The Account

An account is an individual accounting record of increases and decreases in a specific asset, liability, or equity item. For example, Softbyte Inc. (the company discussed in Chapter 1) would have separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so on. (Note that whenever we are referring to a specific account, we capitalize the name.)

In its simplest form, an account consists of three parts: (1) a title, (2) a left or debit side, and (3) a right or credit side. Because the format of an account resembles the letter T, we refer to it as a T-account. Illustration 2-1 shows the basic form of an account.

Illustration 2-1 Basic form of account

We use this form often throughout this book to explain basic accounting relationships.

Debits and Credits

The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account.

When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits. Note the position of the debit side and credit side in Illustration 2-1.

The procedure of recording debits and credits in an account is shown in Illustration 2-2 for the transactions affecting the Cash account of Softbyte Inc. The data are taken from the Cash column of the tabular summary in Illustration 1-10 (page 21).

Illustration 2-2 Tabular summary and account form for Softbyte's Cash account

Every positive item in the tabular summary represents a receipt of cash; every negative amount represents a payment of cash. Notice that in the account form we record the increases in cash as debits, and the decreases in cash as credits. For example, the €15,000 receipt of cash (in red) is debited to Cash, and the −€7,000 payment of cash (in blue) is credited to Cash.

Having increases on one side and decreases on the other reduces recording errors and helps in determining the totals of each side of the account as well as the account balance. The balance is determined by netting the two sides (subtracting one amount from the other). The account balance, a debit of €8,050, indicates that Softbyte had €8,050 more increases than decreases in cash. That is, since it started with a balance of zero, it has €8,050 in its Cash account.

DEBIT AND CREDIT PROCEDURE

In Chapter 1, you learned the effect of a transaction on the basic accounting equation. Remember that each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry system of recording transactions.

Under the double-entry system, the dual (two-sided) effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. As discussed in the Feature Story about Bank of Taiwan (TWN), the double-entry system also helps to ensure the accuracy of the recorded amounts as well as the detection of errors. If every transaction is recorded with equal debits and credits, the sum of all the debits to the accounts must equal the sum of all the credits.

The double-entry system for determining the equality of the accounting equation is much more efficient than the plus/minus procedure used in Chapter 1. On the following pages, we will illustrate debit and credit procedures in the double-entry system.

DR./CR. PROCEDURES FOR ASSETS AND LIABILITIES

In Illustration 2-2 for Softbyte Inc. increases in Cash—an asset—were entered on the left side, and decreases in Cash were entered on the right side. We know that both sides of the basic equation (Assets = Liabilities + Equity) must be equal. It therefore follows that increases and decreases in liabilities will have to be recorded opposite from increases and decreases in assets. Thus, increases in liabilities must be entered on the right or credit side, and decreases in liabilities must be entered on the left or debit side. The effects that debits and credits have on assets and liabilities are summarized in Illustration 2-3.

Illustration 2-3 Debit and credit effects—assets and liabilities

Asset accounts normally show debit balances. That is, debits to a specific asset account should exceed credits to that account. Likewise, liability accounts normally show credit balances. That is, credits to a liability account should exceed debits to that account. The normal balance of an account is on the side where an increase in the account is recorded. Illustration 2-4 shows the normal balances for assets and liabilities.

Illustration 2-4 Normal balances—assets and liabilities

Knowing the normal balance in an account may help you trace errors. For example, a credit balance in an asset account such as Land or a debit balance in a liability account such as Salaries and Wages Payable usually indicates an error. Occasionally, though, an abnormal balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance (i.e., written a check that “bounced”).

EQUITY

As Chapter 1 indicated, there are five subdivisions of equity: share capital—ordinary, retained earnings, dividends, revenues, and expenses. In a double-entry system, companies keep accounts for each of these subdivisions, as explained below.

SHARE CAPITAL—ORDINARY Companies issue share capital—ordinary in exchange for the owners' investment paid in to the company. Credits increase the Share Capital—Ordinary account, and debits decrease it. For example, when an owner invests cash in the business in exchange for ordinary shares, the company debits (increases) Cash and credits (increases) Share Capital—Ordinary.

Illustration 2-5 shows the rules of debit and credit for the Share Capital–Ordinary account.

Illustration 2-5 Debit and credit effects—share capital—ordinary

We can diagram the normal balance in Share Capital—Ordinary as follows.

Illustration 2-6 Normal balance—share capital—ordinary

RETAINED EARNINGS Retained earnings is net income that is kept (retained) in the business. It represents the portion of equity that the company has accumulated through the profitable operation of the business. Credits (net income) increase the Retained Earnings account, and debits (dividends or net losses) decrease it, as Illustration 2-7 shows.

Illustration 2-7 Debit and credit effects and normal balance—retained earnings

DIVIDENDS A dividend is a company's distribution to its shareholders. The most common form of a distribution is a cash dividend. Dividends reduce the shareholders' claims on retained earnings. Debits increase the Dividends account, and credits decrease it. Illustration 2-8 shows that this account normally has a debit balance.

Illustration 2-8 Debit and credit effect and normal balance—dividends

REVENUES AND EXPENSES

The purpose of earning revenues is to benefit the shareholders of the business. When a company earns revenues, equity increases. Revenues are a subdivision of equity that provides information as to why equity increased. Credits increase revenue accounts and debits decrease them. Therefore, the effect of debits and credits on revenue accounts is the same as their effect on equity.

Expenses have the opposite effect: expenses decrease equity. Since expenses decrease net income, and revenues increase it, it is logical that the increase and decrease sides of expense accounts should be the reverse of revenue accounts. Thus, debits increase expense accounts, and credits decrease them.

Illustration 2-9 shows the effect of debits and credits on revenues and expenses.

Illustration 2-9 Debit and credit effects—revenues and expenses

Credits to revenue accounts should exceed debits. Debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. We can diagram the normal balance as follows.

Illustration 2-10 Normal balances—revenues and expenses

Equity Relationships

As Chapter 1 indicated, companies report share capital—ordinary and retained earnings in the equity section of the statement of financial position. They report dividends on the retained earnings statement. And they report revenues and expenses on the income statement. Dividends, revenues, and expenses are eventually transferred to retained earnings at the end of the period. As a result, a change in any one of these three items affects equity. Illustration 2-11 shows the relationships related to equity.

Illustration 2-11 Equity relationships

Summary of Debit/Credit Rules

Illustration 2-12 shows a summary of the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system.

Illustration 2-12 Summary of debit/credit rules

Steps in the Recording Process

Although it is possible to enter transaction information directly into the accounts without using a journal, few businesses do so. Practically every business uses three basic steps in the recording process:

1. Analyze each transaction for its effects on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger.

The recording process begins with the transaction. Business documents, such as a sales slip, a check, a bill, or a cash register tape, provide evidence of the transaction. The company analyzes this evidence to determine the transaction's effects on specific accounts. The company then enters the transaction in the journal. Finally, it transfers the journal entry to the designated accounts in the ledger. Illustration 2-13 shows the recording process.

Illustration 2-13 The recording process

The steps in the recording process occur repeatedly. In Chapter 1, we illustrated the first step, the analysis of transactions, and will give further examples in this and later chapters. The other two steps in the recording process are explained in the next sections.

The Journal

Companies initially record transactions in chronological order (the order in which they occur). Thus, the journal is referred to as the book of original entry. For each transaction, the journal shows the debit and credit effects on specific accounts.

Companies may use various kinds of journals, but every company has the most basic form of journal, a general journal. Typically, a general journal has spaces for dates, account titles and explanations, references, and two amount columns. (See the format of the journal in Illustration 2-14, below.) Whenever we use the term “journal” in this textbook, we mean the general journal, unless we specify otherwise.

The journal makes several significant contributions to the recording process:

1. It discloses in one place the complete effects of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be easily compared.

JOURNALIZING

Entering transaction data in the journal is known as journalizing. Companies make separate journal entries for each transaction. A complete entry consists of: (1) the date of the transaction, (2) the accounts and amounts to be debited and credited, and (3) a brief explanation of the transaction.

Illustration 2-14 shows the technique of journalizing, using the first two transactions of Softbyte Inc. On September 1, shareholders invested €15,000 cash in the corporation in exchange for ordinary shares, and Softbyte purchased computer equipment for €7,000 cash. The number J1 indicates that the company records these two entries on the first page of the general journal. (The boxed numbers correspond to explanations in the list below the illustration.)

Illustration 2-14 Technique of journalizing

It is important to use correct and specific account titles in journalizing. Erroneous account titles lead to incorrect financial statements. However, some flexibility exists initially in selecting account titles. The main criterion is that each title must appropriately describe the content of the account. Once a company chooses the specific title to use, it should record under that account title all later transactions involving the account.¹

SIMPLE AND COMPOUND ENTRIES

Some entries involve only two accounts, one debit and one credit. (See, for example, the entries in Illustration 2-14.) An entry like these is considered a simple entry. Some transactions, however, require more than two accounts in journalizing. An entry that requires three or more accounts is a compound entry. To illustrate, assume that on July 1, Tsai Company purchases a delivery truck costing NT$420,000. It pays NT$240,000 cash now and agrees to pay the remaining NT$180,000 on account (to be paid later). The compound entry is as follows.

Illustration 2-15 Compound journal entry

In a compound entry, the standard format requires that all debits be listed before the credits.

The Ledger

The entire group of accounts maintained by a company is the ledger. The ledger keeps in one place all the information about changes in specific account balances.

Companies may use various kinds of ledgers, but every company has a general ledger. A general ledger contains all the asset, liability, and equity accounts, as shown in Illustration 2-16. Whenever we use the term “ledger” in this textbook, we mean the general ledger, unless we specify otherwise.

Illustration 2-16 The general ledger

The ledger provides the balance in each of the accounts and keeps track of changes in these balances. For example, the Cash account shows the amount of cash available to meet current obligations. The Accounts Receivable account shows amounts due from customers. The Accounts Payable account shows amounts owed to creditors. Each account is numbered for easier identification.

STANDARD FORM OF ACCOUNT

The simple T-account form used in accounting textbooks is often very useful for illustration purposes. However, in practice, the account forms used in ledgers are much more structured. Illustration 2-17 shows a typical form, using assumed data from a cash account.

This is called the three-column form of account. It has three money columns—debit, credit, and balance. The balance in the account is determined after each transaction. Companies use the explanation space and reference columns to provide special information about the transaction.

Illustration 2-17 Three-column form of account

Posting

Transferring journal entries to the ledger accounts is called posting. This phase of the recording process accumulates the effects of journalized transactions into the individual accounts. Posting involves the following steps.

1. In the ledger, enter, in the appropriate columns of the account(s) debited, the date, journal page, and debit amount shown in the journal.
2. In the reference column of the journal, write the account number to which the debit amount was posted.
3. In the ledger, enter, in the appropriate columns of the account(s) credited, the date, journal page, and credit amount shown in the journal.
4. In the reference column of the journal, write the account number to which the credit amount was posted.

Illustration 2-18 shows these four steps using Softbyte Inc.'s first journal entry, the issuance of ordinary shares for €15,000 cash. The boxed numbers indicate the sequence of the steps.

Illustration 2-18 Posting a journal entry

Posting should be performed in chronological order. That is, the company should post all the debits and credits of one journal entry before proceeding to the next journal entry. Postings should be made on a timely basis to ensure that the ledger is up to date.²

The reference column of a ledger account indicates the journal page from which the transaction was posted.³ The explanation space of the ledger account is used infrequently because an explanation already appears in the journal.

CHART OF ACCOUNTS

The number and type of accounts differ for each company. The number of accounts depends on the amount of detail management desires. For example, the management of one company may want a single account for all types of utility expense. Another may keep separate expense accounts for each type of utility, such as gas, electricity, and water. Similarly, a small company like Softbyte Inc. will have fewer accounts than a corporate giant like Anheuser-Busch InBev (BEL). Softbyte may be able to manage and report its activities in 20 to 30 accounts, while Anheuser-Busch InBev may require thousands of accounts to keep track of its worldwide activities.

Most companies have a chart of accounts. This chart lists the accounts and the account numbers that identify their location in the ledger. The numbering system that identifies the accounts usually starts with the statement of financial position accounts and follows with the income statement accounts.

In this and the next two chapters, we will be explaining the accounting for Pioneer Advertising Agency Inc. (a service company). The ranges of the account numbers are as follows.

• Accounts 101–199 indicate asset accounts
• 200–299 indicate liabilities
• 300–399 indicate equity accounts
• 400–499, revenues
• 500–799, expenses
• 800–899, other revenues
• 900–999, other expenses

Illustration 2-19 shows the chart of accounts for Pioneer Advertising Agency Inc. Accounts shown in red are used in this chapter. Accounts shown in black are explained in later chapters.

Illustration 2-19 Chart of accounts for Pioneer Advertising Agency Inc.

You will notice that there are gaps in the numbering system of the chart of accounts for Pioneer Advertising. Gaps are left to permit the insertion of new accounts as needed during the life of the business.

The Recording Process Illustrated

Illustrations 2-20 through 2-29 show the basic steps in the recording process, using the October transactions of Pioneer Advertising Agency Inc. Pioneer's accounting period is a month. A basic analysis and a debit-credit analysis precede the journalizing and posting of each transaction. For simplicity, we use the T-account form in the illustrations instead of the standard account form.

Study these transaction analyses carefully. The purpose of transaction analysis is first to identify the type of account involved, and then to determine whether to make a debit or a credit to the account. You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries in later chapters.

Illustration 2-20 Investment of cash by shareholders

Illustration 2-21 Purchase of office equipment

Illustration 2-22 Receipt of cash for future service

Illustration 2-23 Payment of monthly rent

Illustration 2-24 Payment for insurance

Illustration 2-25 Purchase of supplies on credit

Illustration 2-26 Hiring of employees

Illustration 2-27 Declaration and payment of dividend

Illustration 2-28 Payment of salaries

Illustration 2-29 Receipt of cash for services provided

Summary Illustration of Journalizing and Posting

Illustration 2-30 shows the journal for Pioneer Advertising Agency Inc. for October. Illustration 2-31 (page 70) shows the ledger, with all balances in red.

Illustration 2-30 General journal entries

Illustration 2-31 General ledger

The Trial Balance

A trial balance is a list of accounts and their balances at a given time. Customarily, companies prepare a trial balance at the end of an accounting period. They list accounts in the order in which they appear in the ledger. Debit balances appear in the left column and credit balances in the right column.

The trial balance proves the mathematical equality of debits and credits after posting. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance may also uncover errors in journalizing and posting. For example, a trial balance may well have detected the error at Fidelity Investments discussed in the Feature Story. In addition, a trial balance is useful in the preparation of financial statements, as we will explain in the next two chapters.

The steps for preparing a trial balance are:

1. List the account titles and their balances.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.

Illustration 2-32 shows the trial balance prepared from Pioneer Advertising's ledger. Note that the total debits (28,700) equal the total credits (28,700).

Illustration 2-32 A trial balance

A trial balance is a necessary checkpoint for uncovering certain types of errors. For example, if only the debit portion of a journal entry has been posted, the trial balance would bring this error to light.

Limitations of a Trial Balance

A trial balance does not guarantee freedom from recording errors, however. Numerous errors may exist even though the totals of the trial balance columns agree. For example, the trial balance may balance even when (1) a transaction is not journalized, (2) a correct journal entry is not posted, (3) a journal entry is posted twice, (4) incorrect accounts are used in journalizing or posting, or (5) offsetting errors are made in recording the amount of a transaction. As long as equal debits and credits are posted, even to the wrong account or in the wrong amount, the total debits will equal the total credits. The trial balance does not prove that the company has recorded all transactions or that the ledger is correct.

Locating Errors

Errors in a trial balance generally result from mathematical mistakes, incorrect postings, or simply transcribing data incorrectly. What do you do if you are faced with a trial balance that does not balance? First, determine the amount of the difference between the two columns of the trial balance. After this amount is known, the following steps are often helpful:

1. If the error is $1, $10, $100, or $1,000, re-add the trial balance columns and recompute the account balances.
2. If the error is divisible by 2, scan the trial balance to see whether a balance equal to half the error has been entered in the wrong column.
3. If the error is divisible by 9, retrace the account balances on the trial balance to see whether they are incorrectly copied from the ledger. For example, if a balance was $12 and it was listed as $21, a $9 error has been made. Reversing the order of numbers is called a transposition error.
4. If the error is not divisible by 2 or 9, scan the ledger to see whether an account balance in the amount of the error has been omitted from the trial balance, and scan the journal to see whether a posting of that amount has been omitted.

Use of Currency Signs

Note that currency signs do not appear in journals or ledgers. Currency signs are typically used only in the trial balance and the financial statements. Generally, a currency sign is shown only for the first item in the column and for the total of that column. A single line (a totaling rule) is placed under the column of figures to be added or subtracted. Total amounts are double-underlined to indicate they are final sums. Negative signs or parentheses do not appear in journals or ledgers.

SUMMARY OF LEARNING OBJECTIVES

1 Explain what an account is and how it helps in the recording process. An account is a record of increases and decreases in specific asset, liability, or equity items.

2 Define debits and credits and explain their use in recording business transactions. The terms debit and credit are synonymous with left and right. Assets, dividends, and expenses are increased by debits and decreased by credits. Liabilities, share capital—ordinary, retained earnings, and revenues are increased by credits and decreased by debits.

3 Identify the basic steps in the recording process. The basic steps in the recording process are (a) analyze each transaction for its effects on the accounts, (b) enter the transaction information in a journal, and (c) transfer the journal information to the appropriate accounts in the ledger.

4 Explain what a journal is and how it helps in the recording process. The initial accounting record of a transaction is entered in a journal before the data are entered in the accounts. A journal (a) discloses in one place the complete effects of a transaction, (b) provides a chronological record of transactions, and (c) prevents or locates errors because the debit and credit amounts for each entry can be easily compared.

5 Explain what a ledger is and how it helps in the recording process. The ledger is the entire group of accounts maintained by a company. The ledger keeps in one place all the information about changes in specific account balances.

6 Explain what posting is and how it helps in the recording process. Posting is the transfer of journal entries to the ledger accounts. This phase of the recording process accumulates the effects of journalized transactions in the individual accounts.

7 Prepare a trial balance and explain its purposes. A trial balance is a list of accounts and their balances at a given time. Its primary purpose is to prove the equality of debits and credits after posting. A trial balance also uncovers errors in journalizing and posting and is useful in preparing financial statements.

GLOSSARY

Account A record of increases and decreases in specific asset, liability, or equity items. (p. 52).

Chart of accounts A list of accounts and the account numbers that identify their location in the ledger. (p. 62).

Compound entry A journal entry that involves three or more accounts. (p. 59).

Credit The right side of an account. (p. 52).

Debit The left side of an account. (p. 52).

Dividend A distribution by a company to its shareholders. (p. 54).

Double-entry system A system that records in appropriate accounts the dual effect of each transaction. (p. 53).

General journal The most basic form of journal. (p. 58).

General ledger A ledger that contains all asset, liability, and equity accounts. (p. 60).

Journal An accounting record in which transactions are initially recorded in chronological order. (p. 58).

Journalizing The entering of transaction data in the journal. (p. 58).

Ledger The entire group of accounts maintained by a company. (p. 60).

Normal balance An account balance on the side where an increase in the account is recorded. (p. 53).

Posting The procedure of transferring journal entries to the ledger accounts. (p. 61).

Retained earnings Net income that is kept (retained) in the business. (p. 54).

Simple entry A journal entry that involves only two accounts. (p. 59).

T-account The basic form of an account. (p. 52).

Three-column form of account A form with columns for debit, credit, and balance amounts in an account. (p. 60).

Trial balance A list of accounts and their balances at a given time. (p. 70).