities + equity

Assets are on the left side of the equal sign. Asset accounts are increased with a debit. Liability and equity accounts are on the right side on the equal sign- and they are increased with credits. If you need to increase the balance of an account, consider what type of account it is. Once you know that, you’ll know how to increase the account (either debit or credit).

Say that you need to increase accounts payable. Payables are liability accounts. That means that you increase accounts payable by crediting.

Here’s another way to explain it: If there is an equal sign, that means that the amount on the left has to be equal to the right. So, if one side uses debits, the other side has to use credits. Total debits always equal total credits- and those totals are on opposite sides of the equal sign.

Normal balances

We refer to a normal balance for an account as a positive balance. Cash, for example, has a normal debit balance. If you run a trial balance and have an ending credit balance in cash, that is not normal. A negative (credit) balance in cash means that your account is overdrawn. That credit balance should be reclassified as a loan. Loans are liability accounts-, which are increased with credit balances. A normal balance for a loan is a credit.

How do you keep these concepts straight?

Are these tools helpful? Do you have a tool you use to remember debits and credits? If so, I’d love to hear from you. Please comment below.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies (2015)

Co-Founder: accountinged.com

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(cell) (314) 913-6529

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Accounting-Related Class Action Cases: 2014 Analysis

A class action lawsuit can be devastating to the future prospects of a company. In some cases, the class action case is brought due to an accounting issue. This fascinating study reviews the 2014 class action lawsuits related to accounting. It’s a cautionary tale for all accounting managers.

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Cornerstone Research is a firm that provides economic and financial analysis for commercial litigation and regulatory cases. Here are the highlights of the firm’s 2014 summary of Securities Class Action filings that included Accounting Allegations.

Defining a class action

A class actions lawsuit allows a large number of people with a common interest in a matter to sue (or be sued) as a group. In many of these cases, the common interest is that each person involved in filing the suit owns the firm’s common stock. Generally, the class action suit claims that an accounting irregularity caused as sharp decrease in the price of the stock.

The impact of restating the financials

The report explains that a number of stock price declines occurred after a firm’s financial statements were restated. This article explains some of the circumstances that require restatement of the financials. Here are two that apply to this discussion:

·            Correction of an error

·            Change in GAAP accounting method: If a change in an accounting policy would have changed the prior year financial statements, that change needs to be disclosed.

Explaining the impact of an accounting change allows the statement reader to make a “apples-to-apples” comparison. Assume that the company changed from the FIFO to the LIFO inventory value method. That change would generate a different cost of sales amount- which would also change net income.

GAAP requires that the prior year financial statements must be restated to reflect the new inventory valuation method. Restating the prior year financials allows the statement reader to see the prior year and the current year results using the same inventory valuation method. Using the same method means that the financials are comparable.

Class action accounting cases

The firm explains that cases considered as accounting cases are those that involve GAAP violations, auditing violations or weaknesses in internal controls.

Again, the main reason for the accounting-related suits is a price decline after a restatement. Essentially, the stockholders believe they have been harmed by management’s mistakes- the resulting stock price decline after the restatement. Figure 9 in the 2014 report shows a mean return of a 5% stock price decline after a restatement.

Weakness in internal controls

60% of the accounting cases in the 2014 study alleged an internal control weakness. Internal controls are put in place for two reasons. First, these controls help to segregate duties and prevent theft of assets. Internal controls also ensure that the financial statements are materially correct.

Keep in mind that Sarbanes Oxley (SOX) has raised the bar on management’s responsibility for internal controls. Company management must now review internal controls and report on any internal control weaknesses.

Write-downs

If an asset’s value has been permanently reduced, the asset is impaired. The impaired asset’s value should be adjusted- so that the value of the asset is not overstated. The reduction is value is called a write-down.

A write-down occurs when an asset’s value is posted to an expense. The write-down reduces the asset balance and increases expenses. A number of cases in the study involved write-downs, as well as adjustments to reserve account balances. 

A reserve posts an expense and a liability for contingencies (losses). A good example is a reserve for loan loss at a bank or financial institution that provides loans. If a portion of the entry is reserved, expenses are reduced. Since reserve accounts require judgment, there is some risk for manipulation of expenses.

A cautionary tale

Consider this issues as you manage your business. Staying on top of internal controls is critical. These controls can help you avoid correcting mistakes- and avoid the added challenge of restating your financials.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies (2015)

Co-Founder: accountinged.com

 (amazon author page) amazon.com/author/kenboyd 

(cell) (314) 913-6529

(email) ken@stltest.net

(website) www.stltest.net

 (you tube channel) kenboydstl

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McDonalds: The Impact of Higher Labor Costs

“I’m not in the food business- I’m in the human resources business”.

That was a comment made to me by a McDonalds franchise owner 10 years ago. The comment has stuck with me. Fast food restaurants have constant turnover in staff. That issues requires a huge investment in hiring, training, evaluating- and sometimes firing- staff. So what happens financially when you increase the hourly rate of pay across the board?

Accountinged.com is an online accounting academy. Click here for a free trial.

McDonalds hourly rate increase

McDonalds recently announced an hourly rate increase for its workers. As stated here, the raise only applies to the 1,500 McDonald’s-owned restaurants in the US. The raise does not apply to franchise-owned stores, which make up 90% of the restaurants and most of the workforce in the US.

The franchise relationship

In a franchise, an investor- referred to as a franchisee- purchases the right to use the McDonalds brand and operate a restaurant for a period of years. Page 45 of the McDonald’s 2013 Annual Report explains the arrangement. The franchisee pays an initial fee and annual royalties, based on a percentage of sales. So, your royalties are an additional expense on the franchisee’s income statement. The agreement is typically in force for 20 years.

Wage pressures on profit

McDonalds defines margins as sales less operating costs. In 2013, company-owner restaurants saw a 2% decrease in margins, due in part to higher labor costs. The article explains that the company will increase wages to “more than $10 an hour by the end of 2016- up from $9.01 currently.” To keep things simple, call it an 11% increase in labor costs. Consider the impact of that increase on the financials.

Profitability and cash flow

The firm’s 2013 consolidated income statement states that payroll and employee benefits account are 17% of sales. Now, this report includes both franchise-owned and company-owned stores. This line item includes wages for management- as well as benefit costs that are not payroll. But the schedule does give you a sense of how much of each sales dollar goes toward paying employees.

Assume that, if wages increase by 11% (from about $9 to $10), the entire line item of payroll and employee benefits increases by the same percentage. Payroll and employee benefits would increase to 19% of sales. Again, not a perfect comparison- but you get the idea. A restaurant would spend 2% more of every sales dollar on employee costs.

Higher payroll costs also affect cash flow. If your costs increase by 2%, you need 2% more cash every two weeks to make payroll- everything else being the same. Instead of plowing 2% of your cash generation into business growth, you have to use it for payroll.

All of this is food for thought. Carefully consider the long-term impact of a pay scale increase on your profitability and cash flow.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies (2015)

Co-Founder: accountinged.com

 (amazon author page) amazon.com/author/kenboyd 

(cell) (314) 913-6529

(email) ken@stltest.net

(website) www.stltest.net

(you tube channel) kenboydstl

Image: creative commons licensed (BY 4.0) flickr photo by Sebastiaan ter Brug

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