Lesson 2: Analyze, Record, Summarize

Thinking back to the problems assigned for the previous chapter, a tabular presentation is fine for illustrating the effects of transactions, but would soon become unwieldy if used for actual accounting record-keeping. Imagine a company with 300 accounts, each with an account heading at the top of a very large piece of paper, placing amounts under each heading! Chapter 2 presents the standard methodology for showing increases and decreases in Assets, Liabilities, and Owner Equity accounts. It is efficient and works for any number of accounts -- but it takes a little practice.

Learning Objectives

Our destination is illustrated at the end of Chapter 2, in the Illustrative Problem. When a transaction occurs, the first place it is recorded is in the journal. The journal is a chronological record (in date order) of the transactions in a business. After each transaction is entered in the journal, it is posted to the ledger. The ledger is a collection of separate accounts (think of it as one page for Cash, one page for Accounts Receivable and so on). The ledger is in account order. Finally, a trial balance is prepared in order to prove that debits = credits.

In terms of information management, we need a historical record of transactions, both by date (the journal) and by account (the ledger). These two orderings would allow us to find the answer to the question "what transactions happened on April 3?" by looking at the journal; or, we could ask the question "how much cash do we have?" by looking at the Cash account in the ledger. Under a manual system of accounting (demonstrated by your text), there is a fair amount of work involved in getting the transactions sorted out these two different ways. You will get the impression that each transaction is recorded once in the journal, and then copied over into the ledger. That's essentially what happens. We can summarize the first four steps in the accounting cycle as follows:

1.     Analyze each transaction.

2.     Enter each transaction in the journal

3.     Post (copy) each transaction from the journal to the ledger

4.     Prepare a trial balance

You might think that a mechanical process like copying the transactions from one place to another is a nonproductive activity for an accountant. You'd be right, which is why most people would spend their mental energy on the journalizing part of the process, and then let a computer system take care of the repetitive copying process.

Debits and Credits

In order to journalize and post, you will need to know about debits and credits. Every account has two sides, a debit side and a credit side:

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Every account (asset, liability, owner equity, revenue, expense) has a left side, or debit side, and a right side, or credit side. Debits and credits are used to denote increases and decreases in the accounts, but you must look carefully at the rules for how this is done.

You must know 1) where each account lies in your chart of accounts, and 2) whether that account is being increased or decreased in a transaction. Once you have that information, you can refer to the rules for debit and credit, which are illustrated in the following diagram. For instance, an increase in an asset (Cash, Accounts Receivable, etc.) is recorded with a debit. But, an increase in liabilities or owner equity is recorded with a credit.

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I suggest that you print out the model presented above, or copy it down on a large piece of paper, and actively analyze the small set of transactions described below. Take some time with this and you will be rewarded.

Your textbook uses debits and credits for processing the transactions, but in a larger sense, an understanding of debits and credits makes you more efficient at learning accounting. For example, if you know how Accounts Payable is managed (credit for increase and debit for decrease), then you already know how to record changes in other liabilities, like sales tax payable, bonds payable, and Salaries Payable.

Let us examine how a few transactions from Lesson 1 would be entered as debits and credits in the accounts shown above. Here are the transactions:

1.     Owner invested $15,000 of personal assets in the business.

2.     Company purchased $7000 of equipment for cash.

3.     Supplies were purchased on account (account payable), $1600.

4.     Services were provided for cash, $1200.

5.     Rent was paid in cash, $600.

6.     A total of $250 was paid to creditors on account (Accounts Payable).

7.     The owner withdrew cash from the business, $1300.


Transaction 1: Owner invested $15,000 cash in the business.

In transaction 1, your reasoning would be as follows:

a. There was an increase in cash;
b. Cash is an asset;
c. Increases in assets are recorded with a debit;
d. Therefore, debit Cash for $15,000.

Transaction 1 has a second effect:
a. The Owner Capital increased;
b. Owner Capital is an Owner Equity account;
c. Increases in Owner Equity are recorded with a credit;
d. Therefore, credit Owner Capital for $15,000.

For any transaction, the debit amount and credit amount must be equal

Transaction 2: Purchased Equipment for $7,000 cash.

a. There was an increase in Equipment;
b. Equipment is an Asset;
c. Increases in Assets are recorded with a Debit;
d. Therefore, debit Equipment for $7,000.

Transaction 2 has another effect:
a. There was a decrease in Cash;
b. Cash is an Asset;
c. Decreases in Assets are recorded with a credit;
d. Therefore, credit Cash for $7,000.

After two transactions, our ledger would appear as follows:

ASSETS

LIABILITIES

OWNER EQUITY

Increase:

Debit

Increase:

Credit

Increase:

Credit

Decrease:

Credit

Decrease:

Debit

Decrease:

Debit

CASH

ACCOUNTS PAYABLE

JONES DRAWING

JONES CAPITAL

15,000

7,000

 

 

 

15,000

 

 

 

 

 

 

 

 

Operations

ACCOUNTS RECEIVABLE

NOTES PAYABLE

ADV. EXPENSE

 

SERVICE REVENUE

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SUPPLIES

RENT EXPENSE

UTILITIES EXPENSE

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EQUIPMENT

WAGES EXPENSE

SUPPLIES EXPENSE

7,000

 

 

 

 

 

 

 

 

 

 

 

 

 

The entries that were made in the T-accounts are called postings. So far, we have posted two transactions to the ledger. Although posting is not the first step in the accounting cycle, we need to be able to visualize the posting process when we analyze transactions.

Transaction 3: Purchased Supplies on account for $1,600.

In this transaction, Supplies increased and Accounts Payable increased. So, an increase in an asset (Debit) and an increase in a liability (credit). Debit Supplies and credit Accounts Payable.

Transaction 4: Provided services to customers for cash, $1,200.

We provided services for cash. An asset, Cash, increases, and an owner equity account (Service Revenue) increases. Cash is debited; Service Revenue is credited.

Transaction 5: Rent was paid in Cash, $600.

We paid rent in cash. All expenses are in owner equity. An expense reduces owner equity, so debit Rent Expense for $600. Cash goes down, so credit Cash for $600.

Transaction 6: Paid Accounts Payable with Cash, $250.

Accounts Payable is a liability, which is decreased by $250. Debit Accounts Payable for $250. Cash also decreases, so credit Cash for $250.

Transaction 7: The owner withdrew Cash from the business, $1,300.

This transaction reduces owner equity, and reduces an asset. Debit the Drawing account, and credit Cash for $1,300.

After all 7 transactions have been posted to the accounts, the ledger will appear as follows:

ASSETS

LIABILITIES

OWNER EQUITY

Increase:

Debit

Increase:

Credit

Increase:

Credit

Decrease:

Credit

Decrease:

Debit

Decrease:

Debit

CASH

ACCOUNTS PAYABLE

JONES DRAWING

JONES CAPITAL

15,000

7,000

250

1,600

1,300

 

15,000

1,200

600

 

 

 

 

250

 

 

 

 

1,300

Operations

ACCOUNTS RECEIVABLE

NOTES PAYABLE

ADV. EXPENSE

 

SERVICE REVENUE

 

 

 

 

1,200

 

 

 

 

 

 

 

 

 

 

 

 

SUPPLIES

RENT EXPENSE

UTILITIES EXPENSE

1,600

600

 

 

 

 

 

 

 

 

 

 

 

 

EQUIPMENT

WAGES EXPENSE

SUPPLIES EXPENSE

7,000

 

 

 

 

 

 

 

 

 

 

 

 

 

OK, so much for the analysis. In practice, we do things in a certain order, called the Accounting Cycle.

The Accounting Cycle

1. Analyze each transaction;

2. Journalize each transaction by recording it in the journal;

3. Post each transaction to the appropriate accounts in the ledger;

4. Prepare a trial balance to show the final total for each account.

Although posting is step 3, we need to understand posting before we look at journal entries. Here is a sample journal entry for transaction 4, assuming that the revenue was earned on January 20.

General Journal

Date 

Accounts 

 Ref 

Debit 

Credit 

Jan 20

Cash 

 

1200 

 

 

_______Service Revenue

 

 

1200 

 

Provided services for cash.

 

 

 

The journal is actually the first place where the transaction is recorded. The debit account (in this case, Cash) is entered first; the credit account (Service Revenue) is indented. The date is shown out to the left. Optionally, there may be a description of what occurred in the transaction, in this case, providing services for cash.

Here are transactions 5 and 6, assuming they both happened on January 21.

General Journal

Date 

Accounts 

 Ref 

Debit 

Credit 

Jan 21

Rent Expense

 

600 

 

 

_____Cash

 

 

600 

 

Paid rent in cash.

 

 

 

 

 

 

 

 

Jan 21

Accounts Payable

 

250

 

 

______Cash

 

 

 250

 

Paid cash on account.

 

 

Notice that the columnar arrangement of the numbers in the journal allows you to verify that, at all times, the total debits always equals total credits. Also note that the Ref column has not been filled in. When the posting is made from journal to ledger, the account number to which the debit or credit is posted will be written in this Ref column.

 

General Journal 

 

 

page 59

Date 

Accounts 

 Ref 

Debit 

Credit 

Jan 20

Cash 

101

1200 

 

 

_____Service Revenue

 

 

1200 

 

Provided services for cash.

 

 

 

Accountants are very organized when it comes to account numbers. One numbering system works like this: Assets are assigned numbers 100-199; liabilities are assigned numbers 200-299; the capital and drawing accounts are 300-399; revenues are assigned 400-499; and expenses are given numbers from 500-599. So, if you see an account numbered 203, you can assume it is a liability. An account numbered 402 would undoubtedly be a revenue account. If you were to design an accounting system for a client, you would want to include all accounts likely to be needed. Additionally, within a category, the accounts should be in a logical order. For example, a numbering scheme for current assets might go like this: Cash is 101, Accounts Receivable 104, Inventory 106, Supplies 108, and Prepaid Insurance 110.

Calculating an Account Balance

After you have posted all transactions to the ledger accounts, you transfer the final balance of each account to the trial balance. How do you calculate the final balance of an account? Answer: add up all the debits, add up all the credits, then subtract. The difference is placed on the BIGGER side. If debits > credits, put the balance on the debit side. If the credits > debits, put the difference on the credit side. We should calculate the balance of the Cash account in the example shown above. Debits to Cash are 15,000 + 2,000 = $17,000. The credits to Cash are 7,000 + 600 +250 + 1,300 = 9,150. Subtract one from the other, and because the debits exceed the credits, the ending balance of Cash is a debit balance.

A typical error made by a new accountant would be to enter two balances for Cash in the trial balance. In the above example, you might be tempted to put the debit total of the Cash account in the debit column of the trial balance (17,000), and then put the credit total (9,150) on the credit side. This would be incorrect. Calculate the final balance of cash (debits minus credits) and enter this one figure on the debit side for Cash. Each account has one balance only.

The Trial Balance

A trial balance involves computation of a final balance for each account. Then, each account is listed, along with its debit or credit balance. Logically, if all transactions have equal debit and credit entries, the trial balance should have equal debit and credit totals.

Jones Company

Trial Balance

31-Jan-17

Debit

Credit

Cash

7,050

Acc. Receivable

Supplies

1,600

Equipment

7,000

Accounts Payable

1,350

Jones Capital

15,000

Jones Drawing

1,300

Service Revenue

1,200

Rent Expense

600

 

Totals

17,550

17,550

Trial Balance Errors

I included all accounts in this trial balance; in practice, if an account has no entries, it can be omitted. The trial balance MUST balance. The total debits must equal total credits. If your trial balance does not balance, you have made an error, and must fix it. Common situations in which the trial balance does not balance include: making a debit entry but no credit entry; making unequal debit and credit entries, and transposing digits. Here are a couple of examples of errors and their effects.

Look at the Jones Company trial balance immediately above:

1.     Suppose that the Rent Expense debit of $600 was accidentally left out of the trial balance. What would the debit total and credit total be? The debit total would be 16,950 and the credit total would be 17550, a difference of $600. This one is pretty obvious.

2.     Suppose that when the trial balance was prepared, the $600 Rent Expense balance was accidentally put on the credit side. What would the debit and credit totals be? The debit total would go down to $16,950, as before, but the credit total would go up to $18,150. The difference between debit total and credit total would be $1,200, which is double the $600 amount.

3.     This error illustrates the Rule of 9. Suppose that the Accounts Payable was entered in the trial balance as a credit of $1,530 rather than $1,350. The digits were accidentally transposed and this transposition has a familiar effect. The debit total would still be $17,550, but the credit total would be $17,730. The difference between the two columns would be $180. All accountants know that if a transposition occurs, the difference between debit and credit sides will be a number that is evenly divisible by 9. This is a mathematical property when a transposition occurs.

4.     As your textbook points out, if a slide occurs, the rule of 9 also applies. An example of a slide would be recording a debit to Rent Expense for $600 and accidentally crediting Cash for only $60. The decimal is in the wrong place on the credit entry, and the difference between debit and credit sides in the trial balance would be evenly divisible by 9. Try it out using your calculator.

If you find that your trial balance does not balance, immediately calculate the difference between debit side and credit side. If the difference looks like the balance of one of your accounts, or is double one of the balances, you may have a clue as to how the error occurred. And divide the difference by 9 to discover whether a transposition may have occurred.

Also note that the trial balance may not catch some errors. If Rent Expense was actually $600, but an entry was made in the journal debiting Rent Expense for $800 and crediting Cash for $800, the trial balance will balance, but will be wrong. The trial balance will only catch errors where debits do not equal credits.

In this document, we have looked at the first 4 steps in the Accounting Cycle. You should memorize these first steps, as we will practice them repeatedly.