Analyzing Transactions
The first step in the accounting process is to analyze every transaction (economic event) that affects the business. The accounting equation (Assets = Liabilities + Owner's Equity) must remain in balance after every transaction is recorded, so accountants must analyze each transaction to determine how it affects owner's equity and the different types of assets and liabilities before recording the transaction.
Assume Mr. J. Green invests $15,000 to start a landscape business. This transaction increases the company's assets, specifically cash, by $15,000 and increases owner's equity by $15,000. Notice that the accounting equation remains in balance.
Mr. Green uses $5,000 of the company's cash to place a down-payment on a used truck that costs $15,000, and he signs a note payable that requires him to pay the remaining $10,000 in eighteen months. This transaction decreases one type of asset (cash) by $5,000, increases another type of asset (vehicles) by $15,000, and increases a liability (notes payable) by $10,000. The accounting equation remains in balance, and Mr. Green now has two types of assets ($10,000 in cash and a vehicle worth $15,000), a liability (a $10,000 note payable), and owner's equity of $15,000.
Given the large number of transactions that companies usually have, accountants need a more sophisticated system for recording transactions than the one shown on the previous page. Accountants use the double-entry bookkeeping system to keep the accounting equation in balance and to double-check the numerical accuracy of transaction entries. Under this system, each transaction is recorded using at least two accounts. An
account is a record of all transactions involving a particular item.
T Accounts
The simplest account structure is shaped like the letter
T. The account title and account number appear above the T. Debits (abbreviated Dr.) always go on the left side of the T, and credits (abbreviated Cr.) always go on the right.
Accountants record increases in asset, expense, and owner's drawing accounts on the debit side, and they record increases in liability, revenue, and owner's capital accounts on the credit side. An account's assigned
normal balance is on the side where increases go because the increases in any account are usually greater than the decreases. Therefore, asset, expense, and owner's drawing accounts normally have debit balances. Liability, revenue, and owner's capital accounts normally have credit balances. To determine the correct entry, identify the accounts affected by a transaction, which category each account falls into, and whether the transaction increases or decreases the account's balance. You may find the following chart helpful as a reference.
Occasionally, an account does not have a normal balance. For example, a company's checking account (an asset) has a credit balance if the account is overdrawn.
The way people often use the words
debit and
credit in everyday speech is not how accountants use these words. For example, the word
credit generally has positive associations when used conversationally: in school you receive credit for completing a course, a great hockey player may be a credit to his or her team, and a hopeless romantic may at least deserve credit for trying. Someone who is familiar with these uses for
credit but who is new to accounting may not immediately associate credits with decreases to asset, expense, and owner's drawing accounts. If a business owner loses $5,000 of the company's cash while gambling, the cash account, which is an asset, must be credited for $5,000. (The accountant who records this entry may also deserve credit for realizing that other job offers merit consideration.) For accounting purposes, think of
debit and
credit simply in terms of the left-hand and right-hand side of a T account.
Double‐Entry Bookkeeping
Under the double-entry bookkeeping system, the full value of each transaction is recorded on the debit side of one or more accounts and also on the credit side of one or more accounts. Therefore, the combined debit balance of all accounts always equals the combined credit balance of all accounts.
Suppose a new company obtains a long-term loan for $50,000 on August 1. The company's cash account (an asset) increases by $50,000, so it is debited for this amount. Simultaneously, the company's notes payable account (a liability) increases by $50,000, so it is credited for this amount. Both sides of the accounting equation increase by $50,000, and total debits and credits remain equal.
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Some transactions affect only one side of the accounting equation, but the double-entry bookkeeping system nevertheless ensures that the accounting equation remains in balance. For example, if the company pays $30,000 on August 3 to purchase equipment, the cash account's decrease is recorded with a $30,000 credit and the equipment account's increase is recorded with a $30,000 debit. These two asset-account entries offset each other, so the accounting equation remains in balance. Since the cash balance was $50,000 before this transaction occurred, the company has $20,000 in cash after the equipment purchase.
A compound entry is necessary when a single transaction affects three or more accounts. Suppose the company's owner purchases a used delivery truck for $20,000 on August 6 by making a $2,000 cash down payment and obtaining a three-year note payable for the remaining $18,000. This transaction is recorded by debiting (increasing) the vehicles account for $20,000, crediting (increasing) the notes payable account for $18,000, and crediting (decreasing) the cash account for $2,000.
The debits and credits total $20,000, and the accounting equation remains in balance because the $18,000 net increase in assets is matched by an $18,000 increase in liabilities. After these three transactions, the company has $68,000 in assets (cash $18,000; equipment $30,000; vehicles $20,000) and $68,000 in liabilities (notes payable).
Journal Entries
Tracking business activity with T accounts would be cumbersome because most businesses have a large number of transactions each day. These transactions are initially recorded on
source documents, such as invoices or checks. The first step in the accounting process is to analyze each transaction and identify what effect it has on the accounts. After making this determination, an accountant enters the transactions in chronological order into a journal, a process called
journalizing the transactions. Although many companies use specialized journals for certain transactions, all businesses use a
general journal. In this book, the terms
general journal and
journal are used interchangeably.
The journal's page number appears near the upper right corner. In the example below, GJ1 stands for page 1 of the general journal. Many general journals have five columns: Date, Account Title and Description, Posting Reference, Debit, and Credit.
To record a
journal entry, begin by entering the date of the transaction in the journal's date column. For convenience, include the year and month only at the top of each page and next to each month's first entry. In the next column, list each account affected by the transaction on a separate line, and enter a short description of the transaction immediately below the list of accounts. The accounts being debited always appear above the accounts being credited, which are indented slightly. The posting reference column remains blank until the journal entry is transferred to the accounts, a process called
posting, at which time the account's number is placed in this column. Finally, enter the debit or credit amount for each account in the appropriate columns on the right side of the journal. Generally, one blank line separates each transaction.
The General Ledger
After journalizing transactions, the next step in the accounting process is to post transactions to the accounts in the general ledger. Although T accounts provide a conceptual framework for understanding accounts, most businesses use a more informative and structured spreadsheet layout. A typical account includes date, explanation, and reference columns to the left of the debit column and a balance column to the right of the credit column. The reference column identifies the journal page containing the transaction. The balance column shows the account's balance after every transaction.
When an account does not have a normal balance, brackets enclose the balance. Assets normally have debit balances, for example, so brackets enclose a checking account's balance only when the account is overdrawn.
As the numbered arrows below indicate, you should post a transaction's first line item to the correct ledger account, completing each column and calculating the account's new balance. Then you should enter the account's reference number in the journal. Repeat this sequence of steps for every account listed in the journal entry.
Referencing the account's number on the journal
after posting the entry ensures that every line item that has a reference number in the journal has already been posted. This practice can be helpful if phone calls or other distractions interrupt the posting process.
The Recording Process Illustrated
To understand how to record a variety of transactions, consider the description and analysis of the Greener Landscape Group's first thirteen transactions. Then see how each transaction appears in the company's general journal and general ledger accounts.
Transaction 1: On April 1, 20X2, the owner of the Greener Landscape Group, J. Green, invests $15,000 to open the business. Therefore, an asset account (cash) increases and is debited for $15,000, and the owner's capital account (J. Green, capital) increases and is credited for $15,000.
Notice that the cash account has a debit balance and the J. Green, capital account has a credit balance. Since both balances are normal, brackets are not used.
Transaction 2: On April 2, Mr. Green purchases a $15,000 used truck by paying $5,000 in cash and signing a $10,000 note payable, which is due in eighteen months. One asset account (vehicles) increases and is debited for $15,000. Another asset account (cash) decreases and is credited for $5,000. A liability account (notes payable) increases and is credited for $10,000.
The shaded areas below provide a reference for the transaction's position in the journal and ledger accounts. They are not part of the current entry.
Transaction 3: On April 3, Mr. Green purchases lawn mowers for $3,000 in cash. One asset account (equipment) increases and is debited for $3,000, and another asset account (cash) decreases and is credited for $3,000.
Transaction 4: On April 5, Mr. Green purchases $30 worth of gasoline to power the mowers during April. Since the gas is a cost of doing business during the present accounting period, an expense account (gas expense) increases and is debited for $30. (Remember: increases in asset, expense, and drawing accounts are made with debit entries.) In addition, an asset account (cash) decreases and is credited for $30.
Transaction 5: On April 5, Mr. Green pays $1,200 for a one-year insurance contract that protects his business from April 1 until March 31 of the following year. Given the length of time this contract is in effect, the matching principle requires that the contract's cost initially be recorded as an asset since it provides a future benefit. Therefore, an asset (prepaid insurance) increases and is debited for $1,200. Another asset account (cash) decreases and is credited for $1,200.
Transaction 6: On April 5, Mr. Green purchases $50 worth of office supplies, placing the purchase on his account with the store rather than paying cash. Supplies are a prepaid expense (an asset) until they are used and thereby become a cost of doing business (an expense). Therefore, an asset account (supplies) increases and is debited for $50. Since Mr. Green places the purchase on his account with the store, a liability account (accounts payable) increases and is credited for $50. Accounts payable differ from notes payable. Accounts payable are amounts the company owes based on the good credit of the company or the owner, whereas notes payable are amounts the company owes under formal obligations.
Transaction 7: On April 14, the Greener Landscape Group cuts grass for seven customers, receiving $50 from each. An asset account (cash) increases and is debited for $350, and a revenue account (lawn cutting revenue) increases and is credited for $350.
Transaction 8: On April 20, Mr. Green receives $270 from a customer for six future maintenance visits. An advance deposit from a customer is an obligation to perform work in the future. It is a liability until the work is performed, at which time it becomes revenue. Therefore, the advance deposit is called unearned revenue. An asset account (cash) increases and is debited for $270, and a liability account (unearned revenue) increases and is credited for $270.
Transaction 9: On April 22, the Greener Landscape Group cuts grass for eight customers, billing each one $50 but receiving no cash. In accordance with the revenue recognition principle, revenue is recognized upon the completion of a service or the delivery of a product, even if no cash changes hands at that time. Therefore, an asset account (accounts receivable) increases and is debited for $400, and a revenue account (lawn cutting revenue) increases and is credited for $400.
Notice the new journal page and the corresponding change in posting references on the accounts.
Transaction 10: On April 26, Mr. Green pays $200 in wages to a part-time employee. An expense account (wages expense) increases and is debited for $200, and an asset account (cash) decreases and is credited for $200.
Transaction 11: On April 28, Mr. Green pays $35 to print advertising fliers. An expense account (advertising expense) increases and is debited for $35, and an asset account (cash) decreases and is credited for $35.
Transaction 12: On April 29, Mr. Green withdraws $50 for personal use. The owner's drawing account (J. Green, drawing) increases and is debited for $50, and an asset account (cash) decreases and is credited for $50.
Transaction 13: On April 30, five of the eight previously billed customers each pay $50. Therefore, one asset account (cash) increases and is debited for $250, and another asset account (accounts receivable) decreases and is credited for $250.
The Trial Balance
After posting all transactions from an accounting period, accountants prepare a
trial balance to verify that the total of all accounts with debit balances equals the total of all accounts with credit balances. The trial balance lists every open general ledger account by account number and provides separate debit and credit columns for entering account balances. The Greener Landscape Group's trial balance for April 30,20X2 appears below.
The Greener Landscape Group Trial Balance April 30,20X2
| Account | Debit | Credit |
| 100 | Cash | $ 6,355 | |
| 110 | Accounts Receivable | 150 | |
| 140 | Supplies | 50 | |
| 145 | Prepaid Insurance | 1,200 | |
| 150 | Equipment | 3,000 | |
| 155 | Vehicles | 15,000 | |
| 200 | Accounts Payable | | $ 50 |
| 250 | Unearned Revenue | | 270 |
| 280 | Notes Payable | | 10,000 |
| 300 | J. Green, Capital | | 15,000 |
| 350 | J. Green, Drawing | 50 | |
| 400 | Lawn Cutting Revenue | | 750 |
| 500 | Wages Expense | 200 | |
| 510 | Gas Expense | 30 | |
| 520 | Advertising Expense | 35 | |
| | $26,070 | $26,070 |
Although dollar signs are not used in journals or ledger accounts, trial balances generally include dollar signs next to the first figure in each column and next to each column's total. Trial balances usually include accounts that had activity during the accounting period but have a zero balance at the end of the period.
An error has occurred when total debits on a trial balance do not equal total credits. There are standard techniques for uncovering some of the errors that cause unequal trial balances. After double-checking each column's total to make sure the problem is not simply an addition error on the trial balance, find the difference between the debit and credit balance totals. If the number
2 divides evenly into this difference, look for an account balance that equals half the difference and that incorrectly appears in the column with the larger total. If the Greener Landscape Group's $50 accounts payable balance were mistakenly put in the debit column, for example, total debits would be $100 greater than total credits on the trial balance.
If the number
9 divides evenly into the difference between the debit and credit balance totals, look for a transposition error in one of the account balances. For example, suppose the cash account's balance of $6,355 were incorrectly entered on the trial balance as $6,535. This would cause total debits to be $180 greater than total credits on the trial balance, an amount evenly divisible by
9 ($180 ÷ 9 = $20). Incidentally, the number of digits in the resulting quotient—the quotient
20 has two digits–always indicates that the transposition error begins this number of digits from the right side of an account balance. Also, the value of the leftmost digit in the quotient—
2 in this case— always equals the difference between the two transposed numbers. Test this by transposing any two adjacent numbers in the trial balance and performing the calculations yourself.
If the difference between the debit and credit balance totals is not divisible by
2 or
9, look for a ledger account with a balance that equals the difference and is missing from the trial balance. Of course, two or more errors can combine to render these techniques ineffective, and other types of mistakes frequently occur. If the error is not apparent, return to the ledger and recalculate each account's balance. If the error remains, return to the journal and verify that each transaction is posted correctly.
Some errors do not cause the trial balance's column totals to disagree. For example, the columns in a trial balance agree when transactions are not journalized or when journal entries are not posted to the general ledger. Similarly, recording transactions in the wrong accounts does not lead to unequal trial balances. Another common error a trial balance does not catch happens when a single transaction is posted twice. The trial balance is a useful tool, but every transaction must be carefully analyzed, journalized, and posted to ensure the reliability and usefulness of accounting records.
