Trial balance

[hatton02]

Reading about the trial balance and they put the cost of plant and machinery as a debit and the depreciation on said plant/machinery as a credit. Can anyone explain why this is the case?

I always struggle with accounts, e.g. in my eyes the cost of plant/machinery is an asset and a liability as you have a £850 million factory (asset) but it has cost you £850 million (liability). Depreciation should definitely be a debit in my eyes, no ideas why it's classed as a positive!?

Also, why is inventory in the debits section? Inventory is stocks so surely that's an asset and thus a debit?

 

[Oxymoron]

Reading about the trial balance and they put the cost of plant and machinery as a debit and the depreciation on said plant/machinery as a credit. Can anyone explain why this is the case?

I always struggle with accounts, e.g. in my eyes the cost of plant/machinery is an asset and a liability as you have a £850 million factory (asset) but it has cost you £850 million (liability). Depreciation should definitely be a debit in my eyes, no ideas why it's classed as a positive!?

Also, why is inventory in the debits section? Inventory is stocks so surely that's an asset and thus a debit?

View accounting as a language of translation.

The basic structures of the language are:
1) Debit the receiver, credit the giver
2) Debit what comes in, credit what goes out
3) Debt all expenses and losses, credit all incomes and gains.

Now take it step by step:
1) Borrow cash to buy machinery from bank. "Bank" is the giver, "cash" comes in. Credit "bank", debit "cash".

2) Use cash to buy machinery. Machinery comes in, cash goes out. Credit cash (or "de-debit" cash if you want to call it that way). Debit machinery.

3) With depreciation, it's slightly trickier. Depreciation is an expense, and it reduces the value of the asset. Intuitively, this "de-debits" the value of the machinery. At the same time, since it is an expense - this "de-credits" the value of income (or profit).

Just by this, we have: Debit Profit - Credit Machinery

Now split this into two:
Debit Depreciation - Credit Machinery by a value of "x"
Debit Profit - Credit Depreciation by a a value of "x"

The debit and credit of depreciation cancels out this way which is why you do not see it in the balance sheet (unless you have depreciation reserves, which is something I will, pardon the pun, "reserve" for another day).

 

[Oxymoron]

Also, why is inventory in the debits section? Inventory is stocks so surely that's an asset and thus a debit?

Sames rules.

Cash goes out - inventory comes in. Debit inventory, credit cash (or "de-debit" cash).

 

[Simon James]

Fortunately, the CT2 examiners do not expect you to be fluent in accountancy . They do expect you to have a basic understanding of accounts and to be able to generate and interpret basic accounts.

The dual aspect concept can be helpful to appreciate that every transaction affects two places in the accounts.

Using Oxymoron's example, if we borrow from a bank to buy some machinery, you should be able to spot that the net effect of this is a new asset (the machinery) and a new liability (the bank loan).

That machinery depreciates over year one - so the net value of the asset decreases. The corresponding effect is that profits are reduced by the same amount, reducing retained earnings (hence keeping the balance sheet in balance)

 

[hatton02]

Fortunately, the CT2 examiners do not expect you to be fluent in accountancy . They do expect you to have a basic understanding of accounts and to be able to generate and interpret basic accounts.

The dual aspect concept can be helpful to appreciate that every transaction affects two places in the accounts.

Using Oxymoron's example, if we borrow from a bank to buy some machinery, you should be able to spot that the net effect of this is a new asset (the machinery) and a new liability (the bank loan).

That machinery depreciates over year one - so the net value of the asset decreases. The corresponding effect is that profits are reduced by the same amount, reducing retained earnings (hence keeping the balance sheet in balance)

I didn't follow Oxymoron's example. I think what he's saying is "debit" doesn't mean positive and "credit" doesn't mean negative (or vice versa - I'm so confused!)

Using your last paragraph above, the machinery depreciates in value. Why would this reduce profits? I'd still be producing the same amount of materials from the factory and so get the same income. The costs of making it are still the same, so profit should still be the same.

Let's assume you're right that profit decreases and it reduces retained earnings. Why would the balance sheet balance? Surely the balance sheet reduces? Is it because you cheat and stick depreciation as an asset or something to make it balance?

Edit: I think I've worked out the answer to my last question...it's because retained earnings are part of the "equity and liabilities" section so this figure reduces the same as the asset figure. I've never understood why equity comes under the liabilities part of things...I've always thought it should be Assets + Equity = Liability

 

[Calum]

Equity is the owner's investment in the business (in some sense) and so the business owes it back to the owner.

Going back to the purpose of depreciation, remember that it is there to spread the cost of asset purchases over several years so that profits are not massively negative in the year you bought it. So it has to hit the P&L somehow!

 

[Simon James]

Don't worry too much about "credits" and "debits".

The value of a company to its shareholders (equity) is all of the assets less all of the liabilities. So E = A - L ie A = E + L.

If it helps, as Calum suggests, you can think of it that the company "owes" the equity to the shareholders who have "lent" money to the company in perpetuity.

On depreciation - the cost of using up some machinery goes into the cost of sales - so reducing profits. If we buy a machine for £1m and it will last 10 years, we don't put £1m into the cost of sales in year one, instead we charge deprecation of £100k per year. There is an annual cost of that machinery which is being used to produce the goods which generate the revenue.

As we "use up" the asset, its value is written down (reduced) in the balance sheet.

I hope this helps

Simon

PS no "cheating" involved - simply applying the accounting concepts.