Accounting: The Language of Business (Part 10)

“The word accounting comes from the word accountability. If you are going to be rich, you need to be accountable for your money.” —Robert Kiyosaki

Analyzing Transactions (Part B)

by

Charles Lamson

Analyzing and Summarizing Transactions and Accounts

Every business transaction affects at least two accounts. To illustrate how transactions are analyzed and summarized in accounts we will use the NetSolutions transactions from parts 1-8, with dates added. First, we illustrate how transactions (a), (b), (c) and (f) are analyzed and summarized in balance sheet accounts (assets, liabilities, and owner's equity). Next, we illustrate how transactions (d), (e) and (g) are analyzed and summarized in income statement accounts (revenues and expenses). Finally, we illustrate how the withdrawal of cash by Chris Clarke, transaction (h), is analyzed and summarized in the accounts.

Transactions and Balance Sheet Accounts

Chris Clark's first transaction, (a), was to deposit $25,000 in a bank account in the name of NetSolutions. The effect of this November 1 transaction on the balance sheet is to increase assets and owner's equity, as shown below.

This transaction is initially entered in a record called a journal. The title of the account to be debited is listed first, followed by the amount to be debited. The title of the account to be credited is listed below and to the right of the debit, followed by the amount to be credited. This process of recording a transaction in the journal is called journalizing. This form of recording a transaction is called a journal entry. The journal entry for transaction (a) is shown below.

Entry A

The increase in the asset (cash), which is reported on the left side of the balance sheet, is debited to the cash account. The increase in owner's equity, which is reported on the right side of the balance sheet, is credited to the Chris Clark, capital account. As other assets are acquired, the increases are also recorded as debits to asset accounts. Likewise, other increases in owner's equity will be recorded as credits to the owner's equity accounts.

The effects of this transaction are shown in the accounts by transferring the amount and date of the personal entry to the (debit) side of Cash and to the right (credit) side of Chris Clark, capital, as follows. 

On November 5 (transaction b), NetSolutions bought land for $20,000, paying cash. This transaction increases one asset account and decreases another. It is entered in the journal as a $20,000 increase (debit) to land and a $20,000 decrease (credit) to cash, as shown below.

Entry B

The effect of this entry is shown in the accounts of NetSolutions as follows:

On November 10 (transaction c), NetSolutions purchased supplies on account for $1,350. This transaction increases an asset account and increases a liability account. It is entered in the journal as a $1,350 increase (debit) to supplies and a $1,350 increase (credit) to accounts payable, as shown below. To simplify the illustration, the effect of entry (c) and the remaining journal entries for NetSolutions will be shown in the accounts later.

Entry C

On November 30 (transaction f), NetSolutions paid creditors on account, $950. This transaction decrease is a liability account and decreases an asset account. It is entered in the journal as a $950 decrease (debit) to accounts payable and a $950 decrease (credit) to cash, as shown below.

Entry F

In the preceding examples, you should observe that the left side of asset accounts is used for recording increases and the right side is used for recording decreases. Also, the right side of liability and owner's equity accounts is used to record increases, and the left side of such accounts is used to record decreases. The left side of all accounts whether asset, liability, or owner's equity, is the debit side, and the right side is the credit side. Thus, a debit may be either an increase or a decrease, depending on the account affected. Likewise, a credit may be either an increase or a decrease, depending on the account. The general rules of debit and credit for balance sheet accounts may be thus stated as follows: 

The rules of debit and credit may also be stated in relationship to the accounting equation, as shown below.

Income Statement Accounts

The analysis of revenue and expense transactions focuses on how each transaction affects owner's equity. Transactions that increase revenue will increase owner's equity. Just as increases in owner's equity are recorded as credits, so to, are increases in revenue accounts. Transactions that increase expense will decrease owner's equity. Just as decreases in owner's equity are recorded as debits, increases in expense accounts are recorded as debits.

We will use NetSolutions transactions (d), (e) , and (g) to illustrate the analysis of transactions and the rules of debit and credit for revenue and expense accounts. On November 18 (transaction d), NetSolutions received fees of $7,500 from customers for services provided. This transaction increases an asset account and increases a revenue account. It is entered in the journal as a $7,500 increase (debit) to cash and a $7,500 increase (credit) to Fees Earned, as shown below.

Entry D

Throughout the month, NetSolutions incurred the following expenses: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275. To simplify the illustration, the entry to journalize the payment of these expenses is recorded on November 30 (transaction e), as shown below. This transaction increases various expense accounts and decreases an asset account.

Entry E

Regardless of the number of accounts, the sum of the debits is always equal to the sum of the credits in a journal entry. This equality of debts and credits for each transaction is built into the accounting equation: Assets = Liabilities + Owner's Equity. It is also because of this double equality that the system is known as double-entry accounting.

On November 30, NetSolutions recorded the amount of supplies used in the operations during the month (transaction g).This transaction increases an expense account and decreases an asset account. The journal entry for transaction (g) is shown below.

Entry G

The general rules of debit and credit for analyzing transactions affecting income statement accounts are stated as follows:

The rules of debit and credit for income statement accounts may also be summarized in relationship to the owner's equity in the accounting equation, as shown below.

Withdrawals by the Owner

The owner of a proprietorship may withdraw cash from the business for personal use. This is common practice for owners devoting full time to the business, since the business may be the owners main source of income. Such withdrawals have the effect of decreasing owner's equity. Just as decreases in owner's equity are recorded as debits, increases and withdrawals are recorded as debits. Withdrawals are debited to an account with the owner's name followed by Drawing or Personal.

In transaction (h), Chris Clarke withdrew $2,000 in cash from NetSolutions for personal use. The effect of this transaction is to increase the drawing account and decrease the cash amount. The journal entry for transaction (h) is shown below.

Entry H

Normal Balances of Accounts

The sum of the increases recorded in an account is usually equal to or greater than the sum of the decreases recorded in the account. For this reason, the normal balances of all accounts are positive rather than negative. For example, the total debits (increases) in an asset account will ordinarily be greater than the total credits (decreases). Thus, asset accounts normally have debit balances.

The rules of debit and credit and the normal balances of the various types of accounts are summarized as follows:

When an account normally having a debit actually has a credit balance, or vice versa, an error may have occurred or an unusual situation may exist. For example, a credit balance in the office equipment account could result only from an error. On the other hand, a debit balance in an accounts payable account could result from an overpayment. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 12TH ED., PP. 50-55*

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