Understanding Accounting Transactions: Debits, Credits, and Balance Sheet Explained, Schemes and Mind Maps of Accounting

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Basic Accounting

Supplement for Using Simply Accounting Version 8.0 for Windows

by

M. Purbhoo and D. Purbhoo

Basic Accounting

• Basic Accounting Supplement for Using Simply Accounting Version 8 Page 2 of
• Accounting Theory Contents:
• Basic Accounting
  • Balance Sheet
  • Income Statement
  • Debits and Credits
    • Journal Entries
    • Ledgers
    • Trial Balance
    • Audit Trail
  • Generally Accepted Accounting Principles (GAAP )
• Summary: Accounting Transactions

Basic Accounting Supplement for Using Simply Accounting Version 8 Page 4 of 13

The following is a typical example of a Balance Sheet.

Overview Company

Balance Sheet as at 04-30-

ASSETS LIABILITIES

Current Assets Current Liabilities Cash in Bank 76 245.90 Bank Loan 39 840. Accounts Receivable 806.00 Accounts Payable 21 445. Construction Materials 1 600.00 Vacation Payable 673. Office Supplies 108.00 EI Payable 1 401. Total Current Assets 78 759.90 CPP Payable 1 065. Inventory Assets Income Tax Payable 4 273. Base Materials 4 875.00 Receiver General Payable 6 740. Cobble Pavestones 8 560.00 EHT Payable 197. Edging Stone Blocks 1 500.00 CSB Plan Payable 700. Patio Stone Blocks 5 860.00 WCB Payable 1 416. Paver Slabs 3 860.00 PST Payable 4 976. Stone Slabs 11 920.00 GST Collected on Sales 4 354. Wall Building Blocks 8 900.00 GST Paid on Purchases –1 575. Total Inventory Assets 45 475.00 GST Owing (Refund) 2 779. Plant & Equipment Total Current Liabilities 78 768. Computers & Peripherals 5 000.00 Long Term Liabilities Construction Equipment 78 500.00 Mortgage Payable 199 900. Delivery Truck 51 000.00 Total Long Term Liabilities 199 900. Furniture & Fixtures 3 000. Warehouse 150 000.00 TOTAL LIABILITIES 278 668. Yard 100 000. Total Plant & Equipment 387 500.00 OWNER’S EQUITY R. S., Capital 219 670. R. S., Drawings –2 000. Current Earnings 15 396. TOTAL EQUITY 233 066.

TOTAL ASSETS 511 734.90 LIABILITIES AND EQUITY 511 734.

Notice that each section of the Balance Sheet can be further divided into subgroups of accounts,

such as Current Assets, Inventory Assets, etc. Consider how much more you learn about a

company from this detailed Balance Sheet compared with the single summary amounts for each

section in the accounting equation above the statement. These divisions aid in analyzing the

financial performance of a business.

Income Statement

The Income Statement contains two sections that can be subdivided. Again, the detailed account

names provide a fuller portrait of the business activity.

Revenues and Expenses : Revenues are sources of income, such as revenue from the sale of

merchandise, revenue from providing services or consulting, revenue from interest on bank

deposits or investments, and so on. Expenses are the costs incurred in generating revenue or in

doing business. These may include interest charges on loans or mortgages, the costs of supplies or

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merchandise that is sold, maintenance of equipment and property, rent, utilities, depreciation of

equipment, losses from theft or from customers failing to pay, labour costs, payroll benefits,

advertising, and so on.

Net Income (Loss) : Expenses are subtracted from revenue to determine the net income. If

revenue exceeds expenses, the company has earned a profit. If expenses exceed revenue, the

business will show a net loss. Thus, the income statement shows the economic performance of the

company. The following statement is a typical example:

Overview Company

Income Statement 01-04-01 to 04-30-

REVENUE

Revenue from Sales 15 800. Revenue from Contracting 47 500. Sales Returns & Allowances -1 100. Other Revenue 268. TOTAL REVENUE 62 468.

EXPENSE Advertising & Promotion 400. Bank Charges 32. Construction Materials Used 2 200. Cost of Goods Sold 17 070. Delivery Expense 216. Freight Expense 250. Hydro Expense 200. Interest Expense 2 140. Legal Expenses 200. Repairs & Maintenance 500. Telephone Expense 86. Wages 20 812. EI Expense 817. CPP Expense 532. WCB Expense 1 416. EHT Expense 197. TOTAL EXPENSE 47 071.

NET INCOME 15 396.

Debits and Credits

In a manual accounting approach, assets are generally displayed on the left side of the balance

sheet. Liabilities and Equity are traditionally presented on the right side of a balance sheet. This

presentation is important because it relates to the use of debits and credits. Debit means left and

credit means right. Thus, a debit entry is a left-side entry and a credit entry is a right-side entry.

The sides refer to the balance sheet placement of accounts. Assets, on the left side of the Balance

Sheet, normally have a debit or left-side balance. Furthermore, an increase in assets is represented

by a debit entry. Liability and equity accounts on the right side of the Balance Sheet normally

have a credit balance and increases to these accounts are recorded with credit entries. The Income

Statement accounts, expenses and revenues, are really subsections of the Equity section of the

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Receiver General, it is not counted as part of revenue. The remaining amount, $350, is the tax

collected. Until the tax is remitted, it is owing to the Receiver General — a liability increase — so

it must have a credit entry to keep the debits and credits in balance. The journal entry now looks

like this:

Cash in Bank (Debit) $5 350 Revenue from Sales (Credit) $5 000 GST Collected on Sales (Credit) $

Because the sale involved inventory merchandise, there is another component to the transaction.

Inventory assets that cost $3 000 were sold or reduced. This credit entry must be matched by a

debit entry, the expense or cost associated with the goods. Since they are no longer held as assets

by the business, the cost of purchasing the inventory can now be recorded as an expense as

shown. Again, debits equal credits.

Cost of Goods Sold (Debit) $3 000 Stone Slabs (Inventory) (Credit) $3 000

The final component of the journal entry is the explanation of the transaction; that is, when it took

place and what happened. This makes it possible to trace the journal entry back to its original

source document.

Debits Credits

05/31/98 Invoice #4522, Sold stone slabs to Marchbanks

Cash in Bank (Debit) $5 350 Cost of Goods Sold (Debit) $3 000 Revenue from Sales (Credit) $5 000 GST Collected on Sales (Credit) $ Stone Slabs (Inventory) (Credit) $3 000 Total $8 350 $8 350

The Ledger updates would include the following entries (DR and CR are commonly-used

abbreviations for Debits and Credits, respectively):

General (Accounts) Ledger: Cash in Bank Account

Date Particulars Debit Credit Balance

05/31 Balance forward 10 000 (DR)

05/31 Sale of stone slabs 5 350 15 350 (DR)

Similar entries would appear on the ledger pages for the other four accounts: Cost of Goods Sold,

Revenue from Sales, GST Collected on Sales, and Stone Slabs (Inventory Assets).

Customers (Receivables) Ledger: Marchbanks Account

Date Particulars Debit Credit Balance

05/31 Balance forward 0 (DR)

05/31 Sale of stone slabs 5 350 5 350 (DR)

05/31 Cash receipt with sale 5 350 0 (DR)

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Inventory Ledger: Stone Slabs

Date Particulars Debit Credit Balance

05/31 Balance forward 11 920 (DR)

05/31 Sale to Marchbanks 3 000 8 920 (DR)

The chart that follows summarizes how accounts change in transactions:

SECTION Normal Balance (Side) Increase Decrease

ASSETS : debit balance requires debit entry requires credit entry

(left side of Balance Sheet)

LIABILITY : credit balance requires credit entry requires debit entry

(right side of Balance Sheet)

EQUITY : credit balance requires credit entry requires debit entry

(right side of Balance Sheet)

REVENUE : credit balance requires credit entry requires debit entry

(increases in revenue increase equity)

EXPENSE : debit balance requires debit entry requires credit entry

(increases in expenses decrease equity)

Trial Balance

After all the journal transactions have been entered for a work session and the ledgers are

updated, a Trial Balance should be prepared to check that the debit and credit entries are equal.

The Trial Balance shows the balances in all General Ledger accounts as either debit or credit

amounts. The totals for the debits and credits columns should be equal if the transactions have

been entered correctly. (Of course the Trial Balance may be in balance but incorrect if

transactions were posted to the wrong accounts, or if incorrect amounts were entered.)

Contra Accounts

In the description of account balances, debits and credits, left and right referred to normal

accounts of each type. There is, however, a group of accounts that are opposite to the normal

accounts. These are the contra accounts. Contra means opposite or against. Thus, these accounts

have their balance on the opposite side and they reduce the total of a section. On the Balance

Sheet and Income Statement, they appear as negative amounts. In the Trial Balance, they appear

in the opposite column.

For example, contra asset accounts have a credit balance instead of a debit balance. They are

grouped with the assets because of a logical association. Accumulated Depreciation, for example,

is an amount that shows how much an asset has declined in value as a result of time and use. The

original value of the asset is recorded separately on the Balance Sheet. Allowance for

Uncollectable Accounts is logically associated with Accounts Receivable, but it shows what part

of the Receivables amount may never be collected. Unearned Revenue reflects money that has

been collected from a customer as an advance or deposit for work that is not yet completed. If the

work is never completed, the amount would be returned to the customer so it represents a

reduction in the amount owed by customers.

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1. Business Entity Concept (Accounting Entity)

A business is separate from its owner. It has certain rights and responsibilities that are separate

from the owner. For example, the business must file its own income tax return and pay its debts.

The owner must file his or her own income tax return that is separate from the business return.

The property or assets that a business owns must be recorded separately from the property that the

owner of the business has.

2. Going-Concern Assumption

When a business is started, it is expected to last or continue operations for some time. It does not

plan to go bankrupt or to dissolve immediately. It expects to be able to carry out its commitments

to its customers or clients, either to provide goods or services. The business often continues, even

when the ownership changes.

When you buy a radio from a store and find that it doesn’t work, you expect to be able to return it

or exchange it (unless you bought it in a bankruptcy or liquidation sale). You expect the store to

still be there when you return the next day, or even the next month.

3. Time Period Principle

Even though a business is expected to continue operations for a long time (Going-Concern

Assumption), it must report frequently and at regular time periods on its status and changes for

various reasons such as annual statements to shareholders, income statements for income tax

purposes and for normal business decisions, etc. This need for reporting changes regularly creates

the need to measure various parts of the business at different periods of time (monthly, quarterly

or yearly). For assets, therefore, it is necessary to know how long they can be expected to last so

that their value can be stated at these different times.

4. Monetary Principle

In order for a business to report on its status and progress, we need to be able to measure the

things that it owns and the things that it does. It has been decided that money will be used to

provide this information — dollars in Canada, yen in Japan, etc. Thus, all assets are recorded on

the balance sheet in dollar values, whileincome and expenses are reported in dollars on the

income statement. This principle also assumes that the dollar is stable — it is worth as much now

as it was 20 years ago, and will be 20 years from now. Of course, with inflation, this is not true;

but for now, we have not found a better way to provide information about the business. We could

measure everything in chickens, but that might create some other problems!

5. Objectivity Principle

All estimates and measurements in the business must be fair and reasonable. Whenever possible,

they should be based on fact so that they are not biased. This is why historical costs are preferred

for determining the value of assets. Fair market value is often used as the criterion or guideline.

How much something is worth should not be determined by how much your best friend will give

you for it, but by how much a group of strangers would be willing to pay for it. Your best friend

is less likely to be unbiased or objective. You might be willing to give her a really low price

because she’s your best friend. Or she might be willing to pay extra to help you out because she’s

your best friend. The deal with your friend would be a non-arms-length deal, because of this

potential for bias.

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6. Cost (Historical Cost) Principle

All assets owned by the business are recorded on the balance sheet at their cost price — the fair

market value at the time the asset was purchased. All depreciation expenses are based on this

original cost. If the asset changes very quickly in value, these changes are not shown in the

financial statements of the business. For example, a business that bought its property in

downtown Toronto many years ago must continue to show the value of the land at the price that it

paid (historical cost), even though the market price of the land is now much greater. If a business

buys some machinery that very quickly becomes worthless because a newer and better model is

available, the business must continue to record the value of the machinery at its cost price until it

disposes of it.

7. Realization (Recognition) Principle

Income should be reported (or recognized) when it has been earned (or realized, that is, made

real), regardless of when the payment for the work or goods is received. When the work is

completed, the income should be reported. When a customer walks out of a store with a VCR, the

revenue from the sale should be included in income for that day (or time period). The business

may have a “don’t pay a cent now” policy and the customer may not hand over the cash for

another six months. This policy has nothing to do with when the income is reported.

8. Matching Principle

Expenses should be matched to the revenue that they helped to produce. That is, they should be

reported in the same time period. Sales commissions paid should be reported with the sales that

the salesperson generated. Store rent for the month should be recorded as an expense for the sales

revenue for the same month. (See accrual basis of accounting.)

9. Conservatism Principle

Although most of the time the accountant for a business is objective in measuring the business’

happenings, sometimes she has to make a choice between two ways of recording information.

When making a choice, the accountant should choose the method that is more conservative or

cautious (that is, the method that will report the business income at the lower amount should be

used). For example, when trying to decide about bad debts, the business should not assume that

all customers will pay their accounts (although it hopes that everyone will pay), but should report

some allowance for non-payment. This will lower the income reported for the time period and is

the more conservative approach.

10. Materiality Principle

Anything that is big enough should be included in the financial statements. You can decide

whether something is “big enough” by asking whether it makes a difference to the business or its

owners — would the shareholders want to know about it or might it affect someone’s decision to

invest in the company? Therefore, anything that will affect income should be included. Small

items are not usually included in the statements because their effect on income would be so small

as to be unnoticeable. Thus, a pencil sharpener that cost $3.50 would not appear on the balance

sheet as an asset even if it can be expected to last for 10 years. Small items like this would be

grouped together under an overall category, such as office supplies expense.

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Summary: Accounting Transactions

The following chart lists examples of all possible combinations of debits and credits.

Examples of Accounting Transactions

Assets - DR (inc) Liabilities - CR (inc) purchase inventory, equipment, other assets on credit (payables); secure bank loan* Assets - DR (inc) Equity - CR (inc) owner invests cash in business Assets - DR (inc) Revenue - CR (inc) sale of goods/services for cash or on credit (receivables) Assets - DR (inc) Expense - CR (dec) these transactions do not normally occur** Liabilities - CR (inc) Equity - DR (dec) declaration of dividends Liabilities - CR (inc) Revenue - DR (dec) these transactions do not normally occur Liabilities - CR (inc) Expense - DR (dec) recording expenses in preparation for payment, wage-related expenses that become payables Equity - CR (inc) Revenue - DR (dec) closing revenue accounts from income statement to current earnings Equity - CR (inc) Expense - DR (dec) closing contra-expense accounts from income statement to current earnings, e.g., purchase discounts Revenue - CR (inc) Expense - DR (dec) these transactions do not normally occur Assets - CR (dec) Liabilities - DR (dec) payment of debt (payables or bank loan) by cash/cheque; purchase returns Assets - CR (dec) Equity - DR (dec) owner withdraws cash from business (drawings — contra equity account) for non-business use Assets - CR (dec) Revenue - DR (dec) sales returns, sales discounts Assets - CR (dec) Expense - DR (inc) payment of expenses (wages, operating expenses etc.) by cheque, recognize inventory sold as cost of goods sold Liabilities - DR (dec) Equity - CR (inc) these transactions do not normally occur Liabilities - DR (dec) Revenue CR (inc) sales tax compensation Liabilities - DR (dec) Revenue - CR (inc) purchase discounts Equity - DR (dec) Revenue - CR (inc) closing contra-revenue accounts from income statement to current earnings, e.g., sales discounts Equity - DR (dec) Expense - CR (dec) closing expense accounts from income statement to current earnings Revenue - DR (dec) Expense - CR (dec) these transactions do not normally occur Assets - DR (inc) Assets - CR (dec) purchase of inventory, equipment (assets) with cash/cheque; customers pay receivables Liabilities - CR (inc) Liabilities - DR (dec) record liability for taxes for remittances (e.g., GST Paid and GST Charged transferred to Accounts Payable - Receiver General) Equity - CR (inc) Equity - DR (dec) closing current earnings to retained earnings (capital) Revenue - CR (inc) Revenue - DR (dec) these transactions do not normally occur Expense - DR (inc) Expense - CR (dec) these transactions do not normally occur

• Reversing entries are possible for each of the transactions listed. These represent a trivial case of opposite signs (reversing debit and credit entries) and are not included.

** Some of the combinations that have the entry “these transactions do not normally occur” could be represented by reversing entries.