I n t hi s chapt er you wi l l cont i nue l ear ni ng about t he pr ocess of account i ng. You wi l l see how t he account i ng syst emmai nt ai ns t he equal i t y of t he account i ng equat i on.
The Accounting Equation
As di scussed i n Chapt er 1, r esour ces and wher e t hey come f r omar e at t he hear t of moder n f i nanci al account i ng syst ems. I n busi ness t er mi nol ogy, r esour ces ar e cal l ed asset s. Sour ces of bor r owed r esour ces ar e cal l ed l i abi l i t i es. Sour ces of r esour ces i nvest ed by owner s and gener at ed by management and r et ai ned i n t he company ar e cal l ed st ockhol der s' equi t y. The r el at i onshi p bet ween r esour ces and t hei r sour ces i s r epr esent ed by t he accounting equation:
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Remember , st ockhol der s' equi t y i ncl udes both t he dol l ar amount of r esour ces i nvest ed by owner s and t he dol l ar amount of r esour ces gener at ed t hr ough management oper at i ons and r et ai ned i n t he company because owner s have a r i ght t o t he amount of r esour ces t hey i nvest and t he amount of r esour ces gener at ed by management . The cor r ect use of t he account i ng equat i on guar ant ees mat hemat i cal l y l ogi cal f i nanci al st at ement s even i f event s ar e i ncor r ect l y anal yzed. That i s, as l ong as t he equal i t y of asset s t o l i abi l i t i es pl us st ockhol der s' equi t y i s mai nt ai ned, t he i ncome st at ement wi l l pr oper l y r el at e t o t he st at ement of r et ai ned ear ni ngs, t he st at ement of r et ai ned ear ni ngs wi l l pr oper l y r el at e t o t he bal ance sheet , and t he bal ance sheet wi l l bal ance. I f t he account i ng equat i on does not bal ance, t he bal ance sheet wi l l not bal ance. I f t he f i nanci al st at ement s ar e not mat hemat i cal l y l ogi cal , t hey cannot be r el i ed upon f or i nf or mat i on about a company' s r esour ces. Mat hemat i cal l y l ogi cal f i nanci al st at ement s do not aut omat i cal l y cont ai n usef ul i nf or mat i on, however . Mai nt ai ni ng t he equal i t y of t he account i ng equat i on i s necessar y f or usef ul f i nanci al st at ement s, but i t i s not t he onl y r equi r ement . Thi s chapt er and t he f ol l owi ng chapt er s wi l l exami ne t he r equi r ement s of account i ng syst ems t hat pr oduce usef ul i nf or mat i on.
** You now have t he backgr ound t o do exer ci se 2. 1.
Maintaining the Equality of the Accounting Equation
I n or der f or t he account i ng syst emt o pr ovi de usef ul i nf or mat i on, one i mpor t ant r equi r ement i s t hat t he account i ng equat i on must al ways bal ance. Thus, i t i s i mper at i ve we have a syst emt hat wi l l const ant l y mai nt ai n t he account i ng equat i on' s equal i t y. Remember t he syst emexami ned i n Chapt er 1. I n t hat syst emwe anal yzed event s of t he Par ks Comput er Ser vi ce Cor por at i on, det er mi ned t he ef f ect s of t he event s on speci f i c r esour ces, such as cash and suppl i es, and sour ces of r esour ces, such as account s payabl e and r et ai ned ear ni ngs. We used a pl us ( +) si gn t o show an i ncr ease i n an account or a mi nus ( - ) si gn t o show a decr ease. I n or der t o det er mi ne i f t he account i ng equat i on was i n bal ance we had t o t ake t he f ol l owi ng t wo st eps.
St ep 1: Fi r st we had t o det er mi ne t he bal ance i n each account . For exampl e, t o det er mi ne t he cash bal ance we had t o add al l of 2 Ch. 2: T Accounts, Debits, Credits t he pl us dol l ar amount s and subt r act al l of t he mi nus dol l ar amount s i n t he cash account . St ep 2: Once we det er mi ned t he bal ance i n each account , we had t o add al l t he asset account bal ances t o det er mi ne t he t ot al asset s dol l ar amount , and t hen add al l t he l i abi l i t i es and st ockhol der s' equi t y account bal ances t o det er mi ne t he t ot al l i abi l i t i es and st ockhol der s' equi t y dol l ar amount .
Af t er t aki ng t hese t wo st eps we coul d det er mi ne i f t ot al asset s equal ed t ot al l i abi l i t i es and st ockhol der s' equi t y. Unt i l we compl et ed both st eps, we coul d not be sur e t he account i ng equat i on was i n bal ance. What we need i s a mor e ef f i ci ent way t o make sur e t he account i ng equat i on i s al ways i n bal ance. We need a syst emt hat wi l l mai nt ai n t he bal ance of t he account i ng equat i on wi t hout r equi r i ng each account bal ance t o be det er mi ned and wi t hout r equi r i ng t ot al asset s and t ot al l i abi l i t i es and st ockhol der s' equi t y t o be cal cul at ed af t er each event . A mor e ef f i ci ent way of mai nt ai ni ng t he equal i t y of t he account i ng equat i on was devel oped hundr eds of year s ago and i s known as t he doubl e- ent r y syst em. I t was f i r st pr esent ed i n a book wr i t t en i n 1494 by a Fr anci scan monk, Fr a Luca Paci ol i . The doubl e- ent r y syst emwas devel oped i n r esponse t o t he mat hemat i cal pr obl em: how can i ndi vi dual i t ems i n t he account i ng equat i on change whi l e al ways mai nt ai ni ng t he asset s = l i abi l i t i es + st ockhol der s' equi t y equat i on? Today t he sol ut i on appear s t o be qui t e si mpl e. I f t he l ef t si de of t he equat i on ( asset s) i ncr eases, t hen t he r i ght si de ( l i abi l i t i es and st ockhol der s' equi t y) must al so i ncr ease by t he same dol l ar amount . Si mi l ar l y, i f t he l ef t si de of t he equat i on decr eases, t he r i ght si de must al so decr ease by t he same dol l ar amount . Fr om t hi s r easoni ng, t he f ol l owi ng si mpl e gui del i nes evol ved.
I f an asset i ncr eases, one of t he f ol l owi ng must occur : ( 1) anot her asset must decr ease by t he same amount . As a r esul t , t ot al asset s r emai n const ant and asset s = l i abi l i t i es + st ockhol der s' equi t y. For exampl e, i f suppl i es i ncr ease by $50 and cash decr eases by $50, t ot al asset s r emai n unchanged. The account i ng equat i on i s st i l l i n bal ance. ( 2) a l i abi l i t y must i ncr ease by t he same amount . As a r esul t , t ot al asset s and t ot al l i abi l i t i es i ncr ease by t he same amount and asset s = l i abi l i t i es + st ockhol der s' equi t y. For exampl e, i f suppl i es i ncr ease by $125 and account s payabl e i ncr ease by $125, t ot al asset s i ncr ease by $125 and t ot al l i abi l i t i es and st ockhol der s' equi t y i ncr ease by $125. The account i ng equat i on i s st i l l i n bal ance. ( 3) st ockhol der s' equi t y must i ncr ease by t he same amount . As a r esul t , t ot al asset s and t ot al st ockhol der s' equi t y i ncr ease by t he same amount and asset s = l i abi l i t i es + st ockhol der s' equi t y. For exampl e, i f cash i ncr eases by $1, 000 and common st ock i ncr eases by $1, 000, t ot al asset s i ncr ease by $1, 000 and t ot al l i abi l i t i es and st ockhol der s' equi t y i ncr ease by $1, 000. The account i ng equat i on i s st i l l i n bal ance.
Fr omt hi s basi c mat hemat i cal pr ocess, i t can be concl uded t hat each event af f ect i ng a busi ness has t wo par t s. One par t r esul t s i n a change i n one asset , l i abi l i t y, or st ockhol der s' equi t y account and t he ot her par t r esul t s i n an equal change i n anot her asset , l i abi l i t y, or st ockhol der s' equi t y account . I t i s Ch. 2: T Accounts, Debits, Credits 3 i mpossi bl e f or an event t o r esul t i n onl y an i ncr ease or decr ease i n one account , because t he r esul t woul d be an unbal anced account i ng equat i on. For exampl e, i f cash i ncr eased by $100 and ever yt hi ng el se r emai ned unchanged, asset s woul d no l onger equal l i abi l i t i es pl us st ockhol der s' equi t y. Asset s woul d be $100 l ar ger t han l i abi l i t i es pl us st ockhol der s' equi t y. Remember f r omChapt er 1, an unbal anced account i ng equat i on r esul t s i n unr el i abl e i nf or mat i on.
The T Account
The basi c el ement of t he doubl e- ent r y syst emi s t he T account . T account s ar e used t o r ecor d each event ' s t wo par t s di scussed i n t he pr evi ous par agr aphs. As you can see f r omt he i l l ust r at i on bel ow, i t i s f ai r l y obvi ous wher e t he name T account came f r om: t he account st r ongl y r esembl es t he l et t er T. The l ef t si de of a T account i s cal l ed t he debi t si de ( f r omt he Lat i n debere) and t he r i ght si de i s t he cr edi t si de ( f r omt he Lat i n credere) . Remember , t hi s syst emand i t s t er mi nol ogy have been i n exi st ence f or hundr eds of year s!
Account Name Debi t ( Lef t si de) Cr edi t ( Ri ght si de)
The doubl e- ent r y syst emmakes use of t he T account t o make sur e bot h par t s of each event ar e account ed f or . Remember , when bot h par t s of each event ar e account ed f or , t he account i ng equat i on must bal ance, as t he f ol l owi ng sect i on i l l ust r at es.
Using T Accounts
To see how t he doubl e- ent r y syst emmakes use of T account s, l et us agai n consi der t he J ul y event s of t he Par ks Comput er Ser vi ce Cor por at i on di scussed i n Chapt er 1. We wi l l see how t he doubl e- ent r y syst emguar ant ees t he account i ng equat i on i s al ways i n bal ance.
Get t i ng r esour ces f r omt he owner On J ul y 1, Ni ck Par ks i nvest s $5, 000 cash i n hi s new company, Par ks Comput er Ser vi ce Cor por at i on. Ni ck i nvest s hi s cash by openi ng a checki ng account i n t he company' s name at t he Somer vi l l e Nat i onal Bank. As you r emember f r omChapt er 1, an owner ' s $5, 000 cash i nvest ment i n a company r esul t s i n a $5, 000 i ncr ease i n t he company' s r esour ces and a $5, 000 i ncr ease i n i t s sour ces of r esour ces. The r esour ce t hat i ncr eases i s cash. Si nce t he r esour ce comes f r omt he owner , t he sour ce of r esour ces t hat i ncr eases i s st ockhol der s' equi t y, i n t hi s case common st ock.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y + $5, 000 = + $5, 000
The company' s cash and common st ock bot h i ncr ease by $5, 000. Thi s event wi l l have t he f ol l owi ng ef f ect s on t he company' s T account s. 4 Ch. 2: T Accounts, Debits, Credits
Asset s
=
Li abi l i t i es
+ St ockhol der s' Equi t y Event Cash = Common St ock Owner ' s cash i nvest ment
Not i ce t he $5, 000 i ncr ease i n cash was ent er ed on t he l ef t , or debi t , si de of t he cash T account . I n ot her wor ds, t he $5, 000 was ent er ed as a debi t t o cash. Si nce t hi s i s t he f i r st event we anal yzed, we coul d have ent er ed i t as ei t her a debi t or a cr edi t . Si nce we ent er ed i t as a debi t , we have devel oped an account i ng r ul e: assets increase through debits. Not i ce, however , t he i ncr ease i n common st ock was ent er ed as a cr edi t ( r i ght si de) t o t he common st ock account . We have j ust devel oped anot her account i ng r ul e: stockholders' equity increases through credits. The t wo r ul es we devel oped agr ee wi t h t he account i ng pr ocess used i n moder n f i nanci al account i ng syst ems. Why di d we ent er t he i ncr ease i n asset s as a debi t and t he i ncr ease i n st ockhol der s' equi t y as a cr edi t ? Remember what we ar e t r yi ng t o do. We ar e t r yi ng t o devel op a syst emt hat wi l l const ant l y mai nt ai n t he equal i t y of t he account i ng equat i on af t er each event . Does ent er i ng equal dol l ar amount s of debi t s and cr edi t s keep t he account i ng equat i on i n bal ance? Consi der t hi s f i r st event of t he Par ks Comput er Ser vi ce Cor por at i on. Cash was debi t ed f or $5, 000 and common st ock was cr edi t ed f or $5, 000. Cl ear l y, debi t s equal ed cr edi t s: debi t s wer e $5, 000 and cr edi t s wer e $5, 000. Di d asset s = l i abi l i t i es + st ockhol der s' equi t y? Af t er t he event , asset s ( cash) wer e $5, 000 and l i abi l i t i es + st ockhol der s' equi t y ( common st ock) wer e $5, 000. Thus, usi ng t he doubl e- ent r y met hod of r ecor di ng equal dol l ar amount s of debi t s and cr edi t s enabl ed us t o easi l y mai nt ai n t he equal i t y of t he account i ng equat i on!
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Assets increase through debits. Stockholders equity increases through credits.
Usi ng r esour ces t o buy ot her r esour ces On J ul y 3, t he company pays $25 cash f or suppl i es t o be used t o r epai r and ser vi ce comput er s. Thi s event bot h i ncr eases t he company' s r esour ces when t he suppl i es ar e bought and decr eases i t s r esour ces when t he cash i s pai d. The suppl i es r esour ce i ncr eases and t he cash r esour ce decr eases. Si nce t ot al r esour ces do not change, t ot al sour ces of r esour ces do not change.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 000 = $5, 000 + $25 - $25 $5, 000 = $5, 000
The company' s suppl i es account i ncr eases by $25 whi l e i t s cash account decr eases by $25. These ef f ect s woul d be shown i n t he company' s T account s as f ol l ows. Ch. 2: T Accounts, Debits, Credits 5
Asset s
=
Li abi l i t i es
+ St ockhol der s' Equi t y Event Cash + Suppl i es = Common St ock Owner ' s cash i nvest ment
Not i ce t he $25 i ncr ease i n suppl i es was r ecor ded as a debi t ( l ef t si de) t o t he suppl i es account . Thi s agr ees wi t h t he r ul e we devel oped ear l i er , t hat asset s i ncr ease wi t h debi t s. But what about t he decr ease i n cash? I f asset s i ncr ease wi t h debi t s, shoul d t hey decr ease wi t h cr edi t s? Thi s seems l ogi cal and i t i s t he r eason t he cash account was cr edi t ed ( r i ght si de) f or $25 above. We have j ust devel oped anot her account i ng r ul e: assets decrease through credits. Af t er we ent er ed debi t s and cr edi t s of $25 each, does our account i ng equat i on st i l l bal ance? Af t er t he suppl i es pur chase, t he company has asset s of $5, 000 ( cash of $4, 975 and suppl i es of $25) and l i abi l i t i es and st ockhol der s' equi t y of $5, 000 ( common st ock) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on. Not i ce al so i n t he above cash account , t he $4, 975 debi t bal ance r esul t ed f r omsubt r act i ng t he $25 cr edi t f r omt he $5, 000 debi t . The $4, 975 bal ance i s shown as a debi t because t he debi t dol l ar amount s t ot al ( $5, 000) was gr eat er t han t he t ot al cr edi t dol l ar amount s ( $25) . I f t he cr edi t dol l ar amount s t ot al had been l ar ger t han t he t ot al debi t dol l ar amount s, t he bal ance woul d have been shown as a cr edi t bal ance.
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Assets decrease through credits. St ockhol der s equi t y i ncr eases t hr ough cr edi t s.
Bor r owi ng r esour ces On J ul y 7, t he company buys addi t i onal suppl i es of $135. The company does not i mmedi at el y pay cash f or t he suppl i es, but agr ees t o pay cash wi t hi n t he next 30 days. When t he Par ks Comput er Ser vi ce Cor por at i on buys t he suppl i es by agr eei ng t o pay f or t heml at er , i t s r esour ces and sour ces of r esour ces bot h i ncr ease by $135. The suppl i es r esour ce i ncr eases. Si nce t he suppl i es ar e not pai d f or i mmedi at el y, t he sour ce of r esour ces t hat i ncr eases i s l i abi l i t i es, i n t hi s case account s payabl e. Remember , si nce t he company does not pay f or t he suppl i es i mmedi at el y, i n ef f ect t hey ar e bor r owed.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 000 = $5, 000 + $135 = + $135 $5, 135 = $135 + $5, 000
As t he company buys suppl i es, i t s asset s i ncr ease. Asset s i ncr ease wi t h debi t s, so t he suppl i es T account shoul d show a $135 debi t . Because t he suppl i es must be pai d f or i n t he f ut ur e, t he l i abi l i t y account s payabl e shoul d al so be i ncr eased. Usi ng t he debi t s equal cr edi t s r ul e and r emember i ng we have al r eady debi t ed suppl i es f or $135, t he account s payabl e T account shoul d show a $135 cr edi t , 6 Ch. 2: T Accounts, Debits, Credits whi ch r epr esent s an increase i n t he account . We have j ust devel oped anot her account i ng r ul e: liabilities increase through credits. The r esul t of t hi s t r ansact i on can be seen as f ol l ows.
Af t er we ent er ed debi t s and cr edi t s of $135 each, does our account i ng equat i on st i l l bal ance? Af t er t he suppl i es pur chase, t he company has asset s of $5, 135 ( cash of $4, 975 and suppl i es of $160) and l i abi l i t i es and st ockhol der s' equi t y of $5, 135 ( account s payabl e of $135 and common st ock of $5, 000) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on.
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Liabilities increase through credits. St ockhol der s equi t y i ncr eases t hr ough cr edi t s.
Gener at i ng r esour ces t hr ough management oper at i ons On J ul y 10, Ni ck advi ses a cust omer on t he cust omer ' s needs f or a comput er syst em. I n r et ur n f or t hi s ser vi ce, t he Par ks Comput er Ser vi ce Cor por at i on r ecei ves $200 cash. The act of pr ovi di ng ser vi ce t o a cust omer and r ecei vi ng cash i ncr eases t he company' s r esour ces and sour ces of r esour ces by $200. The cash r esour ce i ncr eases. Si nce t he cash came f r omt he ef f or t s of management , t he sour ce of r esour ces t hat i ncr eases i s st ockhol der s' equi t y, i n t hi s case r et ai ned ear ni ngs. Remember , owner s have r i ght s t o r esour ces gener at ed by management and owner s' r i ght s ar e shown i n st ockhol der s' equi t y.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 135 = $135 + $5, 000 + $200 = + $200 $5, 335 = $135 + $5, 000 + $200
When t he company r ecei ves t he cash, i t s asset s ( cash) i ncr ease and i t s st ockhol der s' equi t y i ncr eases t hr ough r et ai ned ear ni ngs. Si nce asset s i ncr ease wi t h debi t s, t he cash account shoul d now show a debi t of $200. Because st ockhol der s' equi t y i ncr eases wi t h cr edi t s, t he r et ai ned ear ni ngs account shoul d show a cr edi t of $200. These ef f ect s can be seen bel ow. Ch. 2: T Accounts, Debits, Credits 7
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
Once we ent er ed debi t s and cr edi t s of $200 each, our account i ng equat i on st i l l bal ances. Af t er pr ovi di ng t he ser vi ce, t he company has asset s of $5, 335 ( cash of $5, 175 and suppl i es of $160) and l i abi l i t i es and st ockhol der s' equi t y of $5, 335 ( account s payabl e of $135, common st ock of $5, 000, and r et ai ned ear ni ngs of $200) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on. I n busi ness t er mi nol ogy, when asset s ( r esour ces) i ncr ease t hr ough t he pr ocess of pr ovi di ng ser vi ces t o cust omer s, t he i ncr ease i n r et ai ned ear ni ngs i s cal l ed a revenue. The $200 i ncr ease i n r et ai ned ear ni ngs f r ompr ovi di ng ser vi ce t o a cust omer woul d be cal l ed Fees Revenue. As r evenues get l ar ger , par t of t he ef f ect i s t o i ncr ease r et ai ned ear ni ngs: an i ncr ease i n r evenues i s an i ncr ease i n r et ai ned ear ni ngs. Remember , r evenues i ncr ease r et ai ned ear ni ngs because owner s have a r i ght t o t he addi t i onal r esour ces gener at ed by management pr ovi di ng ser vi ces t o cust omer s. I n debi t and cr edi t t er ms, how shoul d we r ecor d an i ncr ease i n a r evenue? Si nce r evenues i ncr ease r et ai ned ear ni ngs and r et ai ned ear ni ngs i ncr eases wi t h cr edi t s, we shoul d r ecor d i ncr eases i n r evenues as cr edi t s. So now we have devel oped anot her r ul e: revenues increase through credits.
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Li abi l i t i es i ncr ease t hr ough cr edi t s. St ockhol der s equi t y i ncr eases t hr ough cr edi t s. Revenues increase through credits.
Payi ng f or bor r owed r esour ces On J ul y 16, t he company pays $70 of t he $135 owed f or suppl i es pur chased on J ul y 7. The r emai ni ng $65 wi l l be pai d i n August . Thi s cash payment of an amount owed t o a suppl i er r educes t he company' s r esour ces and i t s sour ces of r esour ces by $70. The cash r esour ce decr eases. The sour ce of r esour ces t hat decr eases i s l i abi l i t i es, i n t hi s case account s payabl e. By payi ng $70 t o t he suppl i er , t he amount owed t o t he suppl i er ( account s payabl e) decr eases by $70. 8 Ch. 2: T Accounts, Debits, Credits
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 335 = $135 + $5, 000 + $200 - $70 = - $70 $5, 265 = $65 + $5, 000 + $200
The company' s payment of $70 f or suppl i es pur chased ear l i er i n t he mont h r educes t he asset cash and r educes t he l i abi l i t y account s payabl e. Asset s i ncr ease wi t h debi t s and decr ease wi t h cr edi t s. Thus, t he $70 cash r educt i on shoul d appear as a cr edi t . Once we cr edi t cash, we need a debi t . As a r esul t , we woul d show t he r educt i on of account s payabl e as a $70 debi t . So now we have devel oped anot her r ul e: liabilities decrease through debits.
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
Once we ent er ed debi t s and cr edi t s of $70 each, our account i ng equat i on st i l l bal ances. Af t er payi ng par t of i t s l i abi l i t y, t he company has asset s of $5, 265 ( cash of $5, 105 and suppl i es of $160) and l i abi l i t i es and st ockhol der s' equi t y of $5, 265 ( account s payabl e of $65, common st ock of $5, 000, and r et ai ned ear ni ngs of $200) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we const ant l y mai nt ai n t he equal i t y of t he account i ng equat i on.
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Li abi l i t i es i ncr ease t hr ough cr edi t s. Liabilities decrease through debits. St ockhol der s equi t y i ncr eases t hr ough cr edi t s. Revenues i ncr ease t hr ough cr edi t s.
Gener at i ng r esour ces t hr ough management oper at i ons On J ul y 20, Ni ck assi st s i n t he desi gn of a comput er syst emf or anot her cust omer . I n r et ur n f or t hi s ser vi ce, t he Par ks Comput er Ser vi ce Cor por at i on does not r ecei ve cash, but t he cust omer agr ees t o pay $250 by August 19. The act of per f or mi ng a ser vi ce f or a cust omer and r ecei vi ng a pr omi se of cash i ncr eases t he company' s r esour ces and sour ces of r esour ces by $250. The r esour ce t hat i ncr eases i s account s Ch. 2: T Accounts, Debits, Credits 9 r ecei vabl e. Once agai n, si nce t he r esour ce comes f r omt he ef f or t s of management , t he sour ce of r esour ces t hat i ncr eases i s st ockhol der s' equi t y ( r et ai ned ear ni ngs) .
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 265 = $65 + $5, 000 + $200 + $250 = + $250 $5, 515 = $65 + $5, 000 + $450
The company' s asset account s r ecei vabl e i ncr eases by $250 and i t s st ockhol der s' equi t y account r et ai ned ear ni ngs i ncr eases by $250. Asset s i ncr ease wi t h debi t s whi l e st ockhol der s' equi t y i ncr eases wi t h cr edi t s. The ef f ect s of t hi s event on t he company' s T account s can be seen bel ow.
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
Af t er we ent er ed debi t s and cr edi t s of $250 each, our account i ng equat i on st i l l bal ances. The company now has asset s of $5, 515 ( cash of $5, 105, account s r ecei vabl e of $250, and suppl i es of $160) and l i abi l i t i es and st ockhol der s' equi t y of $5, 515 ( account s payabl e of $65, common st ock of $5, 000, and r et ai ned ear ni ngs of $450) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on. Remember , when asset s ( r esour ces) i ncr ease t hr ough t he pr ocess of pr ovi di ng ser vi ces t o cust omer s, t he i ncr ease i n r et ai ned ear ni ngs i s cal l ed a r evenue. The $250 i ncr ease i n r et ai ned ear ni ngs f or pr ovi di ng ser vi ce t o a cust omer woul d be cal l ed Fees Revenue, j ust l i ke t he J ul y 10t h event i n whi ch $200 cash was r ecei ved f or ser vi ce t o a cust omer .
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Li abi l i t i es i ncr ease t hr ough cr edi t s. Li abi l i t i es decr ease t hr ough debi t s. 10 Ch. 2: T Accounts, Debits, Credits St ockhol der s equi t y i ncr eases t hr ough cr edi t s. Revenues i ncr ease t hr ough cr edi t s.
Conver t i ng one r esour ce i nt o anot her On J ul y 25, cash of $100 i s r ecei ved f r om t he cust omer ser vi ced on J ul y 20. No addi t i onal wor k i s done f or t he cl i ent on J ul y 25. Thi s event r esul t s i n bot h an i ncr ease i n t he company' s r esour ces when t he cash i s r ecei ved and a decr ease i n t he company' s r esour ces when account s r ecei vabl e ar e r educed. Remember , t he cl i ent owes t he company $100 l ess af t er t he cl i ent pays t he $100 t o t he company. The cash r esour ce i ncr eases and t he account s r ecei vabl e r esour ce decr eases. Si nce t ot al r esour ces do not change, t ot al sour ces of r esour ces do not change.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 515 = $65 + $5, 000 + $450 + $100 - $100 $5, 515 = $65 + $5, 000 + $450
The r ecei pt of $100 cash f r omt he cl i ent i ncr eases t he company' s asset cash and decr eases t he asset account s r ecei vabl e. Because asset s i ncr ease wi t h debi t s and decr ease wi t h cr edi t s, t he cash T account shoul d be debi t ed f or $100 and t he account s r ecei vabl e T account shoul d be cr edi t ed f or $100, as r ef l ect ed bel ow.
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
Af t er we ent er ed debi t s and cr edi t s of $100 each, our account i ng equat i on st i l l bal ances. The company st i l l has asset s of $5, 515 ( cash of $5, 205, account s r ecei vabl e of $150, and suppl i es of $160) and l i abi l i t i es and st ockhol der s' equi t y of $5, 515 ( account s payabl e of $65, common st ock of $5, 000, and r et ai ned ear ni ngs of $450) . Thus, once agai n, i f we r ecor d each event i n such a way t hat Ch. 2: T Accounts, Debits, Credits 11 t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on.
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Li abi l i t i es i ncr ease t hr ough cr edi t s. Li abi l i t i es decr ease t hr ough debi t s. St ockhol der s equi t y i ncr eases t hr ough cr edi t s. Revenues i ncr ease t hr ough cr edi t s.
Usi ng up r esour ces i n management oper at i ons On J ul y 30, Ni ck exami nes hi s suppl i es and det er mi nes t hat of t he $160 suppl i es pur chased, onl y $110 ar e st i l l l ef t . I n ot her wor ds, management used $50 of suppl i es i n pr ovi di ng ser vi ces t o cust omer s i n J ul y. As a company' s suppl i es ar e used up, i t s r esour ces and sour ces of r esour ces bot h decr ease by $50. The suppl i es r esour ce decr eases. Si nce t he suppl i es wer e used up by management , t he sour ce of r esour ces t hat decr eases i s st ockhol der s' equi t y, i n t hi s case r et ai ned ear ni ngs. Remember , owner s have r i ght s t o r esour ces gener at ed by management , but owner s ar e al so r esponsi bl e f or r esour ces used up by management . Owner s' r i ght s ar e shown i n st ockhol der s' equi t y.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 515 = $65 + $5, 000 + $450 - $50 = - $50 $5, 465 = $65 + $5, 000 + $400
As t he company uses up i t s suppl i es, i t s asset suppl i es account decr eases and i t s st ockhol der s' equi t y r et ai ned ear ni ngs account decr eases. Asset s i ncr ease wi t h debi t s and decr ease wi t h cr edi t s. Thus, t he $50 suppl i es decr ease shoul d appear as a cr edi t . Once we cr edi t suppl i es, we need a debi t . As a r esul t , we woul d show t he r et ai ned ear ni ngs r educt i on as a $50 debi t .
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
5, 000
5, 000
Suppl i es pur chased f or cash
25
25
Suppl i es pur chased on account
135 135
Ser vi ce pr ovi ded t o cust omer
200
200 Cash payment on account
70
70
Ser vi ce pr ovi ded t o cust omer
250
250
12 Ch. 2: T Accounts, Debits, Credits
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Cash col l ect ed f r om cust omer
Af t er we ent er ed debi t s and cr edi t s of $50 each, our account i ng equat i on st i l l bal ances. The company now has asset s of $5, 465 ( cash of $5, 205, account s r ecei vabl e of $150, and suppl i es of $110) and l i abi l i t i es and st ockhol der s' equi t y of $5, 465 ( account s payabl e of $65, common st ock of $5, 000, and r et ai ned ear ni ngs of $400) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on. I n busi ness t er mi nol ogy, when asset s ( r esour ces) ar e used up i n t he pr ocess of pr ovi di ng ser vi ces t o cust omer s, t he decr ease i n r et ai ned ear ni ngs i s cal l ed an expense. The $50 decr ease i n r et ai ned ear ni ngs f or suppl i es used woul d be cal l ed Supplies Expense. As expenses get l ar ger , par t of t he ef f ect i s t o r educe r et ai ned ear ni ngs: an i ncr ease i n expenses i s a decr ease i n r et ai ned ear ni ngs. I n debi t and cr edi t t er ms, how shoul d we r ecor d an i ncr ease i n an expense? Si nce i ncr eases i n expenses decr ease r et ai ned ear ni ngs, and r et ai ned ear ni ngs decr eases wi t h debi t s, we shoul d r ecor d i ncr eases i n expenses as debi t s. So now we have devel oped anot her r ul e: expenses increase through debits. Be car ef ul wi t h t hi s r ul e. I t i s somet i mes a di f f i cul t one f or st udent s t o accept .
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Li abi l i t i es i ncr ease t hr ough cr edi t s. Li abi l i t i es decr ease t hr ough debi t s. St ockhol der s equi t y i ncr eases t hr ough cr edi t s. Revenues i ncr ease t hr ough cr edi t s. Expenses increase through debits.
Di st r i but i ng r esour ces t o t he owner On J ul y 31, t he company pays a $75 cash di vi dend t o i t s owner . Thi s event r esul t s i n a decr ease i n t he company' s r esour ces and i t s sour ces of r esour ces. Cash r esour ces decr ease. Si nce t he owner r ecei ves t he cash, t he sour ce of r esour ces t hat decr eases i s st ockhol der s' equi t y, i n t hi s case r et ai ned ear ni ngs. The cash r ecei ved by t he owner r educes t he owner ' s r i ght s t o t he company s r esour ces because t he owner has t aken some r esour ces out of t he company. Si nce owner s' r i ght s ar e shown i n st ockhol der s' equi t y, st ockhol der s' equi t y decr eases.
Tot al Resour ces
= Sour ces of Bor r owed Resour ces
+ Sour ces of Owner I nvest ed Resour ces
+ Sour ces of Management Gener at ed Resour ces Asset s = Li abi l i t i es + St ockhol der s' Equi t y $5, 465 = $65 + $5, 000 + $400 - $75 = - $75 $5, 390 = $65 + $5, 000 + $325
Ch. 2: T Accounts, Debits, Credits 13 As t he company' s $75 cash goes t o t he owner , t he company' s asset cash account decr eases and i t s st ockhol der s' equi t y r et ai ned ear ni ngs account decr eases. Asset s i ncr ease wi t h debi t s and decr ease wi t h cr edi t s. Thus, t he $75 cash decr ease shoul d appear as a cr edi t . Once we cr edi t cash, we need a debi t . As a r esul t , we woul d show t he r et ai ned ear ni ngs r educt i on as a $75 debi t .
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
Af t er we ent er ed debi t s and cr edi t s of $75 each, our account i ng equat i on st i l l bal ances. The company now has asset s of $5, 390 ( cash of $5, 130, account s r ecei vabl e of $150, and suppl i es of $110) and l i abi l i t i es and st ockhol der s' equi t y of $5, 390 ( account s payabl e of $65, common st ock of $5, 000, and r et ai ned ear ni ngs of $325) . Thus, once agai n, i f we r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, we easi l y mai nt ai n t he equal i t y of t he account i ng equat i on. I n busi ness t er mi nol ogy, when asset s ( r esour ces) t hat wer e gener at ed t hr ough management oper at i ons ar e di st r i but ed t o owner s, t he decr ease i n r et ai ned ear ni ngs i s cal l ed a dividend. A di vi dend i s not a r et ur n t o owner s of some of t he r esour ces i nvest ed by t hem. As di vi dends get l ar ger , par t of t he ef f ect i s t o r educe r et ai ned ear ni ngs: an i ncr ease i n di vi dends i s a decr ease i n r et ai ned ear ni ngs. I n debi t and cr edi t t er ms, how shoul d we r ecor d an i ncr ease i n a di vi dend? Si nce i ncr eases i n di vi dends decr ease r et ai ned ear ni ngs, and r et ai ned ear ni ngs decr eases wi t h debi t s, we shoul d r ecor d i ncr eases i n di vi dends as debi t s. So now we have devel oped anot her r ul e: dividends increase through debits. Be car ef ul wi t h t hi s r ul e, al so. I t i s somet i mes a di f f i cul t one f or st udent s t o accept .
So f ar , t he f ol l owi ng debi t and cr edi t r ul es have been devel oped. Asset s i ncr ease t hr ough debi t s. Asset s decr ease t hr ough cr edi t s. Li abi l i t i es i ncr ease t hr ough cr edi t s. 14 Ch. 2: T Accounts, Debits, Credits Li abi l i t i es decr ease t hr ough debi t s. St ockhol der s equi t y i ncr eases t hr ough cr edi t s. Revenues i ncr ease t hr ough cr edi t s. Expenses i ncr ease t hr ough debi t s. Dividends increase through debits.
** You now have t he backgr ound t o do exer ci ses 2. 2, 2. 3, 2. 4, and 2. 5.
Debits and Credits Summarized
As i l l ust r at ed i n Chapt er 1, f i nanci al st at ement s ar e pr epar ed t o pr ovi de answer s t o speci f i c quest i ons about company r esour ces. Mat hemat i cal l y l ogi cal f i nanci al st at ement s can be pr epar ed onl y i f t he account i ng equat i on, asset s equal l i abi l i t i es pl us st ockhol der s' equi t y, i s const ant l y i n bal ance. As shown i n t he pr evi ous sect i on of t hi s chapt er , t he pr ocess of conver t i ng each event i nt o equal dol l ar amount s of debi t s and cr edi t s guar ant ees t he account i ng equat i on al ways bal ances. Thus, mat hemat i cal l y l ogi cal f i nanci al st at ement s can be gener at ed f r omaccount i ng syst ems t hat mai nt ai n t he dol l ar equal i t y of debi t s and cr edi t s f or each event . The debi t equal s cr edi t pr ocess conver t s each event i nt o debi t s and cr edi t s as f ol l ows:
Account Debits Credits Asset s I ncr eases Decr eases Li abi l i t i es Decr eases I ncr eases St ockhol der s' equi t y Decr eases I ncr eases Revenues Decr eases I ncr eases Expenses I ncr eases Decr eases Di vi dends I ncr eases Decr eases
Al t hough t he above t abl e mi ght appear t o r equi r e a l ot of memor i zat i on, i n r eal i t y, i t i s act ual l y qui t e si mpl e. I n account i ng f or t he vast maj or i t y of busi ness event s, al l you need t o r emember ar e t he f ol l owi ng:
Poi nt 1. Asset s i ncr ease wi t h debi t s Poi nt 2. Debi t s = cr edi t s
These t wo poi nt s can be easi l y appl i ed. Consi der agai n t he J ul y 1 event i n whi ch t he Par ks Comput er Ser vi ce Cor por at i on r ecei ves $5, 000 f r omi t s owner i n r et ur n f or common st ock. Si nce t he company r ecei ves $5, 000 i n cash, you know t he asset cash shoul d i ncr ease by $5, 000. I f you r emember Poi nt 1, asset account s i ncr ease wi t h debi t s, you know you must debi t t he cash account f or $5, 000. Remember i ng al so Poi nt 2, debi t s must equal cr edi t s, you know you must now cr edi t some account f or $5, 000. Logi cal l y, your $5, 000 cr edi t shoul d be t o t he common st ock account si nce t he owner r ecei ved common st ock i n r et ur n f or hi s i nvest ment i n t he company. As a r esul t of memor i zi ng t he t wo si mpl e poi nt s above ( asset s i ncr ease wi t h debi t s and debi t s = cr edi t s) , you shoul d be abl e t o conver t most busi ness event s i nt o debi t s and cr edi t s, i f you can under st and t he event s. As you get mor e pr act i ce i n anal yzi ng event s, t he debi t and cr edi t pr ocess wi l l become easi er . I n f act , as you get mor e pr act i ce you wi l l see i t i s not t he debi t and cr edi t pr ocess t hat i s di f f i cul t . I t i s under st andi ng busi ness event s t hat i s t he most di f f i cul t par t of account i ng. I t i s ext r emel y di f f i cul t t o cor r ect l y account f or an event i f you do not under st and how t he event af f ect s t he company.
Information from Financial Statements
Remember , t he pur pose of t he debi t and cr edi t pr ocess i s t o mai nt ai n t he equal i t y of t he account i ng equat i on. I f a company s event s have been cor r ect l y Ch. 2: T Accounts, Debits, Credits 15 under st ood and t he account i ng equat i on i s i n bal ance, t he r esul t i ng f i nanci al st at ement s can be used t o answer speci f i c quest i ons about t he company' s r esour ces. The f ol l owi ng f i nanci al st at ement s r esul t f r omt he Par ks Comput er Ser vi ce Cor por at i on' s account i ng syst em.
Income Statement
The i ncome st at ement pr ovi des i nf or mat i on about what a company' s management di d wi t h i t s r esour ces. The i ncome st at ement r epor t s t he dol l ar amount of r esour ces gener at ed t hr ough management oper at i ons. The i ncome st at ement f or t he J ul y oper at i ons of t he Par ks Comput er Ser vi ce Cor por at i on appear s as f ol l ows.
Par ks Comput er Ser vi ce Cor por at i on I ncome St at ement f or t he Mont h Ended J ul y 31
Fees Revenue $450 Suppl i es Expense $50 Net I ncome $400
Fr omt he Par ks Comput er Ser vi ce Cor por at i on' s i ncome st at ement we can see t he company' s management used t he company' s r esour ces i n J ul y t o gener at ed $400 of addi t i onal r esour ces. The i ncome st at ement shows management br ought i n r esour ces of $450 ( f ees r evenue) and used $50 of r esour ces ( suppl i es expense) .
** You now have t he backgr ound t o do exer ci se 2. 6.
Statement of Retained Earnings
The st at ement of r et ai ned ear ni ngs pr ovi des i nf or mat i on about what a company di d wi t h t he r esour ces management gener at ed t hr ough oper at i ng t he company. The Par ks Comput er Ser vi ce Cor por at i on' s J ul y st at ement of r et ai ned ear ni ngs appear s as f ol l ows.
Par ks Comput er Ser vi ce Cor por at i on St at ement of Ret ai ned Ear ni ngs f or t he Mont h Ended J ul y 31
Ret ai ned Ear ni ngs, J ul y 1 $0 Pl us: Net I ncome f or J ul y $400 Subt ot al $400 Less: Di vi dends $75 Ret ai ned Ear ni ngs, J ul y 31 $325
Fr omt he Par ks Comput er Ser vi ce Cor por at i on' s st at ement of r et ai ned ear ni ngs we can see t hat of t he $400 of r esour ces gener at ed t hr ough management oper at i ons i n J ul y ( net i ncome) , $75 wer e di st r i but ed t o t he owner ( di vi dends) . I n ot her wor ds, t he company r et ai ned f or f ut ur e use $325 of t he r esour ces gener at ed t hr ough management oper at i ons.
** You now have t he backgr ound t o do exer ci se 2. 7.
Balance Sheet
The bal ance sheet pr ovi des i nf or mat i on about what a company' s r esour ces ar e and wher e t hey came f r om. The Par ks Comput er Ser vi ce Cor por at i on' s J ul y 31 bal ance sheet appear s as f ol l ows.
16 Ch. 2: T Accounts, Debits, Credits Par ks Comput er Ser vi ce Cor por at i on Bal ance Sheet J ul y 31
Asset s Li abi l i t i es & St ockhol der s' Equi t y Cash $5, 130 Li abi l i t i es Account s Recei vabl e $150 Account s Payabl e $65 Suppl i es $110 Tot al Asset s $5, 390 St ockhol der s' Equi t y Common St ock $5, 000 Ret ai ned Ear ni ngs $325 Tot al St ockhol der s' Equi t y $5, 325 Tot al Li abi l i t i es & St ockhol der s' Equi t y $5, 390
The company' s bal ance sheet shows on J ul y 31 t he company had r esour ces ( asset s) of $5, 390. $65 of t he asset s wer e bor r owed ( l i abi l i t i es) . $5, 000 of t he asset s wer e i nvest ed by t he owner ( common st ock) . $325 of asset s wer e gener at ed t hr ough nagement oper at i ons and r et ai ned i n t he company ( r et ai ned ear ni ngs) . ma
Unequal Debits and Credits: Revisited
I t i s i mper at i ve you under st and why account i ng syst ems make use of t he debi t s equal s cr edi t s r ul e. As emphasi zed sever al t i mes i n t hi s chapt er , i f each event af f ect i ng a company i s account ed f or i n such a manner t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, t he account i ng equat i on must al ways be i n bal ance. A bal anced account i ng equat i on l eads t o mat hemat i cal l y l ogi cal f i nanci al st at ement s. Mat hemat i cal l y l ogi cal f i nanci al st at ement s r esul t i ng f r omt he cor r ect under st andi ng of busi ness event s pr ovi de i nf or mat i on usef ul t o answer quest i ons about t he company' s r esour ces. Thus, t he usef ul ness of t he i nf or mat i on pr ovi ded i n f i nanci al st at ement s depends upon t he debi t s equal s cr edi t s r ul e and t he cor r ect under st andi ng of busi ness event s. Consi der what woul d happen t o t he i nf or mat i on pr ovi ded i n f i nanci al st at ement s i f t he debi t s equal s cr edi t s r ul e was not f ol l owed i n t he J ul y 20 event of t he Par ks Comput er Ser vi ce Cor por at i on. Remember , on J ul y 20 management per f or med ser vi ces f or a cust omer who agr eed t o pay $250 by August 19. When we account ed f or t hi s event cor r ect l y i t r esul t ed i n a $250 debi t t o account s r ecei vabl e and a $250 cr edi t t o r et ai ned ear ni ngs ( Fees Revenue) . Suppose, however , we incorrectly r ecor ded i t as a $250 debi t t o account s r ecei vabl e and a $25 cr edi t t o r et ai ned ear ni ngs, as shown i n t he f ol l owi ng T account s.
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Owner ' s cash i nvest ment
5, 000
5, 000
Suppl i es pur chased f or cash
25
25
Suppl i es pur chased on account
135 135
Ser vi ce pr ovi ded t o cust omer
200
200 Cash payment on account
70
70
Ch. 2: T Accounts, Debits, Credits 17 Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Event
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs Ser vi ce pr ovi ded t o cust omer
Af t er we ent er t he debi t of $250 and t he cr edi t of onl y $25, our account i ng equat i on does not bal ance. At t he end of J ul y, t he company' s T account s show asset s of $5, 390 ( cash of $5, 130, account s r ecei vabl e of $150, and suppl i es of $110) and l i abi l i t i es and st ockhol der s' equi t y of $5, 165 ( account s payabl e of $65, common st ock of $5, 000, and r et ai ned ear ni ngs of $100) . Cl ear l y, asset s of $5, 390 do not equal l i abi l i t i es and st ockhol der s' equi t y of $5, 165! You shoul d concl ude f r omt hi s t hat i f you do not r ecor d each event i n such a way t hat t he t ot al dol l ar amount of debi t s equal s t he t ot al dol l ar amount of cr edi t s, you wi l l not mai nt ai n t he equal i t y of t he account i ng equat i on. Addi t i onal l y, i f asset s do not equal l i abi l i t i es and st ockhol der s' equi t y, of what val ue i s t he i nf or mat i on pr ovi ded i n t he f i nanci al st at ement s? I f t he bal ance sheet r epor t s mor e r esour ces ( asset s) t han t he dol l ar amount s t hat came f r ombor r owi ng, f r omst ockhol der s, or t hr ough management oper at i ons, f r omwher e di d t he company get t he addi t i onal r esour ces? Di d t he asset s j ust magi cal l y appear ? I f t he f i nanci al st at ement s ar e t o be r el i ed upon f or usef ul i nf or mat i on, i t i s ext r emel y i mpor t ant t he debi t s equal s cr edi t s r ul e be f ol l owed.
** You now have t he backgr ound t o do exer ci se 2. 8 and pr obl ems 2. 1 and 2. 2.
Chapter 2 Critical Points
The account i ng equat i on, asset s = l i abi l i t i es + st ockhol der s' equi t y i s i mpor t ant i n f i nanci al r epor t i ng because i f i t i s i n bal ance i t guar ant ees t he f i nanci al st at ement s wi l l be mat hemat i cal l y l ogi cal . The debi t s = cr edi t s pr ocess guar ant ees t he account i ng equat i on i s al ways i n bal ance. Asset account s i ncr ease t hr ough debi t s and decr ease t hr ough cr edi t s. Li abi l i t y account s i ncr ease t hr ough cr edi t s and decr ease t hr ough debi t s. St ockhol der s' equi t y account s i ncr ease t hr ough cr edi t s and decr ease t hr ough debi t s. Revenue account s i ncr ease t hr ough cr edi t s and decr ease t hr ough debi t s. Expense account s i ncr ease t hr ough debi t s and decr ease t hr ough cr edi t s. Di vi dends account s i ncr ease t hr ough debi t s and decr ease t hr ough cr edi t s. I f debi t s do not equal cr edi t s, t he account i ng equat i on wi l l not bal ance and t he i nf or mat i on pr ovi ded i n t he f i nanci al st at ement s cannot be r el i ed upon. 18 Ch. 2: T Accounts, Debits, Credits Chapter Two Questions
1. I n account i ng t er mi nol ogy, what does t he t er masset s mean?
2. What does t he t er ml i abi l i t i es mean?
3. What does t he t er mst ockhol der s' equi t y mean?
4. I dent i f y t he t wo separ at e par t s of st ockhol der s' equi t y.
5. Why i s i t i mpor t ant t hat t he f i nanci al st at ement s ar e l ogi cal ?
6. What cont r i but i on di d Fr a Luca Paci ol i make t o account i ng?
7. What i s t he l ef t si de of a T account cal l ed?
8. What i s t he r i ght si de of a T account cal l ed?
9. How does t he debi t s = cr edi t s r ul e af f ect t he account i ng equat i on?
10. What t er mi s used t o i dent i f y t he i ncr ease i n r esour ces t hr ough t he pr ocess of pr ovi di ng ser vi ce t o cust omer s?
11. What af f ect do r evenues have on r et ai ned ear ni ngs?
12. What t er mi s used t o i dent i f y t he decr ease i n r esour ces t hr ough t he pr ocess of pr ovi di ng ser vi ce t o cust omer s?
13. What af f ect do expenses have on r et ai ned ear ni ngs?
14. What t er mi s used t o i dent i f y t he decr ease i n r esour ces t hr ough payment s made t o owner s?
15. What af f ect do di vi dends have on r et ai ned ear ni ngs? Ch. 2: T Accounts, Debits, Credits 19 16. Compl et e t he f ol l owi ng, usi ng t he t er ms debi t s and cr edi t s. Asset s i ncr ease t hr ough _______ and decr ease t hr ough _______. Li abi l i t i es i ncr ease t hr ough _______ and decr ease t hr ough _______. St ockhol der s' equi t y i ncr eases t hr ough _______ and decr ease t hr ough ______. Revenues i ncr ease t hr ough _______ and decr ease t hr ough _______. Expenses i ncr ease t hr ough _______ and decr ease t hr ough _______. Di vi dends i ncr ease t hr ough _______ and decr ease t hr ough _______.
Chapter Two Exercises
Exer ci se 2. 1: Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Peopl es Cor por at i on began busi ness on J ul y 10. Bet ween J ul y 10 and August 31, t he owner s i nvest ed $35, 000, t he company bor r owed $7, 000, management gener at ed $2, 200 r esour ces t hr ough oper at i ons, and t he owner s wer e pai d di vi dends of $250.
1. Det er mi ne t he Peopl es Cor por at i on' s t ot al l i abi l i t i es on August 31.
2. Det er mi ne t he Peopl es Cor por at i on' s t ot al st ockhol der s' equi t y on August 31.
3. Det er mi ne t he Peopl es Cor por at i on' s t ot al asset s on August 31.
Exer ci se 2. 2: Cash T Account
On Febr uar y 1, t he Bussey Cor por at i on had $18, 500 cash on hand. Dur i ng Febr uar y, t he company engaged i n many cash event s, i ncl udi ng ( a) r ecei vi ng a $2, 500 addi t i onal i nvest ment f r omowner s, ( b) payi ng $1, 800 f or suppl i es, ( c) r ecei vi ng $6, 000 f r omcust omer s, ( d) payi ng $3, 200 on account s payabl e, and ( e) payi ng $500 di vi dends t o owner s.
1. Set up a T account f or t he Bussey Cor por at i on' s cash.
2. Usi ng debi t s and cr edi t s, show how each of t he f i ve above event s af f ect ed t he company' s cash T account .
3. Cal cul at e t he Bussey Cor por at i on' s cash bal ance at t he end of Febr uar y.
20 Ch. 2: T Accounts, Debits, Credits Exer ci se 2. 3: Ret ai ned Ear ni ngs T Account
On November 1, t he Raymond Cor por at i on had r et ai ned ear ni ngs of $46, 900. Dur i ng November , t he company engaged i n many event s, i ncl udi ng ( a) r ecei vi ng $1, 000 addi t i onal i nvest ment f r omowner s, ( b) r ecei vi ng $4, 500 cash f r om cust omer s f or ser vi ces pr ovi ded t o t hemi n November , ( c) payi ng $1, 200 t o empl oyees f or wor k t hey di d f or t he company i n November , ( d) r ecei vi ng $2, 900 account s r ecei vabl e f r omcust omer s f or ser vi ces pr ovi ded t o t hemi n November , and ( e) payi ng $300 di vi dends t o owner s.
1. Set up a T account f or t he Raymond Cor por at i on' s r et ai ned ear ni ngs.
2. Usi ng debi t s and cr edi t s, show how each of t he f i ve above event s af f ect ed t he company' s r et ai ned ear ni ngs T account . Hi nt : one event does not af f ect r et ai ned ear ni ngs!
3. Cal cul at e t he Raymond Cor por at i on' s r et ai ned ear ni ngs bal ance at t he end of November .
4. Cal cul at e t he Raymond Cor por at i on' s net i ncome f or November .
Exer ci se 2. 4: Cash, Suppl i es, and Account s Payabl e T Account s
On Apr i l 1, t he Gat el y Cor por at i on had cash of $18, 000, suppl i es of $5, 600, and account s payabl e of $6, 700. Dur i ng Apr i l , t he company engaged i n many event s, i ncl udi ng ( a) payi ng $2, 000 f or addi t i onal suppl i es, ( b) payi ng $3, 400 f or suppl i es pur chased i n J anuar y, ( c) buyi ng $2, 500 addi t i onal suppl i es on account , and ( d) usi ng a t ot al of $4, 000 of suppl i es t o pr ovi de ser vi ces t o cust omer s i n Apr i l .
1. Set up T account s f or t he Gat el y Cor por at i on' s cash, suppl i es, and account s payabl e.
2. Usi ng debi t s and cr edi t s, show how each of t he f our above event s af f ect ed t he company' s cash, suppl i es, and account s payabl e T account s.
3. Cal cul at e t he bal ances i n t he Gat el y Cor por at i on' s cash, suppl i es, and account s payabl e account s.
Ch. 2: T Accounts, Debits, Credits 21 Exer ci se 2. 5: Cash, Account s Recei vabl e, and Ret ai ned Ear ni ngs T Account s
On December 1, t he Bi ckf or d Cor por at i on had cash of $24, 000, account s r ecei vabl e of $9, 200, and r et ai ned ear ni ngs of $67, 000. Dur i ng December , t he company engaged i n many event s, i ncl udi ng ( a) r ecei vi ng $12, 000 f r omcust omer s f or ser vi ces pr ovi ded dur i ng December , ( b) payi ng $700 t o owner s f or di vi dends, ( c) r ecei vi ng a t ot al of $5, 000 f r omcust omer s f or ser vi ces pr ovi ded t o t hemi n Oct ober and November , and ( d) r ecei vi ng pr omi ses of $7, 000 f r omcust omer s f or ser vi ces pr ovi ded t o t hemi n December .
1. Set up T account s f or t he Bi ckf or d Cor por at i on' s cash, account s r ecei vabl e, and r et ai ned ear ni ngs.
2. Usi ng debi t s and cr edi t s, show how each of t he f our above event s af f ect ed t he company' s cash, account s r ecei vabl e, and r et ai ned ear ni ngs T account s.
3. Cal cul at e t he bal ances i n t he Bi ckf or d Cor por at i on' s cash, account s r ecei vabl e, and r et ai ned ear ni ngs account s.
Exer ci se 2. 6: I ncome St at ement
The Al mei da Cor por at i on' s i ncome st at ement f or t he mont h ended J anuar y 31, i s shown bel ow.
Al mei da Cor por at i on I ncome St at ement For t he Mont h Ended J anuar y 31
Revenues $24, 000 Expenses $15, 000 Net I ncome $9, 000
1. Det er mi ne t he dol l ar amount of r esour ces obt ai ned f r omcust omer s f or ser vi ces pr ovi ded t o t hemi n J anuar y.
2. Det er mi ne t he dol l ar amount of r esour ces used up i n pr ovi di ng ser vi ce t o cust omer s i n J anuar y.
3. Det er mi ne t he net dol l ar amount by whi ch t he company' s r esour ces i ncr eased t hr ough management oper at i ons i n J anuar y.
22 Ch. 2: T Accounts, Debits, Credits Exer ci se 2. 7: St at ement of Ret ai ned Ear ni ngs
The Al mei da Cor por at i on' s st at ement of r et ai ned ear ni ngs f or t he mont h ended J anuar y 31, i s shown bel ow.
Al mei da Cor por at i on St at ement of Ret ai ned Ear ni ngs For t he Mont h Ended J anuar y 31
Begi nni ng Bal ance $43, 000 Net I ncome $9, 000 Subt ot al $52, 000 Di vi dends $3, 000 Endi ng Bal ance $49, 000
1. Det er mi ne t he dol l ar amount of r esour ces gener at ed t hr ough management oper at i ons and r et ai ned i n t he company pr i or t o J anuar y 1.
2. Det er mi ne t he net dol l ar amount by whi ch t he company' s r esour ces i ncr eased t hr ough management oper at i ons i n J anuar y.
3. Det er mi ne t he dol l ar amount of r esour ces pai d t o owner s i n J anuar y.
4. Det er mi ne t he dol l ar amount of r esour ces gener at ed t hr ough management oper at i ons and r et ai ned i n t he company by J anuar y 31.
Exer ci se 2. 8: Bal ance Sheet
The Al mei da Cor por at i on' s bal ance sheet on J anuar y 31, i s shown bel ow.
Al mei da Cor por at i on Bal ance Sheet J anuar y 31
Asset s Li abi l i t i es Cash $55, 000 Account s Payabl e $27, 000 Account s Recei vabl e $32, 000 St ockhol der s' Equi t y Suppl i es $6, 000 Common St ock $17, 000 Tot al Asset s $93, 000 Ret ai ned Ear ni ngs $49, 000 Tot al Li ab. & St ock. Eq. $93, 000
1. Det er mi ne t he dol l ar amount of r esour ces on J anuar y 31.
2. Det er mi ne t he dol l ar amount of bor r owed r esour ces.
3. Det er mi ne t he dol l ar amount of r esour ces i nvest ed by owner s.
4. Det er mi ne t he dol l ar amount of r esour ces gener at ed t hr ough management oper at i ons and r et ai ned i n t he company as of J anuar y 31. Ch. 2: T Accounts, Debits, Credits 23 Chapter Two Problem
Pr obl em2. 1: Tr ansact i ons, Account s, and Fi nanci al St at ement s
Hender son Cor por at i on engaged i n t he f ol l owi ng t r ansact i ons dur i ng Apr i l .
Apr i l 1 Rebecca Hender son i nvest ed $6, 000 i n t he company and r ecei ved 6, 000 shar es of $1 par common st ock.
Apr i l 4 Hender son Cor por at i on pr ovi ded $300 ser vi ces t o a cl i ent and r ecei ved f ul l payment i n cash.
Apr i l 7 Hender son Cor por at i on pur chased $500 suppl i es on account . The suppl i es wi l l be pai d i n f ul l by May 7.
Apr i l 10 Hender son Cor por at i on pr ovi ded $200 ser vi ces t o a cl i ent who agr eed t o pay on Apr i l 19.
Apr i l 15 Hender son Cor por at i on pai d $125 t o an empl oyee f or wor k done i n t he f i r st t wo weeks of Apr i l .
Apr i l 18 Hender son Cor por at i on pai d $300 cash f or addi t i onal suppl i es.
Apr i l 19 Hender son Cor por at i on r ecei ved f ul l payment f r omt he cust omer ser vi ced on Apr i l 10.
Apr i l 22 Hender son Cor por at i on pai d $250 as par t i al payment f or t he suppl i es pur chased on Apr i l 7.
Apr i l 25 Hender son Cor por at i on pai d a $100 cash di vi dend t o i t s owner .
Apr i l 28 Hender son Cor por at i on pr ovi ded $400 ser vi ces t o a cl i ent who agr eed t o pay on May 5.
Apr i l 30 A r evi ew of suppl i es r eveal ed $225 of suppl i es had been used up by t he end of Apr i l .
1. By addi t i on and subt r act i on, show t he ef f ect s of t he t r ansact i ons on Hender son Cor por at i on' s r esour ces and sour ces of r esour ces. Not i ce t he f i r st t r ansact i on has been pr ocessed f or you.
Resour ces
Sour ces of Bor r owed Resour ces Sour ces of Owner I nvest ed Resour ces Sour ces of Management Gener at ed Resour ces Asset s Li abi l i t i es St ockhol der s Equi t y Apr i l 1 + $6, 000 _______ + $6, 000 _______ Apr i l 4 ________ _______ ________ _______ Apr i l 7 ________ _______ ________ _______ Apr i l 10 ________ _______ ________ _______ Subt ot al s __$7, 000 ___$500 __$6, 000 ___$500 Apr i l 15 ________ _______ ________ _______ Apr i l 18 ________ _______ ________ _______ Apr i l 19 ________ _______ ________ _______ Subt ot al s __$6, 875 ___$500 __$6, 000 ___$375
24 Ch. 2: T Accounts, Debits, Credits
Resour ces
Sour ces of Bor r owed Resour ces Sour ces of Owner I nvest ed Resour ces Sour ces of Management Gener at ed Resour ces Asset s Li abi l i t i es St ockhol der s Equi t y Subt ot al s __$6, 875 ___$500 __$6, 000 ___$375 Apr i l 22 ________ _______ ________ _______ Apr i l 25 ________ _______ ________ _______ Apr i l 28 ________ _______ ________ _______ Apr i l 30 ________ _______ ________ _______ Tot al s __$6, 700 ___$250 __$6, 000 ___$450
2. By addi t i on and subt r act i on, show t he ef f ect s of t he Apr i l t r ansact i ons on t he T account s of t he Hender son Cor por at i on. Not i ce t he f i r st t r ansact i on has been pr ocessed f or you. Cal cul at e t he bal ance i n each T account at t he end of Apr i l .
Asset s = Li abi l i t i es + St ockhol der s' Equi t y
Dat e
Cash
+ Account s Recei vabl e
+
Suppl i es
= Account s Payabl e
+
Common St ock
+ Ret ai ned Ear ni ngs
Apr i l 1
6, 000
6, 000
Apr i l 4
Apr i l 7
Apr i l 10
Apr i l 15
Apr i l 18
Apr i l 19
Apr i l 22
Apr i l 25
Apr i l 28
Apr i l 30
Bal ances
5, 725
450
Ch. 2: T Accounts, Debits, Credits 25 3. Pr epar e t he Hender son Cor por at i on' s Apr i l f i nanci al st at ement s.
Hender son Cor por at i on I ncome St at ement For t he Mont h Ended Apr i l 30
Revenues $_________ Expenses $_________ Net I ncome $_________
Hender son Cor por at i on St at ement of Ret ai ned Ear ni ngs For t he Mont h Ended Apr i l 30
Ret ai ned Ear ni ngs, Apr i l 1 $________0 Net I ncome $_________ Subt ot al $_________ Di vi dends $_________ Ret ai ned Ear ni ngs, Apr i l 30 $______450
Hender son Cor por at i on Bal ance Sheet Apr i l 30
Asset s Li abi l i t i es Cash $_________ Account s Payabl e $_________ Account s Recei vabl e $_________ St ockhol der s' Equi t y Suppl i es $_________ Common St ock $_________ Tot al Asset s $____6, 700 Ret ai ned Ear ni ngs $_________ Tot al Li ab. & St ock. Eq. $_________
4. The dol l ar amount of Hender son Cor por at i on' s t ot al r esour ces at t he end of Apr i l i s $_______________.
5. The dol l ar amount of r esour ces on hand at t he end of Apr i l t hat Hender son Cor por at i on obt ai ned t hr ough bor r owi ng i s $_______________.
6. The dol l ar amount of r esour ces on hand at t he end of Apr i l t hat Hender son Cor por at i on obt ai ned t hr ough owner ' s i nvest ment s i s $_______________.
7. The net dol l ar amount of r esour ces Hender son Cor por at i on gener at ed t hr ough management oper at i ons i n Apr i l i s $_______________.