1. Introduction to double-entry accounting system
This tutorial is devoted to the technique used by most accountants
in the world. The technique is called the double-entry recording system.
To understand it better we are introducing a T account:
T account is
an individual accounting record that shows information about increases
and decreases in one balance sheet or income statement account. T account is
so called because it has the form of letter T.
Account
Title
|
|
Decreases
& Increases |
Increases
& Decreases |
The left side of the T account is called a debit, and the right side is
called a credit.
Debit is the left
side of a T account.
Credit is the right
side of a T account.
Often these two terms are abbreviated as Dr and Cr. It is common to say
that an account has been debited when an amount is placed on
the left side of an account, and credited if an amount is placed
on the right side of the account.
Account balance
is the difference between the debit side and the credit side of a T account.
Now we can define the double-entry system:
Double-entry
recording system provides for the equality of total debits and
total credits.
The double-entry rules can be helpful when we need to find a
mistake in
financial records. If total debits do not equal total credits,
there must
be a mistake. However, this system cannot ensure complete
accuracy. For example, even if debit balances equal credit ones, an
error may still be present because a wrong account was debited (or
credited) when the entry was made.
The two important rules about the double-entry recording system are as follows:
Assets = Claims (Liabilities and Owner's Equity) |
and
Total Debits = Total Credits |
Let us see how debits and credits affect accounts. As we mentioned earlier, a debit
is the left side and a credit is the right side of an account. Increases
and decreases are recorded differently for asset and claim accounts. Here
is what we mean:
- Debit entries increase asset accounts, and decrease liability and equity accounts.
- Credit entries increase liability and equity accounts, and decrease asset accounts.
Illustration 1: Effects of debits and credits
in T accounts
An easy way to remember these rules is to learn that increases are posted
on the outsides (see plus signs above) and decreases are posted on the
insides (see minus signs above). That rule holds true for asset as well
as liability and equity accounts.
Let's use an illustration. A company, called Huske's Consultants,
started its operations on January 1, 20X6 when the owner, Mrs. Huske,
contributed cash to the business. All accounts had zero beginning balances before this capital contribution.
We will see how each transaction affects T accounts and the accounting
equation. Transaction impacts on the financial statements will be shown
in a horizontal statements model. All events are numbered and their
numbers are used as recording references.
Recall that there are four types
of accounting events:
- Asset source transactions
- Asset use transactions
- Asset exchange transactions
- Claims exchange transactions
The transaction type will be indicated for each accounting event. All transactions
took place during 20X6.
Due to the space limitations, we will not show all accounts while
explaining a transaction. Only those accounts that are affected by a particular
transaction will be shown in the accounting equation.
In the cash flow section of the horizontal model, OA, FA and IA stand
for operating, financing and investing activities, respectively.
4.1. Analysis of cash contribution transaction
Event No. 1: On January 1, 20X6 the owner made a $10,000 cash contribution. This accounting event acts
to increase both assets (Cash) and equity (Contributed Capital). The increase
in the Cash account is recorded as a debit and the increase in the Contributed Capital account (equity) is recorded
as a credit:
Illustration 2: Effect of a capital contribution
in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Cash
|
Contributed
Capital
|
||||||
Debit
(1) + 10,000 |
Credit
(1) + 10,000 |
This is an asset source transaction:
Illustration 3: Effect of a capital contribution
in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
10,000
|
=
|
n/a
|
+
|
10,000
|
n/a
|
-
|
n/a
|
=
|
n/a
|
10,000
|
FA
|
4.2. Analysis of supplies purchase on account transaction
Event No. 2: On May 15, Huske's Consultants
purchased $400 worth of office supplies from a local supply company on
account (i.e., agreed to pay for them on a later date). Purchasing
supplies on account acts to increase
assets (Supplies) and liabilities (Accounts Payable). The
Supplies account
is debited and the Accounts Payable account is credited:
Illustration 4: Effect of a supplies purchase
in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Supplies
|
Accounts
Payable
|
||||||
Debit
(2) + 400 |
Credit
(2) + 400 |
This is an asset source transaction:
Illustration 5: Effect of a supplies purchase
in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
400
|
=
|
400
|
+
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
n/a
|
4.3. Analysis of providing services on account transaction
Event No. 3: On May 20, 20X6 the company provided services on account
(i.e., the company will collect cash later) to Mandy Food Store. The client, Mr.
Mandy's business, was billed for $2,600. The transaction acts to increase
assets (Accounts Receivable) and equity (by increasing Consulting Revenue). The asset
is debited and the equity account is credited:
Illustration 6: Effect of recording revenue
in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Accounts
Receivable
|
Consulting
Revenue
|
||||||
Debit
(3) + 2,600 |
Credit
(3) + 2,600 |
This is an asset source transaction.
Illustration 7: Effect of recording revenue
in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
2,600
|
=
|
n/a
|
+
|
2,600
|
2,600
|
-
|
n/a
|
=
|
2,600
|
n/a
|
Note that no cash flow is shown at this point because the customer agreed to pay the $2,600 later.
Event No. 4: On May 25, 20X6 the company paid $600 cash for operating expenses.
The expense recognition acts to decrease assets (Cash) and equity (Operating
Expenses). The Cash account is credited and the Operating Expense account is debited:
Illustration 8: Effect of paying operating
expenses in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Cash
|
Operating
Expense
|
||||||
Credit
(4) - 600 |
Debit
+ Expense [ - Equity] (4) - 600 |
An increase in expenses results in a decrease in equity. That's why
we showed expenses with a plus sign and equity underneath them with a
minus sign.
This is an asset use transaction:
Illustration 9: Effect of paying operating
expenses in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
(600)
|
=
|
n/a
|
+
|
(600)
|
n/a
|
-
|
(600)
|
=
|
(600)
|
(600)
|
OA
|
Note the $600 cash outflow. The company paid cash for expenses so there is a cash decrease related to this transaction.
Event No. 5: On June 1, 20X6, due to liquidity concerns, Huske's
Consultants decided to borrow $4,000 from Local Business Bank. The company
issued a note that had a 1-year term and carried 7% annual interest rate.
The transaction increases assets (Cash) and liabilities (Note Payable).
The asset increase is recorded as a debit and the liability increase is
recorded as a credit:
Illustration 10: Effect of taking a loan
in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Cash
|
Note
Payable
|
||||||
Debit
(5) + 4,000 |
Credit
(5) + 4,000 |
This is an asset source transaction:
Illustration 11: Effect of taking a loan
in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
4,000
|
=
|
4,000
|
+
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
4,000
|
FA
|
There is a cash inflow of $4,000 from financing activities in this transaction because the company received cash from the bank.
4.6. Analysis of rent prepayment transaction
Event No. 6: On June 1, 20X6 Mrs. Huske realized that the business was
growing and in this connection rented a larger office. $2,400 cash was
paid in advance for a 1-year rent of the new office. The transaction decreases
one asset account (Cash) and increases another (Prepaid Rent). To increase
the Prepaid Rent account it is debited and to decrease the Cash account
it is credited:
Illustration 12: Effect of rent payment
in T accounts
Assets
|
=
|
Claims
|
|||||
Cash
|
+
|
Prepaid Rent
|
|||||
Credit
(6) - 2,400 |
Debit
(6) + 2,400 |
This is an asset exchange transaction.
Illustration 13: Effect of rent payment
in the horizontal model
Assets
|
|||||||||||
Cash
|
+
|
Prepaid Rent
|
=
|
Claims
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
(2,400)
|
+
|
2,400
|
=
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
(2,400)
|
OA
|
There is a cash outflow of $2,400 from operating activities because the company paid cash for the rent.
Event No. 7: On June 15, 20X6 Huske's
Consultants received $1,500
cash from Mandy Food Store for the services provided before (see
Event No. 3). Cash collection increases one asset account (Cash) and
decreases the other
(Accounts Receivable). The Cash account is debited and the
Accounts Receivable account is credited:
Illustration 14: Effect of cash collection
in T accounts
Assets
|
=
|
Claims
|
|||||
Cash
|
+
|
Accounts
Receivable
|
|||||
Debit
(7) + 1,500 |
Credit
(7) - 1,500 |
This is an asset exchange transaction:
Illustration 15: Effect of cash collection
in the horizontal model
Assets
|
|||||||||||
Cash
|
+
|
Accounts
Receivable |
=
|
Claims
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
1,500
|
+
|
(1,500)
|
=
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
1,500
|
OA
|
Note the $1,500 cash inflow from operating activities in this
transaction. This cash collection resulted in cash inflow from the
customer.
Event No. 8: On June 30, 20X6 Mrs. Huske
signed a contract with Mining Company to perform consulting services.
The services are to be provided during the 12 months starting on July 1,
20X6. Huske's Consultants received
an advance cash payment in amount of $3,600 for services to be
performed under this contract.
The transaction acts to increase assets (Cash) and liabilities
(Unearned
Revenue). The asset is debited and the liability is credited:
Illustration 16: Effect of cash advance
receipt in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Cash
|
Unearned
Revenue
|
||||||
Debit
(8) + 3,600 |
Credit
(8) + 3,600 |
This is an asset source transaction:
Illustration 17: Effect of cash advance
receipt in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
3,600
|
=
|
3,600
|
+
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
3,600
|
OA
|
The $3,600 cash received is shown as a cash inflow from operating activities.
Event No. 9: On June 30, 20X6 Huske's Consultants represented Mr.
Debret (a client) in a court hearing, for what the company received $700 cash.
The increase in assets (Cash) is recorded as a debit. The increase in
equity (by increasing Consulting Services) is recorded as a credit:
Illustration 18: Effect of cash revenue
in T accounts
Assets
|
=
|
Liabilities
|
+
|
Equity
|
|||
Cash
|
Consulting
Revenue
|
||||||
Debit
(9) + 700 |
Credit
(9) + 700 |
This is an asset source transaction:
Illustration 19: Effect of cash revenue
in the horizontal model
Assets
|
=
|
Liabilities
|
+
|
Equity
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow
|
|
700
|
=
|
n/a
|
+
|
700
|
700
|
-
|
n/a
|
=
|
700
|
700
|
OA
|
The $700 cash received is shown as a cash inflow from operating activities.
Event No. 10: On August 1, 20X6, Huske's Consultants provided a loan to Jak Building
Company in amount of $3,000. Jak Building Company issued a 1-year, 8% note. The transaction
acts to increase one asset (Notes Receivable) and decrease another asset (Cash).
An increase in the Notes Receivable account is recorded as a debit, and a decrease
in the Cash account is recorded as a credit:
Illustration 20: Effect of cash investment
in T accounts
Assets
|
=
|
Claims
|
|||||
Cash
|
+
|
Notes Receivable
|
|||||
Credit
(10) - 3,000 |
Debit
(10) + 3,000 |
This is an asset exchange transaction:
Illustration 21: Effect of cash investment
in the horizontal model
Assets
|
|||||||||||
Cash
|
+
|
Notes
Receivable |
=
|
Claims
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow |
|
(3,000)
|
+
|
3,000
|
=
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
(3,000)
|
IA
|
Note the decrease in cash from this transaction. This cash outflow represents an investing activity.
Event No. 11: New furniture was required for the recently rented office
(Event No. 6). On August 1, 20X6 Mrs. Huske paid $2,000 cash to purchase
a new office table and chairs. The office equipment is expected to have
a useful life of 2 years and a salvage value of $400. The purchase acts
to increase one asset account (Office Equipment) and to decrease another
(Cash). The Office Equipment account is debited and the Cash account is
credited:
Illustration 22: Effect of furniture purchase
in T accounts
Assets
|
=
|
Claims
|
|||||
Cash
|
+
|
Office Equipment
|
|||||
Credit
(11) - 2,000 |
Debit
(11) + 2,000 |
This is an asset exchange transaction:
Illustration 23: Effect of furniture purchase
in the horizontal model
Assets
|
|||||||||||
Cash
|
+
|
Office
Equipment |
=
|
Claims
|
Rev.
|
-
|
Exp.
|
=
|
Net
Inc.
|
Cash
Flow |
|
(2,000)
|
+
|
2,000
|
=
|
n/a
|
n/a
|
-
|
n/a
|
=
|
n/a
|
(2,000)
|
IA
|
The transaction results in a $2,000 cash outflow from investing activities.
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