Trading oranges as money - Credits and Debits
Now it is time to connect the directed graph to conventional accounting. We will follow the same sequence with the direction of the graph in the most normal way.
Trading
So to recap the scenario is:
- invest in your business.
- buy oranges from an orange farmer
- sell them at a profit at market
Investment
We start from nothing. The first step is an injection of cash from an external investor.
Day book entry
An investor starts the business with £25 of cash on 1st of Jan 20xx.
Journal entry as per Paciolo
Paciolo would write it
1st January 1, MMxx in Venice. Per cash // A - Equity 25 pounds sterling
As cash is the debtor and equity the creditor.
Modern Journal entry
The journal is often left out and would original have had links to pages of the ledger.
1st January 1, 20xx.
Debit cash £25
Credit Equity £25
Ledger T accounts
| Cash (Debtor) | |||
|---|---|---|---|
| Debit | Credit | ||
| Date | £ | Date | £ |
| 20xx-01-01 | 25 | ||
| Equity (Creditor) | |||
|---|---|---|---|
| Debit | Credit | ||
| Date | £ | Date | £ |
| 20xx-01-01 | 25 | ||
Buying stock / inventory
Having got investment in the business lets buy 25 oranges from a farmer for one pound for each orange. The exchange of cash for oranges is denoted by a single accounting entry.
Modern Journal entry
1st January 1, 20xx.
Debit Purchases £25
Credit Cash £25
Ledger T accounts
| Purchases (Debtor) | |||
|---|---|---|---|
| Debit | Credit | ||
| Date | £ | Date | £ |
| 20xx-01-01 | 25 | ||
| Cash (Debitor) | |||
|---|---|---|---|
| Debit | Credit | ||
| Date | £ | Date | £ |
| 20xx-01-01 | 25 | ||
So now we are crediting a debtor account which has the opposite effect of reducing its balance. Unlike the directed graph there needs to be some translation that debiting debtor accounts increases balance but crediting debtor accounts decreases value. Likewise debiting creditor accounts decreases balance whereas crediting creditor accounts increases value. There are then simple mnemonics to try and remember which is a debtor account and which is a creditor account.
D E A D
D — Debit:
E — Expenses
A — Assets
D — Dividends (or drawings)
C L I C
C — Credit:
L — Liabilities
I — Income
C — Capital
Converting sale of oranges to money equivalent
So when you make a sale you transfer money from the Sales revenue node to the cash node.
Overall nodes in money terms
So now looking at the overall picture using money values you have:
From this you can see that no money is owed to the Farmer nor is there any stock. There is also a nice flow of money from left to right.
To make this double entry and to have meaning the inflows must be kept separate from the outflows. This allows the tracking of profitability. In this case it is easy but with different stock items you could separate out profitable and unprofitable lines.
From now on we will leave the external boundary and look only what happens in the firm.
Adding an example liability
If we modify the story a bit we can add a liability. If instead of giving cash to the farmer at the time of the purchase of the oranges you promise to pay on the way back from the market. Then when you get back you will owe the farmer for the oranges (and might not need an investor).
Looking at the business we have inputs and outputs in external nodes (in bold edges) and internal nodes such as assets and liabilities (in thin edges). The total value in the business is the sum of those internal nodes assets + liabilities, as the liabilities are negative.
Balance sheet interpretation
In fact the definition of an asset is a core node with a positive balance and a liability as a core node with a negative liability. Typically but not always nodes are either assets or liabilities. For instance a pile of cash will always be positive. However if you store your money in a bank it can seemlessly switch from positive to negative and back again. So summarising the value in the entity is called the total net assets (net as we have combined the assets and liabilities).
$$ \definecolor{asset}{RGB}{204,221,170} \definecolor{liability}{RGB}{221,221,221} totalNetAssets=\colorbox{asset}{coreNodes}=\colorbox{asset}{assetNodes}+\colorbox{liability}{liabilityNodes}=£37.50 $$
We have promised to pay the farmer and have the cash to do so. The value of the totalNetAssets will not change when we pay the farmer. Because this is a graph all the external nodes equals the negative of all the internal nodes.
Looking at the position of the entrepreneur, they have invested £25 in the business and so the rest of the balances will add up to £25. This says nothing about the health of the business (Balance sheet) or its trading position (Profit and Loss).
The balance sheet is the sum of all the assets minus the liabilities. (Green minus the grey) The value of the balance sheet is the total net assets:
$$ \definecolor{asset}{RGB}{204,221,170} \definecolor{liability}{RGB}{221,221,221} totalNetAssets=\colorbox{asset}{Assets}+\colorbox{liability}{Liabilities} $$
We add the liabilities to the assets but the liabilities are expressed as negative numbers.
So the full equation becomes:
$$ \definecolor{asset}{RGB}{204,221,170} \definecolor{liability}{RGB}{221,221,221} \definecolor{equity}{RGB}{238,238,187} \definecolor{income}{RGB}{187,204,238} \definecolor{expense}{RGB}{255,204,204} totalNetAssets=\colorbox{asset}{Assets}+\colorbox{liability}{Liabilities} =\colorbox{equity}{Equity}+\colorbox{income}{Income}+\colorbox{expense}{Expense} $$
with liabilities, equity and income being typically negative.