Accounting 1
Instructor Notes
CHAPTER TWO
ANALYZING TRANSACTIONS
How do you organize your daily life? Is it with your computer? Is it with your IPhone
or Blackberry? What ever you use, there is a process to organizing. Maybe you set
up a folder for deleted files? Maybe you have folders set up on your computer for
various categories of files? Business also have to organize their transactions. Every
transaction that happens (like the purchase of supplies on account) affects at least
two accounts. In order to keep track of these balances, the transaction has to be
written. This is where we get into GAAP (Generally Accepted Accounting Principles).
Like the IRS tells us how to prepare our tax return, GAAP has rules for us to follow
when writing our transactions and preparing the financial statements. In this chapter
we will learn about Debits and Credits and making sure it all balances out!
1. Introduction
Accountants use the accounting equation Assets = Liabilities + Owners Equity to record
transactions. In order to keep everything straight, they use a separate record (called a ledger)
for each item that appears on the financial statements. For examples, there is a ledger for fees
earned, supplies, cash, etc. These accounts are used to record increases and decreases to these
accounts, and are summarized periodically.
It is also important to note that we are dealing with a service business in these first few
chapters. Therefore the Revenue account is called Fees, Fees earned, or Professional Fees, in
most cases. Later when we get to Merchandising businesses we will call the Revenue account
Sales. Whatever it is called from the above list, it is still considered Revenue and appears on
the Income Statement.
2. ASSETS, LIABILITIES, OWNER'S EQUITY, REVENUE, EXPENSES
ASSETS
1. Any physical thing (tangible) or right (intangible) that has a monetary value is an
asset.
2. Grouped first by Current (used within the year or less) and from most liquid to
least liquid, so generally in this order:
Cash
Accounts Receivable
Supplies
Prepaids
3. Then grouped by Property Plant and Equipment for those assets kept for more
than a year:
Land
Building (less accumulated depreciation)
Equipment (less accumulated depreciation)
LIABILITIES
1. Debts owed to outsiders, CURRENT AND LONG TERM. Current liabilities are
expected to be paid out of current assets.
2. When a long term payment (i.e. a notes payable or a mortgage) is on the balance
sheet, the current payments are listed under current liabilities, and the remainder
under long term liabilities.
OWNER'S EQUITY
1. CAPITAL - is owner's equity in a sole proprietorship and a partnership.
2. DRAWINGS - drawings are amounts withdrawn by sole proprietorships and
partnerships.
REVENUES
1. Gross income resulting from operations
Can be:
Sale of services or merchandise (fees, commissions, fees earned, sales)
Interest revenue
Rent revenue
If have more than one, need to separate those two.
EXPENSES
Costs that have been consumed in the process of producing revenue.
NATURE OF AN ACCOUNT
Three parts
1. Title
2. Space for recording increases
3. Space for recording decreases
3. CHARACTERISTICS OF AN ACCOUNT
THE T-ACCOUNT
TITLE
___________________________
Left Side | Right Side
debit
| credit
|
|
(the left side is always debit, the right side is always credit).
The side for increases and decreases depends on the type of account.
BALANCE SHEET ACCOUNTS
__________________________________________________
|
debit | credit
|
Increase in assets (+) | Decrease in asset (-)
Decrease in liability (-)| Increase in Liability (+)
Decrease in O.E. (-) | Increase in O.E. (+)
EXPENSES
____________________
debit for | credit for
increases | decreases
REVENUE
____________________
debit for | credit for
decreases | increases
So for an asset accounts you would put an increase in an asset on the plus or Debit
side (left side), and a decrease in an asset would be on the minus or credit side
(right side).
For Liabilities the - (decreases) on the left or still debit side, and + (increases) on
the right or still the credit side. As you charge something, think of it as increasing
what you owe, so it would be a credit (or +) as you buy something on account.
When you pay towards what you owe, it is a debit (or -) because what you owe
goes down.
Capital and Revenues are the same as liabilities (Increases or + on the credit side,
decreases or - on the debit side). Revenues and capital will almost always be a
credit entry. One exception would be you would debit a revenue account for a
refund.
Expenses when they occur appear on the Debit side. The expense account is almost
always debited. One exception would be if you received a refund.
REMEMBER: the + and - may change sides but the left is always debit and the right
is always credit no matter what type of account it is.
Abbreviations are CR and DR for credit and debit.
4. ANAYLZING AND SUMMARIZING TRANSACTIONS (important
summary illustration of debits and credits).
Look at the examples. Place each entry into a T-account then make a journal
entry.
T- Accounts and Journal Entry Illustration
In a T-account, the left side is always the debit (DR) side, the right side is always the credit
(CR) side. Which side the increases in an account (indicated by a +) or decreases in an
account (indicated by a -) appear on depends on the type of account. In my examples, the
dollar amounts will just be made up. I am just trying to show you which account to debit and
which to credit.
For example an asset (like cash, AR, supplies, prepaids, equipment), has increases (+) on the
debit side and decreases (-) on the credit side. Expenses and drawing are normally always
debited, and are also + on the Debit side and – on the credit side. I know it seems strange to
put an expense in as a + instead of a -, but think of it as adding all your expenses together
first, then you will subtract them at the end in your income statement
DR
CR
+ Asset |
|
|
DR
CR
+ Expense |
|
|
DR
CR
+ Drawing |
|
|
For Liabilities, Capital, and Revenues, the decrease (-) is on the debit side (left) and the
increase (+) is on the credit side (right). Liabilities go up as you owe or charge something on
account (because you owe more money) and go down as you pay them off. Revenues are
almost always credited.
DR
CR
- Liability (AP) +
|
|
|
DR
CR
- Capital +
|
|
|
DR
CR
- Revenue (fees earned) +
|
|
|
In a transaction, it should affect at least two accounts. Both accounts can go up, both can go
down, or one account can go up and another go down. However, you must always have a
debit and equal credit entry (an equally entry on the left and right side of a T-account). Let us
look at some examples.
1. The owner invests $15,000 cash into the business. Both cash and capital go up.
DR
+
Cash
15,000 |
|
|
-
-
CR
Capital +
| 15,000
|
|
Both are entered on the + side since both go up, but one is a debit and the other is a credit. In
this case, Cash is the Debit since it has increases on the left side, and Capital is the Credit
since it has increases on the right side. This information helps you to write it out as a journal
entry. You need to write the debit entry first, followed by the credit entry indented about ½
inch.
Cash
Capital
15,000
15,000
2. What if we purchased some supplies on AP? Both would go up because we would be
buying supplies and the amount we owe goes up. So it would look like this:
DR
+ Supplies
5,000 |
|
|
-
-
CR
AP
+
|5,000
|
|
Again, we have both going up, and we have a debit and a credit.
The journal entry would look like this:
Supplies
AP
5,000
5,000
I won’t write out any more of the journal entries but there are examples in the textbook of
journal entries for many transactions. I will just concentrate on showing what you should
debit and what you should credit. With all these transactions, you write the debit entry first,
then indent and write the credit entry second.
3. What if we bought some land for cash, cash would go down and land would go up. But
we would still have a debit and credit entry.
+
CR
Cash | 2,000
|
DR
+ Land
2,000 |
|
-
So we debit Land and credit cash. Land would be written first in a journal entry.
4. What if we paid in cash for a rent expense, it would look like this:
+
CR
Cash
| 2,000
|
DR
+ Rent Exp.
2,000 |
|
-
We would debit the expense account, and credit cash. Remember expenses are almost always
debited. Expenses go up as we have increased the amount of expenses that have incurred (we
will subtract the expenses from Revenues but not until we do the income statement) and cash
goes down because we paid these expenses in cash. The only time you would have a credit to
an expense would be in the case of a refund/overcharge or in closing entries (not until we get
to chapter 4).
5. Assume we earned Fees for cash, it would look like this:
DR
+ Cash
1,000 |
|
-
-
Fees Earned
| 1,000
|
CR
+
Both Cash and Fees Earned go up, so Cash is debited and Fees earned is credited.
Revenue accounts (like Fees earned or Sales) are almost always credited. The exception
would be a refund given or closing entry.
6. Assume we earn Fees on Account, it would look like this:
DR
+ AR
1,000 |
|
-
-
CR
Fees Earned +
| 1,000
|
Both AR and Fees earned go up, so AR is debited and Fees earned is credited.
7. What if we make a payment on our AP. AP would go down and we would pay this with
cash, so cash would also go down. It would look like this:
+
CR
Cash
| 200
|
DR
- AP
200 |
|
+
8. What if a customer paid off the amount owed to us which we had previously sold on
account. This amount was previously recorded as a debit to AR, and a credit to Fees Earned.
We do not want to record it in Fees Earned again, we just want to show the receiving of cash
(which goes up) and that AR goes down (because the customer no longer owes us the
money).
DR
+ Cash
1,000 |
|
-
+
CR
AR
|1,000
|
IMPORTANT:
When you write a journal entry …. Notice that the Debit entry is written first and the
credit entry is always written second. The credit entry should be indented in ½ inch
from the date line. Then indent in another ½ inch a short explanation. If you are in
the same month, you only need to put the day in the date column, not month and
year again.
5. ILLUSTRATION OF ANAYLZING AND SUMMARIZING TRANSACTIONS
See examples in textbook for how to post journal entries to ledgers, and on the
following pages in the textbook at the end of chapter 2, is an illustration of
everything in this chapter put together in a problem. After all the postings are done,
you then do a Trial Balance, illustrated on in textbook.
A. NORMAL BALANCES OF ACCOUNTS
Easiest way to remember normal balance is that it is generally on the + side, or the
side you record increases. Therefore, the normal balance for Assets, Expenses and
Drawing is the Debit side. The normal balance for Liabilities, Revenues and Capital is
the Credit side. More accounts will be introduced in later Chapters.
B. JOURNALS AND POSTING TO ACCOUNTS
After you have written your journal entry you must post each Debit and Credit entry
individually to the ledger. There is a ledger for each account (like Cash, Accounts
Payable, Fees earned). If you wrote a Debit entry in the journal, write it as a Debit
entry in the Ledger. Ledgers need to have a continuous balance kept. If you have a
debit balance and a debit entry, add them together and record the balance. Same if
you have two credits. If you have one of each, like a Debit Balance but a new Credit
entry, Subtract and put the balance on the larger side.
View Chapter 2 power point slides for illustrations of posting.
NEW ACCOUNT
They introduce Unearned in this chapter. An unearned (compared to a prepaid) is
when someone pays you revenue in advance (before you have actually earned it).
Therefore, since you have not actually earned it, we call it a liability.
C. TRIAL BALANCE
Equality of debits and credits in the ledger are verified at the end of each accounting
period. To see if debits and credits equal, a form is prepared. This is called the Trial
Balance.
Compare to Balance sheet and the Trial Balance. Balance sheet list by Assets,
Liabilities and Owner’s equity. Trial Balance is by Debits and Credits.
6. DISCOVERY AND CORRECTION OF ERRORS
Example of error – Both debit and credit are wrong:
We purchased Equipment on account for $500. It was recorded like this:
Cash
500
Equipment
500
In this case both parts are wrong as it should be a debit to Equipment and a credit
to AP. So I would reverse the entry (reverse the debit and credit), then write the
correct entry. To correct:
Equipment
500
Cash
500
(to reverse entry from before)
Equipment
AP
500
500
(to write correct entry)
Example of error – Either the debit or the credit is wrong:
We purchased Equipment on Account and it was recorded as:
Equipment
Cash
500
500
Just the credit is wrong as it should be AP, not cash. So to correct, we will debit
cash to zero out the cash, then credit AP (the correct account).
Cash
500
AP
500
TEST NUMBER 1 -There is a lot to the chapter. You need to have a clear understanding of the
following before moving on. This is the type of items you can expect on Test 1.
Understanding Increases and Decreases in Accounts
Income Statement
Statement of Owner’s Equity
Balance Sheet
Debit Vs. Credit
T-Accounts
Writing Journal Entries
Posting Journal entries to Ledgers
Balancing Ledgers
Preparing Trial Balance
Correcting Entries
Your homework and the chapter notes from chapters 1 and 2 will be your best
study source.