Understanding Basic Accountancy (1)

A short guide for One Lesson users

If you’ve understood the ideas of assets, liabilities and raw net worth¹ from the earlier articles, you should find basic accountancy easy to follow. The main things worth understanding are:

1. Balance sheets, and

2. T accounts

People sometimes get confused about the difference between the two because they’re both 2-column tables², which have dividing lines in the shape of a capital ‘T’ (which is where the name “T account” comes from). But once you’ve understood the difference, it’s pretty easy to remember.

At any point in time, every person (whether a real person or a corporation) has a single balance sheet. It’s just a list of all of their assets and liabilities (together with their equity or net worth) at that time. You can find one in a limited company’s financial statement, part of its annual report³.

By contrast, each person typically has many T accounts: a different one for each category of asset, liability or equity (or net worth). A T account is there to record (or show) changes to that type of asset or liability over time. For example, a “Cash” account will show an entry for every time the person pays or receives cash. T accounts are usually only seen by the finance department of a corporation.

Here’s a more detailed description of each.

Balance sheets

Balance sheets are pretty simple. We draw a 2-column table, showing assets on the left and liabilities on the right. As we’ve already seen, equity is just a special type of liability, so it also goes on the right if it exists. Finally, by convention, if net worth isn’t zero, it is shown too, again on the right. This makes sure the two columns have the same total (which gives it the name “balance sheet”).

Let’s see an example from an earlier post. Dom owns a car and 2 loaves of bread. He’s owed £500 by the bank and owes a loaf of bread and £20 to Charlotte.

We could draw his balance sheet like this⁴:

Notice that all the assets (both tangible and debt) are on the left. Liabilities and RNW are on the right. And that, with RNW in the right column, both columns have the same total (which you should check):

But always remember that a person’s (raw) net worth isn’t their liability. It’s not owed to anyone else—it’s theirs. The fact that both column totals are equal has absolutely no significance whatsoever. What’s important is the difference between the person’s assets and their liabilities i.e. their RNW, which for Dom is:

T accounts

The two columns of a T account are different from a balance sheet. The left column is for Debits (often labelled “DR”), and the right column is for Credits (“CR”). If you ask an accountant to explain what is a debit, and what is a credit, you will most likely get a very complicated and confusing reply. Here’s the simple answer:

• Debits are changes which increase the person’s RNW (gain an asset, or lose a liability/equity)

• Credits are changes which decrease the person’s RNW (lose an asset or gain a liability/equity)

The only exception is that you might have a fictional T account for “net worth”, whose debits and credits have no effect on RNW. The reason for having this fictional account is to avoid exceptions to an accounting rule that whenever you debit one account, you must credit another account and vice-versa. We’ll see how this works in a future post.

A T account shows the effects of one end of an economic action (the end of the arrow next to the person whose account it is). So:

• debits represent an arrow pointing towards the person, and

• credits represent an arrow pointing away from the person

Let’s see a couple of examples from Alice’s accounts in a simple scenario, where she buys 5 apples from Bob for £1.

There are 2 actions. First let’s look at the cash payment, which will appear on Alice’s ‘Cash’ account. The arrow points away from Alice, so this is a credit⁵.

“Cash” T account for Alice, showing £1 payment to Bob

Simple enough? Now for the apples. Alice records the fruit she owns in an account called ‘Fruit Bowl’. The arrow points towards Alice (she gains some assets), so this is a debit.

“Fruit Bowl” T account for Alice, showing receipt of 5 apples

You can think of this as the One Lesson approach to accounting—raw accountancy. In a future post, we’ll look at how basic accounting works when every debit and credit is given a money value.

Summary

It’s useful for economists to know some accountancy, particularly when learning from, or discussing with, other economists who use accounting ideas themselves. But when you do, be aware that they usually follow conventions more suited to accountancy than economics⁶.

The two key ideas are the balance sheet, which lists all of a person’s assets and liabilities at a point in time, and the T account, which shows the changes to a category of asset or liability over a period of time.

1. Someone’s raw net worth (RNW) is what they own plus what they’re owed minus what they owe.

2. You might see balance sheets presented in other ways.

3. Here are Bank of America’s recent annual reports. Have a quick look in the 2022 annual report: the balance sheet is on P138. (This balance sheet is formatted with liabilities and equity below assets, rather than to the right).

4. For better use of vertical space, this representation has three assets/liabilities per row.

5. In Bob’s accounts, this action appears as a debit because it’s increasing his RNW.

6. Accountancy exists to assign a fair value to a firm, help investors and managers with decision-making, and reduce errors and fraud in record-keeping.