Chapter 2 NotesEach business transaction is recorded in the accounting equation under a specific account. Different accounts are used for each of the subdivisions of the accounting equation: asset accounts, liabilities accounts, expense accounts, revenue accounts, and so on. What is needed is a way to record the increases and decreases in specific account categories and yet keep them together in one place. The answer is the standard account form (see Figure 2.1). A standard account is a formal account that includes columns for date, item, posting reference, debit, and credit. Each account has a separate form, and all transactions affecting that account are recorded on the form.What is needed is a way to record the increases and decreases in specific account categories and yet keep them together in one place. The answer is the standard account form (see Figure 2.1). A standard account is a formal account that includes columns for date, item, posting reference, debit, and credit. Each account has a separate form, and all transactions affecting that account are recorded on the form.Each account has a separate form, and all transactions affecting that account are recorded on th e form. All the business… account forms (often referred to as ledger accounts) are then placed in a ledger. Each page of the ledger contains one account. The ledger may be in the form of a bound or a loose-leaf book. If computers are used, the ledger m ay be part of a computer file. For simplicity‟s sake, we use the T account form. This form got its name because it looks like the letter T. Generally, T accounts are used for demonstration purposes.Each T account contains three basic parts:•Title of account•Left sideRight sideAll T accounts have this structure. In accounting, the left side of any T account is called the debit side.Just as the word left has many meanings, the word debit for now in accounting means a position, the left side of an account. Do not think of it as good (+) or bad (-). Amounts entered on the left side of any account are said to be debited to an account. The abbreviation for debit, Dr., is from the Latin debere.The right side of any T account is called the credit side. Amounts entered on the right side of an account are said to be credited to an account. The abbreviation for credit, Cr., is from the Latin credere.At this point do not associate the definition of debit and credit with the words increase or decrease. Think of debit or credit as only indicating a position (left or right side) of a T account.Balancing an AccountNo matter which individual account is being balanced, the procedure used to balance it is the same.In the “real” world, the T account would also include the date of the transaction. The date would appear to the left of the entry.Note that on the debit (left) side the numbers add up to $5,600. On the credit (right) side the numbers add up to $900. The $5,600 and the $900 written in small type are called footings. Footings help in calculating the new (or ending) balance. The ending balance ($4,700) is placed on the debit or left side, because the balance of the debit side is greater than that of the credit side.Remember that the ending balance does not tell us anything about increase or decrease. It only tells us that we have an ending balance of $4,700 on the debit side. Instead of first trying to understand all the rules of debit and credit and how they were developed in accounti ng, it is easier to learn the rules by “playing the game.”Have patience. Learning the rules of debit and credit is like learning to play any game: the more you play, the easier it becomes. Table 2.1 shows the rules for the side on which you enter an increase or a decrease for each of the separate accounts in the accounting equation:•Assets are increased with debits and decreased with credits•Liabilities are increased with credits and decreased with debits•Owners‟ Equity Capital account is increased wit h credits and decreased with debits•Withdrawals are increased with debits and decreased with credits•Revenues are increased with credits and decreased with debits•Expenses are increased with debits and decreased with creditsA normal balance of an account is the side that increases by the rules of debit and credit. For example, the balance of cash is a debit balance, because an asset is increased by a debit. We discuss normal balances further in Chapter 3.It might be easier to visualize these rules of debit and credit if we look at them in the T account form, using + to show increase and - to show decrease.Rules for Assets Work in the Opposite Direction to Those for Liabilities When you look at the equation you can see that the rules for assets work in the opposite direction to those for liabilities. That is, for assets the increases appear on the debit side and the decreases are shown on the credit side; the opposite is true for liabilities. As for the owner‟s equity, the rules for withdrawals and e xpenses, whichdecrease owner‟s equity, work in the opposite direction to the rules for capital and revenue, which increase owner‟s equity.This setup may help you visualize how the rules for withdrawals and expenses are just the opposite of those for capital and revenue.Balancing the EquationIt is important to remember that any amount(s) entered on the debit side of a T account or accounts also must be on the credit side of another T account or accounts. This approach ensures that the total amount added to the debit side will equal the total amount added to the credit side, thereby keeping the accounting equation in balance.Our job is to analyze business transactions using a system of accounts guided by the rules of debit and credit that will summarize increases and decreases of individual accounts in the ledger. The goal is to prepare an income statement, statement of owner‟s equity, and balance sheet.The chart of accounts is a numbered list of all of the business' accounts. It allows accounts to be located quickly. In business, for example, 100s are assets, 200s are liabilities, and so on. As you see in Table 2.2, each separate asset and liability account has its own number. Note that the chart may be expanded as the business grows.We will analyze the transactions using a teaching device called a transaction analysis chart to record these five steps. Keep in mind that the transaction analysis chart is not a part of any formal accounting system.) The five steps to analyzing each business transaction include the following:Step 1 Determine which accounts are affected.Example: Cash, Accounts Payable, Rent Expense. A transaction always affects at least two accounts.Step 2 Determine which categories the accounts belong to: assets, liabilities, capital, withdrawals, revenue, or expenses.Example: Cash is an asset.Step 3 Determine whether the accounts increase or decrease.Example: If you receive cash, that account increases.Step 4 What do the rules of debit and credit say (Table 2.1)?Step 5 What does the T account look like? Place amounts into accounts either on the left or right side depending on the rules in Table 2.1.The following chart shows the five-step analysis from another perspective:1.Accounts affected2.Category3.Decrease or increase4.Rules of Dr. and Cr.5.Appearance of T AccountsDo not try to debit or credit an account until you go through the first three steps of the transaction analysis.A transaction that involves more than one debit or more than one credit is called a compound entry. This first transaction of Mia Wong‟s law firm is a compound entry; it involves a debit of $6,000 to Cash and a debit of $200 to Office Equipment (as well as a credit of $6,200 to Mia Wong, Capital).The name for this double-entry analysis of transactions, where two or more accounts are affected and the total of debits and credits is equal, is double-entry bookkeeping. This double-entry system helps in checking the recording of business transactions.As we saw in Learning Unit 2-2, when all the transactions are recorded in the accounts, the total of all the debits should be equal to the total of all the credits. If they are not, the accountant must go back and find the error by checking the numbers and adding every column again.The Trial BalanceFootings are used to obtain the totals of each side of every T account that has more than one entry. The footings are used to find the ending balance. The ending balances are used to prepare a trial balance. The trial balance is not a financial statement, although it is used to prepare financial statements. The trial balance lists all the accounts with their balances in the same order as they appear in the chart of accounts. It proves the accuracy of the ledger.The trial balance lists all the accounts with their balances in the same order as they appear in the chart of accounts. It proves the accuracy of the ledger.Keep in mind that the figure for capital might not be the beginning figure if any additional investment has taken place during the period. You can tell by looking at the capital account in the ledger.A more detailed discussion of the trial balance is provided in the next chapter. For now, notice the heading, how the accounts are listed, the debits in the left column, the credits in the right, and that the total of debits is equal to the total of credits.The trial balance is used to prepare the financial statements.The trial balance is a list of accounts and their ending balances. Each accountwill have either a debit or credit balance (but not both). When a trial balance is complete the total of all the debits must equal the total of all the credits. When preparing a trial balance you list out assets, liabilities, capital, withdrawals, revenue, and expenses.Income StatementOnce the trial balance is complete the first report to make is the income statement, which is made up of only revenue and expense. Remember that there are no debits or credits on financial reports. All we are taking are the ending balances of each title from the trial balance.Statement of Owner’s EquityThe second report to prepare is the statement of owner‟s equity, which shows how to calculate a new figure for capital.Balance SheetThe third report is the balance sheet, which lists out each asset, liability, and the new figure for capital.The chart of accounts aids in locating and identifying accounts quickly.Remember that the rules of debit and credit only tell us on which side to place information. Whether the debit or credit represents increases or decreases depends on the account category: assets, liabilities, capital, and so on. Think of a business transaction as an exchange: you get something and you give or part with something.A transaction that involves more than one debit or more than one credit is called a compound entry.You will notice that assets, withdrawals, and expenses increase when you put amounts on the left, or debit, side of these accounts. The accounting system balances because liabilities, capital, and revenue increase when you put amounts on the right, or credit, side of these accounts. The increase side of any account will represent its normal balance.Footings are used to obtain the totals of each side of every T account that has more than one entry. The footings are used to find the ending balance. The ending balances are used to prepare a trial balance. The trial balance is not a financial statement, although it is used to prepare financial statements. The trial balance lists all the accounts with their balances in the same order as they appear in the chart of accounts.The trial balance is a list of ending balances of ledger accounts. These balances are used to prepare the three financial reports. Financial reports have no debits or credits. The inside columns are used to subtotal numbers. Revenue and expensesgo on the income statement. Withdrawals and either net income or net loss go on the statement of owner‟s equity to calculate a new figu re for capital. The balance sheet is a list of assets, liabilities, and the new amount for ending capital. Remember that the trial balance has debit or credits, not the financial reports.Once the trial balance is complete, the first statement to make is the income statement, which is made up of only revenue and expenses. Remember that there are no debits or credits on financial statements. All we are taking are the ending balances of each title from the trial balance. For the income statement, we list fees as the revenue and then list the expense titles in the inside column. Total operating expenses are then subtracted from the fees to arrive at a net income or a net loss.The second statement to prepare is the statement of owner‟s equity, which s hows how to calculate a new figure for capital. The third report is the balance sheet, which lists out each asset, liability, and the new figure for capital.。
