Types of Accounts, Debit & Credit Rules, Recording Transactions in the Journal

The transaction worksheet illustration shown at the end of chapter 1 is intended to get
you thinking in terms of the double entry system of accounting. It is not really the way
we record transactions. Chapter 2 starts to address the actual process of keeping the
books for a business enterprise.

The Accounting Cycle consists of about 8 steps that must be completed in order. In
Chapter 2, the text covers the first four steps in the cycle. Unfortunately, the first step is
one of the more difficult steps. Steps two through four are purely clerical in nature -
they are simple, but tedious.

Accounting Cycle
1. Record transactions in a journal.
2. Post the transactions from the journal to the ledger.
3. Determine account balances.
4. Prepare a "Trial Balance".

The General Journal is a two-column book that is used to record transactions.

Transactions are recorded chronologically as they occur. The General Ledger is the
accounting book that contains the company's accounts (called "T" accounts due to their
appearance). On the top of the "T" is the account name & number. The left hand side
of the "T" is known as the debit side, and the right hand side is the credit side.

Debits and credits simply refer to the left or right side of an account.

The account names used by companies might vary somewhat, but all companies use
the same types or classes of accounts. The major account classification types are as
follows:

Chart of Accounts

1. Assets
2. Liabilities Balance Sheet Accounts/Permanent Accounts
3. Equity

4. Revenue Income Statement/Temporary Accounts

5. Expenses

The General Ledger is always constructed with the asset accounts first, followed by the
liability accounts, then the equity accounts. The revenue accounts come next, and the
expense accounts are last.

Furthermore, asset account numbers usually begin with the number 1, liability accounts
with the number 2, equity accounts with the number 3, revenue accounts with the
number 4, and expense accounts with a number 5 or higher.
I mention the numbering system because occasionally you will encounter an account
title that you haven’t seen before & its number can help you to identify the class of
account that it represents.

These account types need further definition before we begin the first step of the
accounting cycle.

Assets are cash, receivables, or property that has monetary value attached to them.
Assets are often broken down into two main groups - current assets & plant
assets.

Current Assets are cash, receivables that are expected to be collected within one
year and property that the company expects to use up or to expire within one
year (ex. Supplies, Prepaid Insurance). (Receivables are amounts owed to the
company by its customers for work performed on a credit basis).

Plant (or Fixed) Assets are properties that the company owns that will last for
more than one year (ex. Land, Buildings, Equipment, Furniture).

Assets can also be defined as "Unexpired Costs" - that is, a cost for something
that the company can continue to use in the future.

Liabilities are debts that the company owes or obligations that it must perform. These
are usually divided into two groups - current liabilities & long term liabilities.

Current liabilities are debts that must be repaid within one year. The most
commonly used current liability account is called "Accounts Payable". It is
used when a company buys something on credit. It is usually just a verbal
arrangement between the buyer & seller. More formal "payables" result when
loan papers are signed - "Loans Payable" or "Notes Payable".

Long-Term liabilities are debts that will take more than a year to pay off.

Liabilities usually contain the word "Payable" in the title, but they may also
represent obligations that the company has to perform services. For
example, if a customer pays for a service before that service is performed,
then the company has an obligation to do the work . These advance
payments are usually recorded as "Unearned Revenue". Unearned revenue
is a liability account. So, the word "unearned" in an account title usually
indicates that the account is a liability account.

Equity accounts are used to keep track of the owner’s investment in the business. For
sole-proprietorships, there are only two equity accounts. The owner’s Capital
account (used to keep track of increases in the
owner’s investment) and the owner’s Drawing account (used to keep track of
any withdrawals the owner may take from the business).
Revenue accounts are used to record the income generated by the operation of the
business. Income is recorded in revenue accounts but is transferred to Equity
at the end of the accounting cycle (hence the reference to these being
temporary accounts).

Expense accounts are used to record the costs incurred in the operation of the
business. Another definition could be that expenses are "Expired Costs" - that
is, costs for things that the company has fully used up and from which there is
no future benefit or only a very short period of future benefit (when you pay the
phone bill, you are paying for calls that you have already made, when you pay
the rent, the benefit lasts only a month).

When we record transactions, we use a system of debits & credits to keep track of the
increases and decreases in the company’s accounts. If we analyze a transaction
properly, it will always result in at least two accounts being affected (double entry
system). It will also work out that one of those accounts will have to be "Debited" and
the other will have to be "Credited". There are no exceptions to this rule - every
transaction that you record in the journal must contain an equal amount of debits
& credits.

DEBIT & CREDIT RULES:

Debit Credit
Assets + -
Liabilities - +
Equity - +
Revenue - +
Expense + -

As you can see, debits are used to record increases in asset account balances &
expense account balances. Credits are used to record increases in liability, equity and
revenue account balances. Asset & expense account balances are decreased by
credits, while liability, equity and revenue account balances are decreased by debits.

Because of the different debit & credit rules that apply depending upon the types of
accounts used, it is extremely important to be able to tell which type of account you are
using.

The thought process that you follow when recording transactions should be:

1. Visualize the transaction being described.

2. Refer to the chart of accounts to select the specific accounts affected.
3. Identify which group of accounts the chosen ones belong to.
4. Record the transaction in the journal - it must work out that you have an equal
debit & credit.

Many students initially have trouble with these debit/credit rules. To many, they seem to
be backwards. They are not. The reason for this impression is that we are conditioned
to hearing these terms (debit & credit) applied as someone else uses them. The bank
tells you that they will credit your account when you make a deposit. The store tells you
that they will credit your account when you return something. This is correct, but in this
course, you must record the transaction as it affects your company. Your account, to
the bank, is a liability - they owe you that money. So, when you make a deposit, the
bank increases a liability account, by crediting accounts payable to you.

There is much to consider as we begin to complete the first step of the accounting
cycle! Review the following demonstration:

Wildlife Co. completed the following transactions during the month of May:

May 1 - Paid rent for the month, $2,500.

May 2 - Paid advertising expense, $500.
May 4 - Paid cash for supplies, $770.
May 5 - Purchased office equipment, on account, $7,200.
May 8 - Collect cash from customers, on account, $3,000.
May 12 - Paid a creditor $2,000, on account.
May 15 - Owner withdrew cash for personal use, $1,000.
May 25 - Paid cash for repairs to the office equipment, $120.
May 30 - Paid the phone bill, $195.
May 31 - Recorded fees earned and billed to customers, on account, $11,500.
May 31 - Paid the electric bill, $430.

Record these transactions in the general journal of Wildlife Company. The chart of
accounts for Wildlife Co. is as follows:

10 - Cash 42 - Fees Earned

12 - Accounts Receivable
14 - Supplies
16 - Office Equipment
22 - Accounts Payable
31 - J. Wren - Capital
32 - J. Wren Drawing
52 - Rent Expense
54 - Advertising Expense
56 - Utilities Expense
59 - Miscellaneous Expense

Hints: When you see the phrase "on account", it means that the transaction involves
credit. One of the accounts affected will be either Accounts Receivable (if the
description involves a sale, a service performed, billing customers or cash collected) or
Accounts Payable (if the description involves a purchase or a cash payment).

Print out these lecture notes and refer to the debit & credit rules as you go through the
entries. Click on the Excel spreadsheet file (below) to see how the entries would be
recorded in the journal. Please take note of the style of the journal entry. The debit part
of the entry is always entered first & the credit should be shown on the next line but
slightly indented. The amounts should be shown in the appropriate debit or credit
column.
Wildlife - General Journal
 Page 15
REF
Date Accounts & Descriptions . Debit Credit
Wildlife Co. - General Ledger

Cash 10 Fees Earned 42

Date Explanation Ref. Debit Credit Balance Date Explanation Ref. Debit Credit Balance
May
May 1 Balance 10,000-- Dr. 1 Balance --

Accounts Receivable 12 Rent Expense 52

Date Explanation Ref. Debit Credit Balance Date Explanation Ref. Debit Credit Balance
May
May 1 Balance 3,000-- Dr. 1 Balance --

Supplies 14 Advertising Expense 54

Date Explanation Ref. Debit Credit Balance Date Explanation Ref. Debit Credit Balance
May
May 1 Balance 1,400-- Dr. 1 Balance --

Equipment 16 Utilities Expense 56

Date Explanation Ref. Debit Credit Balance Date Explanation Ref. Debit Credit Balance
May
May 1 Balance 5,000-- Dr. 1 Balance --

Accounts Payable 22 Miscellaneous Expense 59

Date Explanation Ref. Debit Credit Balance Date Explanation Ref. Debit Credit Balance
May
May 1 Balance 2,000-- Cr. 1 Balance --

J. Wren - Capital 31
Date Explanation Ref. Debit Credit Balance
May 1 Balance 17,400-- Cr.

J. Wren - Drawing 32
Date Explanation Ref. Debit Credit Balance
May 1 Balance --