Saturday, 23 March 2013

Double-entry Accounting System...

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.


On the top of the horizontal bar there is the account title. Account decreases and increases are placed on the either side of the vertical bar:

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.

2. Double-entry accounting system and its rules 
 
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
3. Effects of debits and credits on accounts 

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:
  1. Debit entries increase asset accounts, and decrease liability and equity accounts.
  2. Credit entries increase liability and equity accounts, and decrease asset accounts.
Illustration 1: Effects of debits and credits in T accounts

Effects on debits & credits
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.


4. Illustration of applying double-entry accounting system 


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.
4.4. Analysis of paying cash for expenses transaction 

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.

4.5. Analysis of taking a loan 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.
4.7. Analysis of cash collection transaction 

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.

4.8. Analysis of cash advance receipt transaction 

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.


4.9. Analysis of cash revenue transaction 

 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.

4.10. Analysis of cash investment transaction 

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.

4.11. Analysis of furniture purchase transaction 

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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