Capturing Economic Events

Capturing Economic Events

This chapter  introduces the concepts of debit and credit, and demonstrates bookkeeping activities. After studying Chapter 3 you should be able to:

• Prepare common journal entries
• Post to the Ledger accounts
• Prepare a basic Income Statement

Accounting Cycle - sequence of procedures used to record, classify and summarize accounting information in financial reports, on a regular basis.

Steps in the Accounting Cycle

1) Record (journalize) transactions.
2) Post journal entries to Ledger accounts.
3) Prepare a Trial Balance.
4) Make adjusting entries.
5) Prepare an Adjusted Trial Balance.
6) Prepare financial statements.
7) Journalize and post closing entries.
8) Prepare After-Closing Trial Balance.

General Journal and Journal Entries

Every business transaction is recorded in the General Journal. 
The General Journal is called the book of original entry. 
A journal is a chronological record of transactions - they are in date order.
Each entry is called a journal entry, and represents a different business transaction. Each transaction is recorded once, and only once.
All journal entries follow the rules of debit and credit.

Journal entries should be made contemporaneously with the event they are recording, or reasonably soon after the event. Keep in mind that a journal is a chronological record of events. A contemporaneous writing is one that takes place at the same time as the event. This is the best time to record an event, because the facts and details are still fresh in our minds. Necessary documents, conversations, calculations, etc., are readily available to create a correct record of the event. If we wait too long, the event will be much more difficult to reconstruct. 

In a legal sense, a contemporaneous writing carries much more weight than a writing made at a later date. And a writing carries much more weight than a mere 
recollection of events, months or years after the event has taken place. The courts recognize that people's memories about events are much clearer right after the event has taken place. As to the sale of real estate, state laws require a contemporaneous writing, to establish the exact terms and conditions of the sale. In contract law, this is called a �meeting of the minds,� and must be present for a valid contract to exist. 

We will use verifiable, tangible evidence whenever it exists. Tangible evidence has physical existence � we can touch it, fold, staple, copy and file the document. We will look for a check, invoice, purchase order, contract or other business document that is a record of the event, a confirmation of payment received and goods delivered, etc. These documents become the back-up documentation for our journal entry. 
 

General Ledger
Transactions are classified into accounts appropriate to the business.
Accounts represent major classifications, or categories, organized according to the 5 account types covered in Chapter 2. The accounts are listed in a Chart of Accounts.

Posting - journal entries are copied to the accounts in the Ledger. 
After posting, the balance in each account is updated. Accounts always carry the most current balance.

Balances in Ledger accounts  ==become==>  Financial Statements

Books & Bookkeeping
Journals and Ledgers were historically written in by hand. They were actual books, which is where many of the terms we use come from. Terms like bookkeeping, journal, balanced books, etc. all came from the days of manually recording entries in books.

Today we use computers to do the same job, but the terminology is usually the same. The concepts we follow are identical whether we use a manual or computer based accounting system. We will use the rules of debit and credit, enter transactions into the Journal, and post to the Ledger.

Debits and Credits
Journals and Ledgers can be viewed as pages of a book. Each page has lines and columns. A journal page has columns for the date, account name, and two columns for dollar amounts, referred to as the Debit and Credit columns.

Caution!! Do not confuse the concepts of debit and credit we use here, with what you read in your bank statement. Banks copy their records, and send them to you. It reflects your bank account, from the bank's perspective - which is opposite of your perspective, in an accounting sense. 

The Ledger page has an additional column to calculate the balance in the account. The balance is updated after each entry. 

A Credit balance is usually indicated by enclosing the number in parentheses: 
$ (500) would indicate a $500 Credit balance. 

The Dollar Sign $ is usually omitted in actual practice. We will always assume that we are using the US Dollar in all transactions, journals, ledgers and financial statements.

Entries are transferred (Posted) from the journal to the ledger pages on a regular basis. 

When do we use Debit or Credit?
When to use a debit or credit to record a journal entry is one of the biggest problems for beginning accounting students. It doesn't have to be difficult, if you remember a few simple rules.

First, you will always use both a debit and credit. That's the idea of the double-entry system. You have two columns, so every journal entry will have an equal dollar amount in each column. 

Remember the Accounting Equation?

Accounts on the Left side will INCREASE with a Debit (Left column) entry.
Accounts on the Right side will INCREASE with a Credit (Right column) entry.
They will each DECREASE with the OPPOSITE entry.

Refer to the Chart of Accounts to determine whether an account falls on the Left or Right side of the Accounting Equation. You will learn more about how this works as the course progresses. The textbook has many good examples.

Normal Account Balances
Accounts have a normal balance - the balance they would have if increases to the account are more than decreases to the account. If the account has a balance opposite its normal balance, we say the balance is negative, in relation to what it should be. Negative in this sense does not refer to debits or credits, but to a normal or negative balance, regardless of whether that is a debit or credit balance.

You will save a lot of time making journal entries if you remember the normal balance for the accounts. 

If you are recording a sale, or other income transaction, you would credit the revenue account, and debit some other account (cash or accounts receivable). If you are recording an expense, you would debit the expense account, and credit some other account.

Many transactions are so common it's easier to remember them, rather than try and think them through each time you have to record them. If you remember how to record one side of the journal entry it is fairly easy to figure out the other side from the information given, e.g.. cash sale v. credit sale. 
 

If you refer to these charts in the beginning it will writing journal entries much easier. Soon you won't have to refer to your charts any more.
 

A funny accounting story (yes, there are accountant jokes)
A young accountant often asked his boss for advice in writing journal entries. The boss would always open his desk drawer, look at something for a moment and then tell the young accountant how the make the correct journal entry. This went on for many years.

Finally the old accountant was ready to retire. The younger accountant asked the old man, "I don't know what I'm going to do without you. Whenever I've had a question you always knew the answer. What will I do when you're gone? And what's in your desk drawer? Every time I ask for advice you look in there?"

The old accountant took the younger one into his office and opened his desk drawer. There was a 3" x 5" index card. It said: "Debits on the Left, Credits on the Right"
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When you are just learning how to make journal entries, a little reminder or hint can make the task much easier. Don't try and reason out every journal entry. If you are going to replace the oil in your car, you don't have to know everything about how the engine works. You only have to find the one bolt to turn to let the oil out. Don't make the job any more difficult than it is. 

As an accounting student I kept these little reminders around all the time. As a professional I've done the same thing, except with more complex issues. This is just good practice. Many of the tasks we do are very mechanical in nature. Follow a few simple rules, refer to the hints and tips. 

About my student, Al (a true story)
I taught at the Columbia College Jefferson City, MO Campus for several years. We had an administrative assistant there who enrolled in my accounting course. His name was Al (I didn't change the name, you know who you are ;-)

Al struggled for 7 weeks trying to understand debits & credits, and how it all fit together. Along about week 8 he was sweating bullets, and not at all comfortable about taking the comprehensive final. All sat in the front row. About the middle of the next to last class he sat up and loudly proclaimed, "I get it! I get it! I understand how it all works." He aced the final, and the course.

And then there was Mary (another true story)
Mary was another student (I did change her name). She was a last semester senior, and needed accounting for her business major. This was her third attempt, and we were all hoping 3 would be a charm. At the end of the first week she told me her story, and said she had trouble with the terminology. 

Mary worked in the real estate field, and had associated the term "equity" with "real property." In her mind, this was a correct association, and perhaps common slang in her office. If you look up the word equity in the dictionary, there is no association with real property. Mary was working under an incorrect definition.

In accounting real property falls under the Asset category, and equity specifically refers to Owners' Equity - the owners' claim to the business assets. This is also a dictionary definition. But Mary never could get past her own personal (incorrect) definition of equity. She dropped the course, and changed her major. She was looking at a minimum of 2 more years in school, because she got hung up on one definition.

I'm telling these stories for two reasons. First you might be another Al. The concepts we use may seem a little strange at first. But most students catch on, and usually long before the 8th week. And second, to make you aware that each discipline you study in college has its own vocabulary, terms and concepts. Some of them may be very unique to that particular field of study, and the terms may not apply anywhere else. 

In the field of accounting, our terminology IS widely used. Millions of people use the same terms and concepts daily to mean the same thing. This is part of the concept of "generally accepted" - the part of GAAP that refers to common practices. Take a little time to understand the terminology you learn in this course, and it will help you for many years to come. 

Accounting is nothing more than a way to organize information, so it is useful to people who have to make financial and business decisions. A large number of people use the same concepts, methods, etc. on a daily basis. You can too. 

Easy Method to journal entries.
Follow these simple steps. Ask yourself these questions:

1) Is Cash used in this transaction? Cash is your first Asset account, it falls on the Left side of the equation, and will be used very often. It is easy to remember the rules for the Cash account: Debit = Increase; Credit = Decrease.

2) Was Cash received or paid?

Cash Received = Increase = Debit Column = Left Column

Cash Paid = Decrease = Credit Column = Right Column

Decide whether Cash belongs in the Debit or Credit column, write the word "Cash" in the Account column, and the dollar amount in the Debit or Credit column. You are now half way done with the journal entry.

3) Enter the balancing dollar amount in the opposite column as Cash.
You  don't need to worry about the other account title yet. Remember that a double-entry journal entry needs equal dollar amounts in the Debit and Credit column for each journal entry. Make that dollar entry now, and you're 75% done.

4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part of the journal entry. Use account titles exactly as they appear in the Chart of Accounts. Don't get creative and make up account titles. If you want to be creative take an art class. (hee, hee... just kidding ;-) 

5) If Cash was not used you can substitute "Cash" temporarily where it would go IF it had been used in the transaction. For instance, suppose you are at a restaurant. You could pay in cash, or charge the meal on a credit card. Either way you have paid for a meal, and the journal entry will be very similar. So you can pencil in the word "cash" lightly where it would go. After you finish the journal entry, refer to the Chart of Accounts and replace "cash" with the appropriate account, which will usually end with "Payable" or "Receivable" such as Accounts Payable, Interest Receivable, etc.

..............
The Cash account is equivalent to the company's checking account. The balance goes up when money is deposited in the account, and the balance goes down when checks are written. It works just like your checking account!

So now you know that Cash is an Asset account, is on the Left side of the accounting equation, and the balance can go up or down. The rules you use for the Cash account will be the same for all asset accounts. Now you know how to make journal entries for all asset accounts. Wasn't that easy?

Liability and Owners' Equity accounts are on the Right side of the Accounting Equation, and they follow the OPPOSITE rules as the Cash account. Now you know how to make journal entries for all those accounts! Wasn't that easy, too?

So if you can remember one thing, how the Cash account works, you can easily figure out each and every other account. Since there are only 2 sides to the Accounting Equation, there are only 2 possibilities. Pretty simple.

..............
Let's try an easy example using my simple system. 
Some transactions are routine and happen very frequently. It helps to know these, because they represent 99% of the total journal entries a company will make. All companies earn some sort of revenue, so let's look at a sale transaction:
March 20, the company made a cash sale for $100. 

1) Is Cash used in this transaction? Yes.
2) Was Cash received or paid? Received.  [Increase = Debit Column]
--- enter the Cash portion of the journal entry
 

The date always starts a journal entry. Enter the month once on a page, and put the day in front of each journal entry on the page, even if they are all on the same date. The day indicates the beginning of a new journal entry. You should also leave one or two blank lines between journal entries on a page.

3) Enter the balancing dollar amount in the opposite column from Cash.
 

4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. This is a sale, so we will use Sales Revenue for the Credit side of the journal entry.
 

The journal entry is in balance, and is complete. The textbook will show that a memorandum can be entered on the line below the journal entry. This should be additional information that is not contained in the journal entry itself; information that will be useful when trying to reconstruct events at a later date.

..............
Another example. April 1, the company paid rent $500.
1) Is Cash used in this transaction? Yes.
2) Was Cash received or paid? Paid.  [Decrease = Credit Column]
--- enter the Cash portion of the journal entry
3) Enter the balancing dollar amount in the opposite column as Cash. 
 

Note that it is customary to enter the debit part first, and the credit entry second. The credit entry account title is indented, to help set it off from the debit account titles. These practices are used to make the journal entry easier to read, and reduce errors in posting.

4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. This is an example of paying an expense, in this case Rent Expense. 
 

1) Is Cash used in this transaction? No.  [We will use the substitution method]
2) If Cash were used...Would it be received or paid? Paid.  [Decrease = Credit Column]
--- enter the "cash" portion of the journal entry.
Pencil "cash" in lightly, you will replace it later with the correct account title.
3) Enter the balancing dollar amount in the opposite column.
 

Notice that I have roughed in the structure of the journal entry, but the actual accounts have not been entered yet.

4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. This is an example of buying equipment, in this case we will use the account Office Equipment. 

5) Refer to the Chart of Accounts and replace "cash" with the appropriate account, which will usually end with "Payable" or "Receivable" such as Accounts Payable, Interest Receivable, etc. 

In this case we will use Accounts Payable, one of the most frequently used accounts. Accounts Payable is used to refer to most of the common, day-to-day debts and current liabilities that a company incurs. It is short-term debt, meant to be paid soon, like the phone bill, utility bill, etc. 
 

These are all examples of simple journal entries. There is one debit and one credit. Some transactions might involve more then two accounts, and we would use three or more lines to write those entries. These are called compound journal entries (or complex journal entries). There is no limit to the number of debit or credit accounts that can be included in a journal entry. All necessary accounts will be used. The journal entry will balance, regardless of the number of accounts used. 

Let's try an example of a compound journal entry. June 5, the company buys building and land for $100,000. They make a down payment of $20,000 and sign a mortgage note with their bank for the balance. An appraisal shows the land alone has a value of $10,000.

1) Is Cash used in this transaction? Yes & No.  [We will use the substitution method along with Cash]
2) If Cash were used...Would it be received or paid? Paid.  [Decrease = Credit Column]
--- enter the Cash portion of the journal entry. We will use Notes Payable to enter the $80,000 we borrowed from the bank, on its own line, but on the same side as Cash - the Credit side in this case.
 

3) Enter the balancing dollar amount in the opposite column.
4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. I left 2 blank lines above, because I knew we had both land and a building, which must be entered separately.
 

In this example I have totaled the columns to show that the journal entry is in balance. In real accounting systems a total is only drawn at the bottom of the page, not after each journal entry.

Here's another example of a compound journal entry. This one also shows how to record the issue of common stock, a very important journal entry to know. On May 1, Bill, Bob and Quinn create a new corporation, BBQ, Inc. They raise capital in the company by selling 10,000 shares of Common Stock for $5 per share. The common stock has a Par value of $1 per share.

1) Is Cash used in this transaction? Yes. The organizers are raising initial capital to start a new company. If the stock were sold on a stock exchange this would be referred to as an IPO (Initial Public Offering).
2) If Cash were used...Would it be received or paid? Received.  [Increase = Debit Column]
--- enter the Cash portion of the journal entry. They sold 10,000 shares of stock at $5 per share, so they have raised 10,000 x $5 = $50,000.
 

3) Enter the balancing dollar amount in the opposite column.
4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. 
Common stock is recorded as a credit to the Common Stock account. It is recorded at Par value, in this case $1 per share. So 10,000 x $1 = $10,000.
 

The journal entry is out of balance and we need to finish it up. Any excess raised by the sale of stock is credited to the Additional Paid-In Capital account. 
 
 

This is a good example of an important journal entry every accountant and bookkeeper should know. We don't use it very often, but it's important to know how to make this type of journal entry. 

A word about issuing stock.
Each state has slightly different laws regarding corporations. Most states permit Par value stock, and some have a Legal Capital rule, forcing corporations to maintain tangible capital equal to the Legal Capital. This is in place to protect stockholders. Some states permit No-Par stock. 

States also allow Preferred stock, which pays a fixed dividend, similar to an interest-bearing investment. Preferred stock usually has a Par value, and is recorded as in the example above, except the Preferred Stock account is used. Some company's maintain a separate account Additional Paid-In Capital on Preferred Stock, but Additional Paid-In Capital usually reverts to the Common stockholders, regardless of it's source.

Posting to the Ledger
Journal entries must be posted to the Ledger accounts on a regular basis. In many computer based systems this is done automatically, when journal entries are made. In a manual system, and some computer systems, the journal entries are posted on a daily, weekly or monthly basis, called "batch posting." 

When you Post, you simply take each line from the journal entries, and transfer the amounts to the corresponding Ledger accounts. You have to be very careful to post all journal entries, get the dollar amounts right, and enter them in the correct column of the correct account. Needless to say, in a manual system errors do get made. 

Posting is actually a routine and mechanical procedure. 

Using T-Accounts
You will see many examples of T-Accounts in your textbook. A T-Account is just a simple way to represent a Ledger account. It's handy for accounting students, because you can make quite a few T-Accounts on one page, and post journal entries quickly. This makes it easier to do homework assignments or analyze transactions.

Most of your homework assignments will only use a few accounts, and there will only be one or two entries to each account. You can make 3 T-Accounts across a page, and several rows down the page. The Cash account should be larger than the rest, since it will have quite a few entries in most assignments.

When you post to T-Accounts, make a large T and write the name of the account above it. Write the Debit entries on the left half of the T, and Credit entries on the right side of the T. I usually draw a line underneath the entries, net all the entries together, and put the balance on the correct side of the T below the line. 

The Income Statement
Relates to a period of time.
Revenue - the price of your goods and services
Expenses - costs incurred in earning revenue

Net Income - the excess of Revenue over Expenses, on the Income Statement
Net Loss - the excess of Expenses over Revenue, on the Income Statement

Net Income is synonymous with Net Profit. 

Debit and Credit Rules
Revenues = Credit Entry
Expenses = Debit Entry

All revenue and expense entries follow these simple rules. The opposite side entry is usually made only to correct an error in an earlier journal entry. This is true of all income statement accounts. 

Many balance sheet accounts tend to increase and decrease on a regular basis. Cash, Inventory, Accounts Receivable, Supplies, Accounts Payable all change on a frequent basis. Income statement accounts only increase, and do so according the the rules above. It is really easy to remember this simple rule. 

..... Revenue .....
Example February 3, the company makes a credit sale of $250. 
 

Example February 5, the company makes a cash sale of $250. 
 

These two entries are almost identical. Notice that Sales Revenue is on the Credit side in both entries. Remember this and it will make all your journal entries easier. When you record a revenue you will put it on the Credit side.

..... Expenses .....
Example February 1, the company pays rent, $500. 
 

Example February 5, the company has an service company clean their office every week. The fee is $100 each week, and the bill is paid at the end of the month. This is the first time the office has been cleaned this month.
 

These are both examples of an Expense entry. The expense part is always in the Debit column. You will list it first, and then either Cash or Accounts Payable. An entry to record Payroll Expense would credit Wages Payable. An entry to record Interest Expense would credit Interest Payable. These are special payable accounts. Most common business expenses will credit Accounts Payable or occasionally Cash.

When to record Revenue
Realization Principle - at the time goods are sold or services are rendered.

When to record Expenses
Matching Principle - offsetting expenses against revenues in the appropriate time period. For instance, the bill for June's long distance phone calls is paid in July. The long distance expense should show up on the June income statement.