Everything in accounting starts with the accounting equation. I often tell my students that they have paid a lot of tuition to learn something pretty basic, but important; Assets = Liabilities + Equity
As we have seen, each element of the accounting equation is made up of several smaller elements. We call those elements “accounts.”
Companies can have just a few accounts or, in the case of large corporations, thousands of different accounts. To organize and keep track of the accounts, companies will assign numbers to the accounts, and then group the accounts by account type. So, for example, all of the asset account numbers might begin with “1,” while the liability account numbers will begin with a “2,” the equity account numbers with a “3,” and so on.
Exhibit 2-4 shows the chart of accounts for Smart Touch Learning. You can see how the account types are grouped with the numbering system separating each group of accounts from the other. Also, note that there are gaps in the account numbers. This allows the company to add more accounts in that group, as needed. For example, if Smart Touch needs to add an account for Equipment or for Merchandise Inventory, they can easily fit the accounts in the list where they should be.
In accounting, we use what is referred to as a “double-entry bookkeeping system.” This name refers to the transaction analysis process. If you recall, when we did our transaction analysis in Chapter 1, we were focused on making sure that the accounting equation stayed balanced after entering the information about a particular transaction. When we entered information for one part of the transaction, it caused the accounting equation to be unbalanced, until we entered the equal (but opposite) information somewhere else in the equation. For example, when Smart Touch purchased land for $20,000 cash, we first recognized that Cash decreased the asset side of the accounting equation. We “re-balanced” the equation by increasing Land by the same amount.
While the “transaction analysis” approach that we used in Chapter 1 helped us to understand how to analyze a transaction, it is not very helpful for the purpose of implementing a system that is capable of handling thousands of transactions. For that purpose we are going to introduce some new tools. The first of those tools is called a T-account. We call it a
T-account, because it resembles a capital “T.” We will put the name of the account across the top “bar” of the T-account. The left and right side of the T-account will be used to record increases and decreases in the account. We will put all of the increases on one side and all of the decreases on the other side.
Will call the two sides of the T-account Debits and Credits. Debit is simply a word that means “left.” Credit means “right.” So, when we put need to put something on the left side of a
T-account, we say we are “debiting” the account. When we need to put information in the right side of the T-account, we say we are “crediting” the account.
At the end of the period, if the total of all debits in the account exceeds the total of all the credits in the account, we will say that the account has a “debit” balance. If the credits exceed the debits, we say that the account will have a “credit” balance. So, when do we know whether to put information on the debit side of the account or on the credit side of the account?
Starting with the accounting equation, we will stipulate that whenever an asset is increased, we will put that information on the debit side of the account. When an asset is decreased, we will put that information on the credit side of the account. Because it would be impossible to have more decreases in an asset account than increases (there is, for example, no such thing as “negative” land), we know that the balance in an asset account will always be on the debit side.
Likewise, with liabilities, we will put increases on the credit side and decreases on the debit side (the opposite of how we treat assets). Generally, liabilities will always have a credit balance at the end of a period.
Equities are more complex, being an account that is actually a composite of several other accounts. But generally, if the company has more profit than losses over time, the balance in the equity accounts will be a credit balance.
If we look at this from a broader view, we see the that total debit balances on the left side of the accounting equation will always therefore be equal to the total of all the credit balances on the right side of the accounting equation. We can sum up this observations with a second equality.
Total Debits = Total Credits
In the case of Smart Touch’s transaction when they bought land for $20,000 cash, we can now use debits and credits to explain how the information is recorded in the system. We will increase Land by putting $20,000 in the debit column. We will decrease Cash by putting $20,000 in the credit column.
Now, let’s take a look at the Owner’s Equity component of the accounting equation. As capital contributions increase, we will put debits in the Cash account (because the company received cash from the owner) and credit the Owner’s Capital account. This increase in capital contributions causes a corresponding increase in Owner’s Capital. When the owner takes a withdrawal from the business, we will show the decrease in Cash with a credit, and put a corresponding debit in the Owner’s Withdrawals account. As our model indicates, this increase (debit) in Owner’s Withdrawals, will cause a decrease in the Owner’s Capital.
We can explain how revenues and expenses impact equity in much the same manner. We will start with identifying that we will increase Revenues using credits, and we will increase Expenses using debits. As Revenues increase (with credits), then Net Income, and subsequently, Owner’s Capital will also increase. As Expenses increase (with debits), those debits will cause Owner’s Capital to decrease.
The next major step in the recording process is to formally enter the transaction information into the General Journal. Essentially, the General Journal is a chronological record of each of the transactions, recorded in a standardized format.
The Journal Entry format is standardized. The first column is for the date of the transaction. The information about which accounts are impacted by the transactions is recorded in the description column, with the account being debited being entered first. The account being credited is entered on the next line, after indenting. The amounts are placed in the appropriate column.
In Transaction #1, Bright contributed $30,000 to Smart Touch to start the business on November 1. As we discussed earlier, the increase in Smart Touch’s cash is recorded as a debit in the Cash account. The increase in Bright’s capital contribution is recorded as a credit in the Bright, Capital account.
The format is standardized so that most transactions will look similar.
Entering the transaction into the journal is not the last step. Next, the information for each part of the journal entry must be entered in the General Ledger. The General Ledger is the listing of all the accounts used by the company, and the information for each account is accumulated in a single place.
In this case, the debit to Cash is posted in the Cash general ledger account. The credit to Bright, Capital is recorded in the Bright, Capital general ledger account.
In Transaction #2, Smart Touch purchased land for $20,000 cash on November 2. The increase in Smart Touch’s land is recorded as a debit in the Land account. The decrease in Smart Touch’s cash is recorded as a credit in the Cash account.
The information is entered in the journal. If we were to look at a full journal page, we would see these entries recorded one following the other in chronological order.
The amounts will next be entered into the General Ledger.
As each piece is posted to the appropriate General Ledger account, note that since we already had a Cash account that was created in Transaction #1, we simply add the $20,000 credit to the already existing account. The balance in the Cash account would now be a $10,000 debit balance.
In Transaction #3, Smart Touch purchased office supplies for $500 on account on November 3. The increase in Smart Touch’s office supplies is recorded as a debit in the Office Supplies account. The increase in Smart Touch’s accounts payable is recorded as a credit in the Accounts Payable account.
The amounts are entered into the journal.
Again, we will post each piece of the journal entry into the appropriate accounts in the general ledger.
We will repeat this procedure for each and every journal entry that is recorded during the period. At the end of the period, we will have a “set” of populated accounts, each having a balance.
Once the period is over, we will list the balances of each account in the ledger as either a debit balance or a credit balance. This listing is called a “trial balance.” After all of the account balances have been listed and totaled, the total of all the debit account balances should be equal to the total of all the credit balances.
As we learned earlier, the Income Statement is always prepared first. The information for the income statement comes from the Trial Balance. Once it is used in the income statement, it is not used for any other statements. The Revenues and Expenses are highlighted in blue, here, to “mark” the information so that we remember, that that information cannot be used on any other statement.
The Statement of Owner’s Equity is prepared next. The information comes from the trial balance and from the income statement, as shown. The statement starts with the beginning balance in Owner’s Capital. The ending balance in Owner’s Capital will be transferred to the Balance Sheet.
The rest of the information on the trial balance is now used to prepare the Balance Sheet. The balance in Bright, Capital does not come from the trial balance, however. That information comes from the Statement of Owner’s Equity.
