Welcome. I've introduced you to T-accounts before,
but in this video I'm going to show you one of the reasons I really like T-accounts.
That's that to me they facilitate a way to think about
understanding the history of what's going on in a balance sheet account.
That's a question you're often going to ask,
why did an account change?
Another way to think about this is,
why did that snapshot in time that I'm seeing change from the last snapshot in time?
Balance sheet accounts are really helpful because of
the fact that they capture that snapshot in time.
But there's sometimes when you really do want to understand their evolution.
For example, imagine that you were looking at
a company's financial statements and you notice their inventories increased.
You want to try to figure out did they buy
more inventory during this period or did they just use less of it up.
If they bought more inventory,
that might be a good sign that could indicate that in
fact they're building up for big growth that they expect in the future.
On the other hand, if they used up less inventory during this period,
that might indicate that they're having a hard time making sales.
You can see that that increase in inventory
can actually provide two different sorts of signals.
In one case it's a positive signal- we're going to have future growth,
and in another case it's a negative signal- we're going to have a decline in the future.
Let's think of another question.
Maybe the accounts receivable balance were shrinking for the company.
You're trying to figure out is this because sales are
down and the company is really heading into a slump?
Or is this because they have faster and more effective collections?
We can look at the evolution of the account again to
get some better sense of what's going on in the company.
If credit sales are shrinking,
this might indicate a weakness in the future,
versus if they're more effectively collecting on their accounts,
that might tell us that they've enhanced their operational efficiency.
Now, both of those are examples where you're outside of
a firm trying to get some sense of what's going on inside.
So maybe you aren't able to get private reports,
but even inside the firm there are times when you do want to look at
a simple change in the accounts in order to get some sense of what's going on.
Maybe you're concerned you have an operational issue or some sort of error has been made
and you want to test that by looking at how your accounts evolved over time.
Think about the question of whether somebody is stealing cash.
By looking at the account you might be able to get a sense of
where is the cash disappearing or what's going on with it.
Let me show you how you can use a T-account to do this.
Remember when we have T- accounts they just
look like a T with some sort of title at the top.
If you have an asset T-account then you're always going to have
a beginning balance on the debit side- that's the left hand side.
And when something gets added to the account,
that's also going to be a debit.
And then when something gets taken out of the account,
that is it gets used up, that's going to be a credit.
So it's going to go on the right hand side,
and that's going to bring us down to the ending balance of the account.
If you think of a liability account,
it looks pretty much the same as for a T-account,
it's just the mere opposite of it.
So the beginning balance,
the additions in the ending balances are all in the credit or right hand side,
and the things that left the account are on the left hand side now or the debit side.
Let's take an example of looking at how we can use
this structure to get a better understanding of what's going on.
We'll return to our inventory example.
So you can get the beginning and ending inventories off of the company's balance sheet.
You can go to the income statement and get the cost of goods sold.
Now what you're trying to figure out is what were their purchases during this period,
was it that build up that's really driving the growth in
the inventory account or was it a decline in cost of goods sold?
Of course, those two things are relative,
which is why we need to know the purchases.
How does the structure that we see in the T-account help us to answer this question?
Well, it really makes clear to us the relationship between the beginning balance,
the cost of goods sold, the ending balance,
and this purchases number that we're trying to understand.
It gives us a way to put together an equation to solve for purchases by showing us that
purchases are equal to the beginning
balance- everything we had plus the cost of goods sold.
Everything that we took out of there minus whatever's left over at the end of the period.
In doing this we can get this purchases number compared to last year's purchases number,
and compare the cost of goods sold across the two periods from the income statement.
That's going to give us some sense of whether inventory is growing because of
increased purchases or because of declining sales and declining cost of goods sold.
It's an ad-hoc approach.
I get that, but it's a good first step towards developing understanding.
Once you have some sense of whether purchases have increased
during the period or whether they're relatively flat,
you'll ask different questions of the company as you try to understand the company more.
Let's take a look at that petty cash example.
Remember there were working inside the company,
but we're concerned that somebody may be stealing some of our cash.
So how do we go about capturing that?
Well, again, we'll start with the beginning and ending balances.
In these situations we may just count that cash
ourselves at the beginning of the period and again at the end of the period,
or maybe the cash is in a bank.
So instead of us counting it the bank counts it.
But it should be pretty easy for us to get those beginning and ending numbers.
Now, as receipts came in,
again we would have counted those and put those into our system,
or they would have come into our bank and our bank would have counted those.
So we feel comfortable that we have that number as well.
What we need to solve for here are the disbursements,
what went out of the company.
And as we look at the structure,
we can do the same sort of thing we did last time.
We can put together an equation using the T-account which will help us understand that
disbursements equals the beginning balance
plus all the receipts that came in minus the ending balance.
Now, once we've done this,
we can compare that computed disbursements number to the authorized disbursements by
going back and looking at all the different things that
the company actually approved people could do.
We can get that authorized disbursement number
by looking at all of our journal entries from the past.
If we find that our authorized disbursements don't match our computed disbursements,
it tells us we may have a cash problem.
It doesn't tell us who took the cash or how it was taken,
but it does indicate that an investigation is needed.
Both of these are just simple examples of how breaking down
the evolution of a balance sheet account can help you to understand the company.
They also show you how the T-account structures
it so that you can more clearly think about what's going on into the account.
It's kind of like a cheat sheet that just makes sure that
you don't in a rush make some sort of an error.
I hope this shows you another good reason to
get familiar and comfortable with T-accounts.
Greg MillerProfessor
