Section 4.1 - Accounts
Bank, Accounts Receivable, Supplies, Bank Loan, Mortgage Payable and B. Gold, Capital are all examples of accounts.
There are asset accounts, liability accounts and owner’s equity accounts.
Accounts appear on balance sheets (and in ledgers, trial balances and income statements as you will soon learn).
T-Accounts
T-accounts are simply another way of representing an account.
There is one T-account for each account on a balance sheet.
Each T-account contains the name and balance (current dollar value) of a particular account.
The current value of a T-account is always taken from the most recently prepared balance sheet.
The opening balance and normal balance of an asset account goes on the left side of a T-account because assets appear on the left side of a balance sheet.
On the other hand, the opening balance and normal balance of a liability or owner’s equity (capital) account goes on the right side of a T-account because liabilities and owner’s equity appear on the right side of a balance sheet.
Ledger
A ledger is simply a collection or group of all of the accounts of a business and their current balances on a particular date.
Both the Chapter 4 ledger and the balance sheet show the financial position (A = L + OE) of a company on a particular date.
Section 4.2 - Rules of Debit Credit Theory
Owing to their Latin roots, the left side of a T-account is always called the debit side (debere or debitum in Latin) while the right side of a T-account is always called the credit side (credere or creditum in Latin).
The short form of debit is dr and the short form of credit is cr.
You already know that the opening balance and normal balance of an asset account appears on the left side of a T-account while the opening balance and normal balance of a liability or owner’s equity (capital) account appears on the right side of a T-account.
Therefore, we say that an asset account normally has a debit (left side) balance and a liability or owner’s equity (capital) account normally has a credit (right side) balance.
A T-account is also useful in recording changes to the value of an account resulting from a business transaction.
You may recall that in elementary mathematics, we always place a number to be added to another number just below that other number.
Accordingly, to increase an asset, we debit the account. It only makes sense than that to decrease an asset, we credit the account.
The opposite is true for liabilities and owner’s equity. Namely, to increase a liability or owner’s equity (capital) account, we credit the account while to decrease a liability or owner’s equity (capital) account, we debit the account.
In short then, we always increase an account on the side of the normal or opening balance.
The above is known as the rules of debit credit theory.
Section 4.3 - Transaction Analysis Sheet
A transaction analysis sheet, much like the equation analysis sheet from the previous chapter, is an informal and unofficial business document that assists accounting students who are learning the basics of bookkeeping.
When you record an accounting entry on a transaction analysis sheet, you are recording the changes (increases/decreases) in the values of the accounts caused by a single business transaction, expressed in terms of debits and credits.
An example of an TAS is found in the next document on your Chapter 4 Content list.
Double Entry System of Accounting
You may have noticed that for each business transaction:
at least one account must be debited and at least one account must be credited (at least one debit and one credit)
debits are always listed first and credits are always listed last (debits before credits)
the total dollar value of the debits must equal the total dollar value of the credits (debits equal credits)
The above is known as the double entry system of accounting because each transaction is recorded in two steps.
First it is recorded as a debit (or debits) and then secondly as a credit (or credits) so that the total value of the debit entries equals the total value of the credit entries.
If speaking, we state a typical transaction as follows:
Supplies debit $2000, Cash credit $2000
Another example:
Cash debit $500, Accounts Receivable credit $500
Click here for a summary of debit credit theory and the double entry system of accounting
Summary of Five Transactions Affecting the Capital Account using Debit/Credit Theory
The Capital account is only affected (increased/credited or decreased/debited) when one of the following five business transactions takes place:
(1) goods or services are sold by the business to its customers (hint: revenues) in the ordinary course of operations (whether for cash or on account)
e.g. goods or services sold for cash -- Cash (dr) -- Capital (cr)
e.g. goods or services sold on credit/on account -- A/R (dr) -- Capital (cr)
(2) money is paid out or a bill is received (hint: expenses) concerning ordinary/routine business costs (e.g., rent, advertising, wages)
e.g. paid wages to company employees -- Capital (dr) -- Cash (cr)
e.g. received bill from Toronto Star re: September advertising -- Capital (dr) -- A/P - Toronto Star (cr)*
*. the only exception to the rule that states at least one asset must always change in each business transaction
(3) money or other assets are withdrawn (hint: drawings) from the business by the owner
e.g. owner withdraws cash from the business -- Capital (dr) -- Cash (cr)
(4) money or other assets are invested into the business by the owner (hint: still Capital)
e.g. owner invests personal vehicle into the business -- Automobile (dr) -- Capital (cr)
(5) a business asset (e.g., automobile, equipment, furniture) is sold for a gain or a loss in an extraordinary transaction, i.e., not in the ordinary course of operations (hint: still Capital)
e.g. company vehicle listed at $6000 sold at a loss for $4000
-- Cash (dr $4000) -- Capital (dr $2000) -- Automobile (cr $6000)
e.g. company equipment listed at $8000 sold at a gain for $9000
-- Cash (dr $9000) -- Equipment (cr $8000) -- Capital (cr $1000)
Notice how each of the above transactions affects the overall value of the business - that is why the Capital account must be increased or decreased in each scenario.
You may also notice that an increase to Capital corresponds with an overall increase to the value of the business. Conversely, a decrease to Capital corresponds with an overall decrease to the value of the business.
And please note that later on in this course, once we have learned about revenue, expense and drawings accounts and ultimately debit/credit theory and the double-entry system of accounting, this lesson will become much clearer in terms of understanding the concept of equity.
Calculating the Updated Balance of a T-account
You already know that a T-account indicates the name and balance of each account in the balance sheet or ledger. And as previously stated, over time business transactions result in changes to the balances in those accounts.
In order to calculate the updated balance of a T-account:
a. add up the left side (debit) figures and place the tiny subtotal (pin total/pencil footing) beneath the last item on the debit side
b. add up the right side (credit) figures and place the tiny subtotal (pin total/pencil footing) beneath the last item on the credit side
c. subtract the smaller side subtotal from the larger side subtotal
d. place the difference on the side with the larger subtotal
e. circle that difference to highlight the new balance and whether it is a debit or credit balance
Cash
=================
2000 / 300
500 / 400
2500 700
1800
Exceptional Account Balances
As you already know, asset accounts normally have debit balances while liability and capital accounts normally have credit balances. But sometimes a situation will occur whereby an asset account will temporarily end up with a credit balance or a liability or capital account will temporarily show a debit balance.
Most of these scenarios, called exceptional balances, are the result of mistakes.
For example, if our debtor customer sends us a cheque that is greater than the amount owing, her A/R account will temporarily show a credit balance and technically, our business will owe her the overpayment.
Similarly, if our business writes a cheque that is greater than the current amount in our Bank account, our Bank account will temporarily show a credit balance.
Exceptions are typically detected by appearing as the opposite of the general rules in use.
And finally, try not to confuse exceptional balances with extraordinary transactions, as one has nothing to do with the other.
Additional Notes on Buying and Selling on Account
Businesses with good reputations are typically able to buy goods and services on credit – meaning they can buy today but delay payment until later. It is not uncommon for a business to receive thirty days or more of credit.
The term “on credit” is sometimes used interchangeably with the term “on account.”
There are four uses of the term "on account" (your teacher's preference) in accounting today:
Vendor/seller
1(a) sale on account, $600 (sell now)
Accounts Receivable dr 600
B. Gold, Capital (Revenue) cr 600
1(b) receipt on account, $600 (collect/receive payment later)
Cash dr 600
Accounts Receivable cr 600
Purchaser/buyer
2(a) purchase on account, Supplies, $300 (buy now)
Supplies dr 300
Accounts Payable cr 300
2(b) payment on account, $300 (pay later)
Accounts Payable dr 300
Cash cr 300
Section 4.4 - Trial Balance
Occasionally a business must check the accuracy of the T-accounts in the ledger. This is done via the preparation of a formal, official financial statement known as a trial balance.
A trial balance is a listing of all of the accounts of a business and their current balances on a particular date expressed as either debits or credits. (As of Chapter 4 in this course, all of the accounts refers to assets, liabilities and capital only.)
More specifically, assets are expressed as debit balances while liabilities and capital are expressed as credit balances on a trial balance as their normal balances would suggest.
As a result, debit balances should equal credit balances on a trial balance given that the fundamental accounting equation suggests that assets (debits) should equal liabilities plus owner's equity (credits).
if A = L + OE
and if A = dr while L + OE = cr
then dr = cr
If debit balances do equal credit balances on a trial balance, we say the trial balance is “in balance.”
If debit balances do not equal credit balances on a trial balance, we say the trial balance is “out of balance.”
A trial balance can be thought of as an informal balance sheet.
A trial balance is usually prepared at the end of every day, week or month.
The accounts in the trial balance are listed in the same order as they appear on the balance sheet - assets, liabilities and then equity.
Four dollar signs appear on a typical grade 11 accounting trial balance: first debit, first credit, two totals.
A trial balance always begins with a proper heading (name of company, name of financial statement, date of preparation) and ends with double underlines below the debit and credit totals.
Keep in mind, though, that as the trial balance is a listing of all of the accounts of the business and their balances on a particular date, when the number of accounts increases (as will be the case in Chapter 5) the trial balance will also be expanded.
Click here for a good example of a Chapter 4 trial balance
Trial Balance Out of Balance
If the trial balance is out of balance (debits do not equal credits), at least one accounting error has been made. (Of course, even if the trial balance is in balance, it is still possible that an accounting error has been made.)
There is a four-step procedure to follow when the trial balance is out of balance, wherein we retrace our steps backwards beginning with the most recently-prepared documentation:
1. Add up the trial balance columns again (debits and credits)
2. Check the balances from the ledger (T-accounts) against those listed in the trial balance (missing, wrong side, wrong amount)
3. Recalculate the balances for each T-account in the ledger
4. Check that there is a balanced accounting entry (dr = cr) in the ledger accounts for each transaction