Accounting: The Language of Business (Part 9)

“Never call an accountant a credit to his profession; A good accountant is a debit to his profession.” —Unknown

Analyzing Transactions (Part A)

by

Charles Lamson

Assume that you have been hired by a pizza restaurant to deliver pizzas, using your own car. You will be paid $6 per hour plus $0.30 per mile plus tips. What is the best way for you to determine how many miles you have driven each day in delivering pizzas?

One method would be to record the odometer mileage before work and then at quitting time. The difference would be the miles driven. For example, if the odometer read 56,743 at the start of work and 56,889 at the end of work, you would have driven 146 miles. This method is subject to error, however, if you copy down the wrong reading or make a math error.

In the same way, business managers need information about the status of the business at different points in time. Such information is useful for analyzing the effects of transactions on the business for making decisions. For example, the manager of your neighborhood dry cleaners needs to know how much cash is available, how much has been spent, and what services have been provided.

In the preceding parts of this analysis, we analyzed and recorded this kind of information by using the accounting equation, Assets = Liabilities + Owner's Equity. Since such a format is not practical for most businesses, in the next several posts we will study more efficient methods of recording transactions. We will conclude this group of posts by discussing how accounting errors may occur and how they may be detected by the accounting process. 

Usefulness of an Account

Before making a major purchase, such as buying a digital camera, you need to know the balance of your bank account. Likewise, managers need timely, useful information in order to make good decisions about their businesses.

How are accounting systems designed to provide this information? We illustrated a very simple design in the preceding posts, where transactions were recorded and summarized in the accounting equation format. However, this format is difficult to use when thousands of transactions must be recorded daily. Thus, accounting systems are designed to show the increases and decreases in each financial statement item in a separate record. This record is called an account. For example, since cash appears on the balance sheet, a separate record is kept of the increases and decreases in cash. Likewise, a separate record is kept of the increases and decreases for supplies, land, accounts payable, and the other balance sheet items. Similar records would be kept for income statement items, such as fees earned, wages expense, and rent expense.

A group of accounts for a business entity is called a ledger. A list of the accounts in the ledger is called a chart of accounts. The accounts are normally listed in the order in which they appear in the financial statements. The balance sheet accounts are usually listed first, in the order of assets, liabilities, and owner's equity. The income statement accounts are then listed in the order of revenues and expenses. Each of these major account classifications is briefly described below.

Assets are resources owned by the business entity. These resources can be physical items, such as cash and supplies, or intangibles that have value, such as patent rights. Some other examples of assets include accounts receivable, prepaid expenses (such as insurance), buildings, equipment, and land.

Liabilities are debts owed to outsiders (creditors). Liabilities are often identified on the balance sheet by titles that include the word payable. Examples of liabilities include accounts payable, notes payable, and wages payable. Cash received before services are delivered creates a liability to perform the services. These future service commitments are often called unearned revenues. Examples of unearned revenues are magazine subscriptions received by a publisher and tuition received by a college at the beginning of a term.

Owner's equity is the owner's right to the assets of the business. For a proprietorship, the owner's equity on the balance sheet is represented by the balance of the owner's capital account. A drawing account represents the amount of withdrawals made by the owner.

Revenues are increases in owner's equity as a result of selling services or products to customers. Examples of revenues include fees earned, fares earned, commissions revenue, and rent revenue.

The using up of assets or consuming services in the process of generating revenues results in expenses. Examples of typical expenses include wages expense, rent expense, utilities expense, supplies expense, and miscellaneous expense.

A chart of accounts is designed to meet the information needs of a company's managers and other users of its financial statements. The accounts within the chart of accounts are numbered for use as references. A flexible numbering system is normally used, so that new accounts can be added without affecting other account numbers.

Exhibit 1 is NetSolution's chart of account that we will be using in the next several posts. Additional accounts will be introduced in later posts. In Exhibit 1, each account number has two digits. The first digit indicates the major classification of the ledger in which the account is located. Accounts beginning with 1 represent assets; 2, liabilities; 3, owner's equity; 4, revenue; and 5, expenses. The second digit indicates the location of the account within its class.

EXHIBIT 1 Chart of Accounts for NetSolutions

Characteristics of an Account

An account, in its simplest form, has three parts. First, each account has a title, which is the name of the item recorded in the account. Second, each account has a space for recording increases in the amount of the item. Third, each account has a space for recording decreases in the amount of the item. The account form presented below is called a T account because it resembles the letter T. The left side of the account is called the debit side, and the right side is called the credit side.

Amounts entered on the left side of an account, regardless of the account title, are called debits to the account. When debits are entered in an account, the account is said to be debited (or charged). Amounts entered on the right side of an account are called credits, and the account is said to be credited. Debits and credits are sometimes abbreviated as Dr. and Cr.

In the cash account that follows, transactions involving receipts of cash are listed on the debit side of the account. The transactions involving cash payments are listed on the credit side. If at any time the total of the cash receipts is needed, the entries on the debit side of the account may be added and the total ($10,950) inserted below the last debit (This amount, called a memorandum balance, should be written in small figures or identified in some other way to avoid making the amount for an additional debt). The total of the cash payments, $6,850 in the example, may be inserted on the credit side in a similar manner. Subtracting the smaller sum from the larger, ($10,950 - $6,850), identifies the amount of cash on hand, $4,100. The amount is called the balance of the account. It may be inserted in the account, next to the total of the debit column. In this way, the balance is identified as a debit balance. If a balance sheet were to be prepared at this time, cash or $4,100 would be reported. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 48-50*

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