Hi, I'm Larry Walther, and this is principlesofaccounting.com, Chapter 2.
In this module, we're going to look at accounts, debits, and credits.
Let's begin by considering an accounting system.
An accounting system is a system whereby transactions and events
are reliably processed and summarized into financial statements and reports.
Whether that system is manual or automated,
it will have several elements in common.
It will include the idea of accounts.
It'll include understanding of debits and credits.
It will include the concept of journals and
it will include the concept of a general ledger.
Let's begin by considering accounts.
Accounts are the records that are kept for each asset,
liability, equity, revenue, expense, or dividend component of an entity.
Assets, liabilities, and equity, of course, are found on the balance sheet.
Revenues and expenses are found on the income statement.
Dividends would appear on the statement of retained earnings.
The other amounts you might see in the financial statements,
such as net income, is not really an account per se,
it's simply the difference between revenues and expenses.
These then are your six basic types of accounts.
Collectively, all the accounts are set to comprise the general ledger.
We'll see more on this later.
But let's look at an example,
a representative example of a ledger type account.
Here I'm showing cash, the beginning balance on January 1 was $50,000.
On January 2, we collected $10,000 from a customer causing an increase in cash
to $60,000 balance.
On January 3,
we had a cash sale transaction further increasing cash to $65,000.
On January 5, we had a $7,000 payment for rent, causing cash to decrease to $58,000.
You can see this cash account really doesn't look much different than
a bank statement you might keep.
But recognize, this is for the cash account.
You would have a similar general ledger account for each item or
each element of the company's financial statement, such as accounts receivable,
such as inventory, such as accounts payable, and so forth.
Now, let's think about debits and
credits as the next feature that we need to consider.
Debits and credits are unique accounting tools to describe the change in
a particular account that is necessitated by a transaction.
You might be thinking, what exactly does that mean?
Well, every transaction that occurs for
the company can be described in its debit-credit effects.
And each transaction, it can be described in such a way that debits equal credits.
We might think about describing as we did with our cash account.
You might think of it, rather than using a debit-credit system,
why not use a system of pluses and minuses?
But that's really not a sufficient system.
Let's think about some examples.
First of all, are there transactions that have a plus-plus effect?
For example, if we borrow money, we would think of increasing cash and
increasing debt.
Cash goes up, a plus.
Debt goes, a plus.
It's a plus-plus effect.
Other transactions might be a plus-minus effect.
If we collect an account receivable, our company's cash goes up and
our company’s accounts receivables go down.
That's a plus-minus effect.
Can you think of a minus-plus effect?
Well, let’s see.
How about if we use cash to buy equipment?
Cash goes down and equipment goes up, there's a minus-plus that I’m describing.
Or what about a minus-minus?
If we use cash to pay off an account payable, cash goes down and
accounts payable goes down, a minus-minus effect.
So the reason we substitute or
use a debit-credit type system is because a plus-minus type system doesn't maintain
equality such that every transaction is plus-plus or minus-minus or plus-minus.
There's a mixture.
With debit-credit system, we're going to find that every transaction can be
described in a way that reflects debits equaling credits.
Let's look closer at debit-credit rules.
First of all, the accounts assets, expenses, and
dividends have something in common.
They carry a debit balance, normally.
And debits increase those accounts and credits decrease those accounts.
It's the opposite effect when we consider liabilities, revenues, and
equity accounts.
They carry a credit balance, they're increased with credits and
decreased with debits.
Now to help you remember this, and
it is important that you memorize this and remember it.
It will make the rest of your study of accounting go much more smoothly.
It might be helpful initially to think about this acronym, DEAD.
Debits, the D, have a similar effect on expenses, assets, and dividends.
That is, these accounts are increased with debits and decreased with credits.
Now, let's think about analyzing transactions and events.
What we need to do is consider the source documents such as checks, invoices,
receipts, and so on.
And think about what accounts are being impacted by a transaction?
What is their effect on accounts?
Are those accounts being increased or decreased?
And then translating that to a debit-credit consequence.
Recognize that we need to have control systems in place to be sure that all
transactions and events are captured correctly.
Without that such as prenumbered documents, periodic reconciliations,
we might capture the transactions we think of but forget some.
So in addition to being able to effectively capture transactions,
we need to be sure we're capturing all transactions and
putting them into the accounting system.
All right, let's see how we're going to determine an account's balance.
This is returning to the earlier illustration,
except now you should notice that instead of saying increase and
decrease in these columns, I'm saying debit or credit.
In this case, we've got cash that has a beginning balance of $50,000.
The normal balance for an asset is debit.
And so, here we see $50,000 of cash presenting it to be a debit balance,
the normal balance.
On January 2nd, we collected a receivable, cash went up.
Hence, cash is being debited $10,000.
Cash, an asset, is increased with a debit.
The balance is now $60,000.
In the next transaction, we have a cash sale.
Cash again goes up another $5,000.
Hence a debit to cash of $5,000.
In the next transaction, we're paying rent.
Cash is going down, so
we need to credit cash, $7,000 to reduce it to the $58,000 balance.
All right, so that's how transactions are impacting this particular account,
the debit or credit effect.
What we'll see in the next module is how a journal entry is actually constructed so
that we see both sides of the equation.
For example, this collection of a receivable where we're
debiting cash to reflect the increase of cash.
We also need to be simultaneously recording the credit to another account,
in this case accounts receivable, to show the decrease
in the other asset account that's affected by the transaction.
So that will be the subject of the next module.