Chapter 2



Chapter 2

T Accounts, Debits, and Credits

In this chapter you will continue learning about the process of accounting. You will see how the accounting system maintains the equality of the accounting equation.

The Accounting Equation

As discussed in Chapter 1, resources and where they come from are at the heart of modern financial accounting systems. In business terminology, resources are called assets. Sources of borrowed resources are called liabilities. Sources of resources invested by owners and generated by management and retained in the company are called stockholders' equity. The relationship between resources and their sources is represented by the accounting equation:

|Assets |= |Liabilities |+ |Stockholders' Equity |

Remember, stockholders' equity includes both the dollar amount of resources invested by owners and the dollar amount of resources generated through management operations and retained in the company because owners have a right to the amount of resources they invest and the amount of resources generated by management.

The correct use of the accounting equation guarantees logical financial statements even if events are incorrectly analyzed. That is, as long as the equality of assets to liabilities plus stockholders' equity is maintained, the income statement will properly relate to the statement of retained earnings, the statement of retained earnings will properly relate to the balance sheet, and the balance sheet will balance. If the accounting equation does not balance, the balance sheet will not balance. If the financial statements are not logical, they cannot be relied upon for information about a company's resources.

Logical financial statements do not automatically contain useful information, however. Maintaining the equality of the accounting equation is necessary for useful financial statements, but it is not the only requirement. This and the following chapters will examine the requirements of accounting systems that produce useful information.

** You now have the background to do exercise 2.1.

Maintaining the Equality

of the Accounting Equation

In order for the accounting system to provide useful information, one important requirement is that the accounting equation must always balance. Thus, it is imperative we have a system that will constantly maintain the accounting equation's equality.

Remember the system examined in Chapter 1. In that system we analyzed events of the Parks Computer Service Corporation, determined the effects of the events on specific resources, such as cash and supplies, and sources of resources, such as accounts payable and retained earnings. We used a plus (+) sign to show an increase in an account or a minus (-) sign to show a decrease. In order to determine if the accounting equation was in balance we had to take the following two steps.

Step 1: First we had to determine the balance in each account. For example, to determine the cash balance we had to add all of the plus dollar amounts and subtract all of the minus dollar amounts in the cash account.

Step 2: Once we determined the balance in each account, we had to add all the asset account balances to determine the total assets dollar amount, and then add all the liabilities and stockholders' equity account balances to determine the total liabilities and stockholders' equity dollar amount.

After taking these two steps we could determine if total assets equaled total liabilities and stockholders' equity. Until we completed both steps, we could not be sure the accounting equation was in balance.

What we need is a more efficient way to make sure the accounting equation is always in balance. We need a system that will maintain the balance of the accounting equation without requiring each account balance to be determined and without requiring total assets and total liabilities and stockholders' equity to be calculated after each event.

A more efficient way of maintaining the equality of the accounting equation was developed hundreds of years ago and is known as the double-entry system. It was first presented in a book written in 1494 by a Franciscan monk, Fra Luca Pacioli.

The double-entry system was developed in response to the mathematical problem: how can individual items in the accounting equation change while always maintaining the assets = liabilities + stockholders' equity equation? Today the solution appears to be quite simple. If the left side of the equation (assets) increases, then the right side (liabilities and stockholders' equity) must also increase by the same dollar amount. Similarly, if the left side of the equation decreases, the right side must also decrease by the same dollar amount. From this reasoning, the following simple guidelines evolved.

If an asset increases, one of the following must occur:

(1) another asset must decrease by the same amount. As a result, total assets remain constant and assets = liabilities + stockholders' equity. For example, if supplies increase by $50 and cash decreases by $50, total assets remain unchanged. The accounting equation is still in balance.

(2) a liability must increase by the same amount. As a result, total assets and total liabilities increase by the same amount and assets = liabilities + stockholders' equity. For example, if supplies increase by $125 and accounts payable increase by $125, total assets increase by $125 and total liabilities and stockholders' equity increase by $125. The accounting equation is still in balance.

(3) stockholders' equity must increase by the same amount. As a result, total assets and total stockholders' equity increase by the same amount and assets = liabilities + stockholders' equity. For example, if cash increases by $1,000 and common stock increases by $1,000, total assets increase by $1,000 and total liabilities and stockholders' equity increase by $1,000. The accounting equation is still in balance.

From this basic mathematical process, it can be concluded that each event affecting a business has two parts. One part results in a change in one asset, liability, or stockholders' equity account and the other part results in an equal change in another asset, liability, or stockholders' equity account. It is impossible for an event to result in only an increase or decrease in one account, because the result would be an unbalanced accounting equation. For example, if cash increased by $100 and everything else remained unchanged, assets would no longer equal liabilities plus stockholders' equity. Assets would be $100 larger than liabilities plus stockholders' equity. Remember from Chapter 1, an unbalanced accounting equation results in unreliable information.

The T Account

The basic element of the double-entry system is the T account. T accounts are used to record each event's two parts discussed in the previous paragraphs. As you can see from the illustration below, it is fairly obvious where the name T account came from: the account strongly resembles the letter T. The left side of a T account is called the debit side (from the Latin debere) and the right side is the credit side (from the Latin credere). Remember, this system and its terminology have been in existence for hundreds of years!

| | | |

| |Account Name | |

| |Debit |Credit | |

| |(Left side) |(Right side) | |

| | | | |

The double-entry system makes use of the T account to make sure both parts of each event are accounted for. Remember, when both parts of each event are accounted for, the accounting equation must balance, as the following section illustrates.

Using T Accounts

To see how the double-entry system makes use of T accounts, let us again consider the July events of the Parks Computer Service Corporation discussed in Chapter 1. We will see how the double-entry system guarantees the accounting equation is always in balance.

Getting resources from the owner On July 1, Nick Parks invests $5,000 cash in his new company, Parks Computer Service Corporation. Nick invests his cash by opening a checking account in the company's name at the Somerville National Bank. As you remember from Chapter 1, an owner's $5,000 cash investment in a company results in a $5,000 increase in the company's resources and a $5,000 increase in its sources of resources. The resource that increases is cash. Since the resource comes from the owner, the source of resources that increases is stockholders' equity, in this case common stock.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|+ $5,000 |= | | |+ $5,000 | | |

|Event | |Cash |= | | |Common Stock |

|Owner's cash | | | | | | | | | |

|investment | |5,000 | | | | | | |5,000 |

| | |[- $5,000 -] |= |[---------- $5,000 ---------] |

Notice the $5,000 increase in cash was entered on the left, or debit, side of the cash T account. In other words, the $5,000 was entered as a debit to cash. Since this is the first event we analyzed, we could have entered it as either a debit or a credit. Since we entered it as a debit, we have developed an accounting rule: assets increase through debits. Notice, however, the increase in common stock was entered as a credit (right side) to the common stock account. We have just developed another accounting rule: stockholders' equity increases through credits. The two rules we developed agree with the accounting process used in modern financial accounting systems.

Why did we enter the increase in assets as a debit and the increase in stockholders' equity as a credit? Remember what we are trying to do. We are trying to develop a system that will constantly maintain the equality of the accounting equation after each event. Does entering equal dollar amounts of debits and credits keep the accounting equation in balance? Consider this first event of the Parks Computer Service Corporation. Cash was debited for $5,000 and common stock was credited for $5,000. Clearly, debits equaled credits: debits were $5,000 and credits were $5,000. Did assets = liabilities + stockholders' equity? After the event, assets (cash) were $5,000 and liabilities + stockholders' equity (common stock) were $5,000. Thus, using the double-entry method of recording equal dollar amounts of debits and credits enabled us to easily maintain the equality of the accounting equation!

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Stockholders’ equity increases through credits.

Using resources to buy other resources On July 3, the company pays $25 cash for supplies to be used to repair and service computers. This event both increases the company's resources when the supplies are bought and decreases its resources when the cash is paid. The supplies resource increases and the cash resource decreases. Since total resources do not change, total sources of resources do not change.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,000 |= | | |$5,000 | | |

|+ $25 | | | | | | |

The company's supplies account increases by $25 while its cash account decreases by $25. These effects would be shown in the company's T accounts as follows.

| | | | | | |Stockholders' |

| | |Assets |= |Liabilities |+ |Equity |

|Event | |Cash |+ |Supplies |= | | |Common Stock |

|Owner's cash | | | | |

|investment | |5,000 | | |

Notice the $25 increase in supplies was recorded as a debit (left side) to the supplies account. This agrees with the rule we developed earlier, that assets increase with debits. But what about the decrease in cash? If assets increase with debits, should they decrease with credits? This seems logical and it is the reason the cash account was credited (right side) for $25 above. We have just developed another accounting rule: assets decrease through credits.

After we entered debits and credits of $25 each, does our accounting equation still balance? After the supplies purchase, the company has assets of $5,000 (cash of $4,975 and supplies of $25) and liabilities and stockholders' equity of $5,000 (common stock). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

Notice also in the above cash account, the $4,975 debit balance resulted from subtracting the $25 credit from the $5,000 debit. The $4,975 balance is shown as a debit because the debit dollar amounts total ($5,000) was greater than the total credit dollar amounts ($25). If the credit dollar amounts total had been larger than the total debit dollar amounts, the balance would have been shown as a credit balance.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Stockholders’ equity increases through credits.

Borrowing resources On July 7, the company buys additional supplies of $135. The company does not immediately pay cash for the supplies, but agrees to pay cash within the next 30 days. When the Parks Computer Service Corporation buys the supplies by agreeing to pay for them later, its resources and sources of resources both increase by $135. The supplies resource increases. Since the supplies are not paid for immediately, the source of resources that increases is liabilities, in this case accounts payable. Remember, since the company does not pay for the supplies immediately, in effect they are borrowed.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,000 |= | | |$5,000 | | |

|+ $135 |= |+ $135 | | | | |

As the company buys supplies, its assets increase. Assets increase with debits, so the supplies T account should show a $135 debit. Because the supplies must be paid for in the future, the liability accounts payable should also be increased. Using the debits equal credits rule and remembering we have already debited supplies for $135, the accounts payable T account should show a $135 credit, which represents an increase in the account. We have just developed another accounting rule: liabilities increase through credits. The result of this transaction can be seen as follows.

| | | | | | |Stockholders' |

| | |Assets |= |Liabilities |+ |Equity |

| | | | | | |Accounts | | |

|Event | |Cash |+ |Supplies |= |Payable |+ |Common Stock |

|Owner's cash | | | | |

|investment | |5,000 | | |

After we entered debits and credits of $135 each, does our accounting equation still balance? After the supplies purchase, the company has assets of $5,135 (cash of $4,975 and supplies of $160) and liabilities and stockholders' equity of $5,135 (accounts payable of $135 and common stock of $5,000). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Stockholders’ equity increases through credits.

Generating resources through management operations On July 10, Nick advises a customer on the customer's needs for a computer system. In return for this service, the Parks Computer Service Corporation receives $200 cash. The act of providing service to a customer and receiving cash increases the company's resources and sources of resources by $200. The cash resource increases. Since the cash came from the efforts of management, the source of resources that increases is stockholders' equity, in this case retained earnings. Remember, owners have rights to resources generated by management and owners' rights are shown in stockholders' equity.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,135 |= |$135 |+ |$5,000 | | |

|+ $200 |= | | | | |+ $200 |

When the company receives the cash, its assets (cash) increase and its stockholders' equity increases through retained earnings. Since assets increase with debits, the cash account should now show a debit of $200. Because stockholders' equity increases with credits, the retained earnings account should show a credit of $200. These effects can be seen below.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | | |

|Event | |Cash |+ |Supplies |

Once we entered debits and credits of $200 each, our accounting equation still balances. After providing the service, the company has assets of $5,335 (cash of $5,175 and supplies of $160) and liabilities and stockholders' equity of $5,335 (accounts payable of $135, common stock of $5,000, and retained earnings of $200). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

In business terminology, when assets (resources) increase through the process of providing services to customers, the increase in retained earnings is called a revenue. The $200 increase in retained earnings from providing service to a customer would be called Fees Revenue. As revenues get larger, part of the effect is to increase retained earnings: an increase in revenues is an increase in retained earnings. Remember, revenues increase retained earnings because owners have a right to the additional resources generated by management providing services to customers. In debit and credit terms, how should we record an increase in a revenue? Since revenues increase retained earnings and retained earnings increases with credits, we should record increases in revenues as credits. So now we have developed another rule: revenues increase through credits.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Paying for borrowed resources On July 16, the company pays $70 of the $135 owed for supplies purchased on July 7. The remaining $65 will be paid in August. This cash payment of an amount owed to a supplier reduces the company's resources and its sources of resources by $70. The cash resource decreases. The source of resources that decreases is liabilities, in this case accounts payable. By paying $70 to the supplier, the amount owed to the supplier (accounts payable) decreases by $70.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,335 |= |$135 |+ |$5,000 |+ |$200 |

|- $70 |= |- $70 | | | | |

The company's payment of $70 for supplies purchased earlier in the month reduces the asset cash and reduces the liability accounts payable. Assets increase with debits and decrease with credits. Thus, the $70 cash reduction should appear as a credit. Once we credit cash, we need a debit. As a result, we would show the reduction of accounts payable as a $70 debit. So now we have developed another rule: liabilities decrease through debits.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | | |

|Event | |Cash |+ |Supplies |

Once we entered debits and credits of $70 each, our accounting equation still balances. After paying part of its liability, the company has assets of $5,265 (cash of $5,105 and supplies of $160) and liabilities and stockholders' equity of $5,265 (accounts payable of $65, common stock of $5,000, and retained earnings of $200). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we constantly maintain the equality of the accounting equation.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Liabilities decrease through debits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Generating resources through management operations On July 20, Nick assists in the design of a computer system for another customer. In return for this service, the Parks Computer Service Corporation does not receive cash, but the customer agrees to pay $250 by August 19. The act of performing a service for a customer and receiving a promise of cash increases the company's resources and sources of resources by $250. The resource that increases is accounts receivable. Once again, since the resource comes from the efforts of management, the source of resources that increases is stockholders' equity (retained earnings).

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,265 |= |$65 |+ |$5,000 |+ |$200 |

|+ $250 |= | | | | |+ $250 |

The company's asset accounts receivable increases by $250 and its stockholders' equity account retained earnings increases by $250. Assets increase with debits while stockholders' equity increases with credits. The effects of this event on the company's T accounts can be seen below.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | |Accounts |

|Event | |Cash |+ |Receivable |

After we entered debits and credits of $250 each, our accounting equation still balances. The company now has assets of $5,515 (cash of $5,105, accounts receivable of $250, and supplies of $160) and liabilities and stockholders' equity of $5,515 (accounts payable of $65, common stock of $5,000, and retained earnings of $450). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

Remember, when assets (resources) increase through the process of providing services to customers, the increase in retained earnings is called a revenue. The $250 increase in retained earnings for providing service to a customer would be called Fees Revenue, just like the July 10th event in which $200 cash was received for service to a customer.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Liabilities decrease through debits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Receiving cash from customers On July 25, cash of $100 is received from the customer serviced on July 20. No additional work is done for the client on July 25. This event results in both an increase in the company's resources when the cash is received and a decrease in the company's resources when accounts receivable are reduced. Remember, the client owes the company $100 less after the client pays the $100 to the company. The cash resource increases and the accounts receivable resource decreases. Since total resources do not change, total sources of resources do not change.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,515 |= |$65 |+ |$5,000 |+ |$450 |

|+ $100 | | | | | | |

The receipt of $100 cash from the client increases the company's asset cash and decreases the asset accounts receivable. Because assets increase with debits and decrease with credits, the cash T account should be debited for $100 and the accounts receivable T account should be credited for $100, as reflected below.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | |Accounts |

|Event | |Cash |+ |Receivable |

After we entered debits and credits of $100 each, our accounting equation still balances. The company still has assets of $5,515 (cash of $5,205, accounts receivable of $150, and supplies of $160) and liabilities and stockholders' equity of $5,515 (accounts payable of $65, common stock of $5,000, and retained earnings of $450). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Liabilities decrease through debits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Using up resources in management operations On July 30, Nick examines his supplies and determines that of the $160 supplies purchased, only $110 are still left. In other words, management used $50 of supplies in providing services to customers in July. As a company's supplies are used up, its resources and sources of resources both decrease by $50. The supplies resource decreases. Since the supplies were used up by management, the source of resources that decreases is stockholders' equity, in this case retained earnings. Remember, owners have rights to resources generated by management, but owners are also responsible for resources used up by management. Owners' rights are shown in stockholders' equity.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,515 |= |$65 |+ |$5,000 |+ |$450 |

|- $50 |= | | | | |- $50 |

As the company uses up its supplies, its asset supplies account decreases and its stockholders' equity retained earnings account decreases. Assets increase with debits and decrease with credits. Thus, the $50 supplies decrease should appear as a credit. Once we credit supplies, we need a debit. As a result, we would show the retained earnings reduction as a $50 debit.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | |Accounts | | |

|Event | |Cash |+ |Receivable |+ |Supplies |

| | | | |Accounts |

|Event | |Cash |+ |Receivable |

After we entered debits and credits of $50 each, our accounting equation still balances. The company now has assets of $5,465 (cash of $5,205, accounts receivable of $150, and supplies of $110) and liabilities and stockholders' equity of $5,465 (accounts payable of $65, common stock of $5,000, and retained earnings of $400). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

In business terminology, when assets (resources) are used up in the process of providing services to customers, the decrease in retained earnings is called an expense. The $50 decrease in retained earnings for supplies used would be called Supplies Expense. As expenses get larger, part of the effect is to reduce retained earnings: an increase in expenses is a decrease in retained earnings. In debit and credit terms, how should we record an increase in an expense? Since increases in expenses decrease retained earnings, and retained earnings decreases with debits, we should record increases in expenses as debits. So now we have developed another rule: expenses increase through debits. Be careful with this rule. It is sometimes a difficult one for students to accept.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Liabilities decrease through debits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Expenses increase through debits.

Distributing resources to the owner On July 31, the company pays a $75 cash dividend to its owner. This event results in a decrease in the company's resources and its sources of resources. Cash resources decrease. Since the owner receives the cash, the source of resources that decreases is stockholders' equity, in this case retained earnings. The cash received by the owner reduces the owner's rights to company resources because the owner has taken some resources out of the company. Since owners' rights are shown in stockholders' equity, stockholders' equity decreases.

| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of Management Generated |

|Total Resources |= |Resources |+ |Resources |+ |Resources |

|Assets |= |Liabilities |+ |Stockholders' Equity |

|$5,465 |= |$65 |+ |$5,000 |+ |$400 |

|- $75 |= | | | | |- $75 |

As the company's $75 cash goes to the owner, the company's asset cash account decreases and its stockholders' equity retained earnings account decreases. Assets increase with debits and decrease with credits. Thus, the $75 cash decrease should appear as a credit. Once we credit cash, we need a debit. As a result, we would show the retained earnings reduction as a $75 debit.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | |Accounts |

|Event | |Cash |+ |Receivable |

After we entered debits and credits of $75 each, our accounting equation still balances. The company now has assets of $5,390 (cash of $5,130, accounts receivable of $150, and supplies of $110) and liabilities and stockholders' equity of $5,390 (accounts payable of $65, common stock of $5,000, and retained earnings of $325). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

In business terminology, when assets (resources) that were generated through management operations are distributed to owners, the decrease in retained earnings is called a dividend. As dividends get larger, part of the effect is to reduce retained earnings: an increase in dividends is a decrease in retained earnings. In debit and credit terms, how should we record an increase in a dividend? Since increases in dividends decrease retained earnings, and retained earnings decreases with debits, we should record increases in dividends as debits. So now we have developed another rule: dividends increase through debits. Be careful with this rule, also. It is sometimes a difficult one for students to accept.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Liabilities decrease through debits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Expenses increase through debits.

Dividends increase through debits.

** You now have the background to do exercises 2.2, 2.3, 2.4, and 2.5.

Debits and Credits Summarized

As illustrated in Chapter 1, financial statements are prepared to provide answers to specific questions about company resources. Logical financial statements can be prepared only if the accounting equation, assets equal liabilities plus stockholders' equity, is constantly in balance.

As shown in the previous section of this chapter, the process of converting each event into equal dollar amounts of debits and credits guarantees the accounting equation always balances. Thus, logical financial statements can be generated from accounting systems that maintain the dollar equality of debits and credits for each event.

The debit equals credit process converts each event into debits and credits as follows:

|Account |Debits |Credits |

|Assets |Increases |Decreases |

|Liabilities |Decreases |Increases |

|Stockholders' equity |Decreases |Increases |

|Revenues |Decreases |Increases |

|Expenses |Increases |Decreases |

|Dividends |Increases |Decreases |

Although the above table might appear to require a lot of memorization, in reality, it is actually quite simple. In accounting for the vast majority of business events, all you need to remember are the following:

Point 1. Assets increase with debits

Point 2. Debits = credits

These two points can be easily applied. Consider again the July 1 event in which the Parks Computer Service Corporation receives $5,000 from its owner in return for common stock. Since the company receives $5,000 in cash, you know the asset cash should increase by $5,000. If you remember Point 1, asset accounts increase with debits, you know you must debit the cash account for $5,000. Remembering also Point 2, debits must equal credits, you know you must now credit some account for $5,000. Logically, your $5,000 credit should be to the common stock account since the owner received common stock in return for his investment in the company. As a result of memorizing the two simple points above (assets increase with debits and debits = credits), you should be able to convert most business events into debits and credits, if you can understand the events. As you get more practice in analyzing events, the debit and credit process will become easier. In fact, as you get more practice you will see it is not the debit and credit process that is difficult. It is understanding business events that is the most difficult part of accounting. It is extremely difficult to correctly account for an event if you do not understand how the event affects the company.

Information from Financial Statements

Remember, the purpose of the debit and credit process is to maintain the equality of the accounting equation. If a company’s events have been correctly understood and the accounting equation is in balance, the resulting financial statements can be used to answer specific questions about the company's resources. The following financial statements result from the Parks Computer Service Corporation's accounting system.

Income Statement

The income statement provides information about what a company's management did with its resources. The income statement reports the dollar amount of resources generated through management operations. The income statement for the July operations of the Parks Computer Service Corporation appears as follows.

|Parks Computer Service Corporation |

|Income Statement |

|for the Month Ended July 31 |

|Fees Revenue |$450 |

|Supplies Expense |$50 |

|Net Income |$400 |

From the Parks Computer Service Corporation's income statement we can see the company's management used the company's resources in July to generated $400 of additional resources. The income statement shows management brought in resources of $450 (fees revenue) and used $50 of resources (supplies expense).

** You now have the background to do exercise 2.6.

Statement of Retained Earnings

The statement of retained earnings provides information about what a company did with the resources management generated through operating the company. The Parks Computer Service Corporation's July statement of retained earnings appears as follows.

|Parks Computer Service Corporation |

|Statement of Retained Earnings |

|for the Month Ended July 31 |

|Retained Earnings, July 1 |$0 |

|Plus: Net Income for July |$400 |

|Subtotal |$400 |

|Less: Dividends |$75 |

|Retained Earnings, July 31 |$325 |

From the Parks Computer Service Corporation's statement of retained earnings we can see that of the $400 of resources generated through management operations in July (net income), $75 were distributed to the owner (dividends). In other words, the company retained for future use $325 of the resources generated through management operations.

** You now have the background to do exercise 2.7.

Balance Sheet

The balance sheet provides information about what a company's resources are and where they came from. The Parks Computer Service Corporation's July 31 balance sheet appears as follows.

|Parks Computer Service Corporation |

|Balance Sheet |

|July 31 |

|Assets | | |Liabilities & Stockholders' Equity | |

|Cash |$5,130 | |Liabilities | |

|Accounts Receivable |$150 | |Accounts Payable |$65 |

|Supplies |$110 | | | |

|Total Assets |$5,390 | |Stockholders' Equity | |

| | | |Common Stock |$5,000 |

| | | |Retained Earnings |$325 |

| | | |Total Stockholders' Equity |$5,325 |

| | | |Total Liabilities & Stockholders' Equity |$5,390 |

The company's balance sheet shows on July 31 the company had resources (assets) of $5,390. $65 of the assets were borrowed (liabilities). $5,000 of the assets were invested by the owner (common stock). $325 of assets were generated through management operations and retained in the company (retained earnings).

Unequal Debits and Credits: Revisited

It is imperative you understand why accounting systems make use of the debits equals credits rule. As emphasized several times in this chapter, if each event affecting a company is accounted for in such a manner that the total dollar amount of debits equals the total dollar amount of credits, the accounting equation must always be in balance. A balanced accounting equation leads to logical financial statements. Logical financial statements resulting from the correct understanding of business events provide information useful to answer questions about the company's resources. Thus, the usefulness of the information provided in financial statements depends upon the debits equals credits rule and the correct understanding of business events.

Consider what would happen to the information provided in financial statements if the debits equals credits rule was not followed in the July 20 event of the Parks Computer Service Corporation. Remember, on July 20 management performed services for a customer who agreed to pay $250 by August 19. When we accounted for this event correctly it resulted in a $250 debit to accounts receivable and a $250 credit to retained earnings (Fees Revenue). Suppose, however, we incorrectly recorded it as a $250 debit to accounts receivable and a $25 credit to retained earnings, as shown in the following T accounts.

| | |Assets |= |Liabilities |+ |Stockholders' Equity |

| | | | |Accounts | | |

|Event | |Cash |+ |Receivable |+ |Supplies |

| | | | |Accounts |

|Event | |Cash |+ |Receivable |

After we enter the debit of $250 and the credit of only $25, our accounting equation does not balance. At the end of July, the company's T accounts show assets of $5,390 (cash of $5,130, accounts receivable of $150, and supplies of $110) and liabilities and stockholders' equity of $5,165 (accounts payable of $65, common stock of $5,000, and retained earnings of $100). Clearly, assets of $5,390 do not equal liabilities and stockholders' equity of $5,165! You should conclude from this that if you do not record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, you will not maintain the equality of the accounting equation.

Additionally, if assets do not equal liabilities and stockholders' equity, of what value is the information provided in the financial statements? If the balance sheet reports more resources (assets) than the dollar amounts that came from borrowing, from stockholders, or through management operations, from where did the company get the additional resources? Did the assets just magically appear? If the financial statements are to be relied upon for useful information, it is extremely important the debits equals credits rule be followed.

** You now have the background to do exercise 2.8 and problems 2.1 and 2.2.

Chapter 2 Critical Points

• The accounting equation, assets = liabilities + stockholders' equity is important in financial reporting because if it is in balance it guarantees the financial statements will be logical.

• The debits = credits process guarantees the accounting equation is always in balance.

• Asset accounts increase through debits and decrease through credits.

• Liability accounts increase through credits and decrease through debits.

• Stockholders' equity accounts increase through credits and decrease through debits.

• Revenue accounts increase through credits and decrease through debits.

• Expense accounts increase through debits and decrease through credits.

• Dividends accounts increase through debits and decrease through credits.

• If debits do not equal credits, the accounting equation will not balance and the information provided in the financial statements cannot be relied upon.

Chapter Two Questions

1. In accounting terminology, what does the term assets mean?

2. What does the term liabilities mean?

3. What does the term stockholders' equity mean?

4. Identify the two separate parts of stockholders' equity.

5. Why is it important that the financial statements are logical?

6. What contribution did Fra Luca Pacioli make to accounting?

7. What is the left side of a T account called?

8. What is the right side of a T account called?

9. How does the debits = credits rule affect the accounting equation?

10. What term is used to identify the increase in resources through the process of providing service to customers?

11. What affect do revenues have on retained earnings?

12. What term is used to identify the decrease in resources through the process of providing service to customers?

13. What affect do expenses have on retained earnings?

14. What term is used to identify the decrease in resources through payments made to owners?

15. What affect do dividends have on retained earnings?

16. Complete the following, using the terms debits and credits.

Assets increase through _______ and decrease through _______.

Liabilities increase through _______ and decrease through _______.

Stockholders' equity increases through _______ and decrease through ______.

Revenues increase through _______ and decrease through _______.

Expenses increase through _______ and decrease through _______.

Dividends increase through _______ and decrease through _______.

Chapter Two Exercises

Exercise 2.1: Assets = Liabilities + Stockholders' Equity

Peoples Corporation began business on July 10. Between July 10 and August 31, the owners invested $35,000, the company borrowed $7,000, management generated $2,200 resources through operations, and the owners were paid dividends of $250.

1. Determine the Peoples Corporation's total liabilities on August 31.

2. Determine the Peoples Corporation's total stockholders' equity on August 31.

3. Determine the Peoples Corporation's total assets on August 31.

Exercise 2.2: Cash T Account

On February 1, the Bussey Corporation had $18,500 cash on hand. During February, the company engaged in many cash events, including (a) receiving a $2,500 additional investment from owners, (b) paying $1,800 for supplies, (c) receiving $6,000 from customers, (d) paying $3,200 on accounts payable, and (e) paying $500 dividends to owners.

1. Set up a T account for the Bussey Corporation's cash.

2. Using debits and credits, show how each of the five above events affected the company's cash T account.

3. Calculate the Bussey Corporation's cash balance at the end of February.

Exercise 2.3: Retained Earnings T Account

On November 1, the Raymond Corporation had retained earnings of $46,900. During November, the company engaged in many events, including (a) receiving $1,000 additional investment from owners, (b) receiving $4,500 cash from customers for services provided to them in November, (c) paying $1,200 to employees for work they did for the company in November, (d) receiving $2,900 accounts receivable from customers for services provided to them in November, and (e) paying $300 dividends to owners.

1. Set up a T account for the Raymond Corporation's retained earnings.

2. Using debits and credits, show how each of the five above events affected the company's retained earnings T account. Hint: one event does not affect retained earnings!

3. Calculate the Raymond Corporation's retained earnings balance at the end of November.

4. Calculate the Raymond Corporation's net income for November.

Exercise 2.4: Cash, Supplies, and Accounts Payable T Accounts

On April 1, the Gately Corporation had cash of $18,000, supplies of $5,600, and accounts payable of $6,700. During April, the company engaged in many events, including (a) paying $2,000 for additional supplies, (b) paying $3,400 for supplies purchased in January, (c) buying $2,500 additional supplies on account, and (d) using a total of $4,000 of supplies to provide services to customers in April.

1. Set up T accounts for the Gately Corporation's cash, supplies, and accounts payable.

2. Using debits and credits, show how each of the four above events affected the company's cash, supplies, and accounts payable T accounts.

3. Calculate the balances in the Gately Corporation's cash, supplies, and accounts payable accounts.

Exercise 2.5: Cash, Accounts Receivable, and Retained Earnings T Accounts

On December 1, the Bickford Corporation had cash of $24,000, accounts receivable of $9,200, and retained earnings of $67,000. During December, the company engaged in many events, including (a) receiving $12,000 from customers for services provided during December, (b) paying $700 to owners for dividends, (c) receiving a total of $5,000 from customers for services provided to them in October and November, and (d) receiving promises of $7,000 from customers for services provided to them in December.

1. Set up T accounts for the Bickford Corporation's cash, accounts receivable, and retained earnings.

2. Using debits and credits, show how each of the four above events affected the company's cash, accounts receivable, and retained earnings T accounts.

3. Calculate the balances in the Bickford Corporation's cash, accounts receivable, and retained earnings accounts.

Exercise 2.6: Income Statement

The Almeida Corporation's income statement for the month ended January 31, is shown below.

|Almeida Corporation |

|Income Statement |

|For the Month Ended January 31 |

|Revenues |$24,000 |

|Expenses |$15,000 |

|Net Income |$9,000 |

1. Determine the dollar amount of resources obtained from customers for services provided to them in January.

2. Determine the dollar amount of resources used up in providing service to customers in January.

3. Determine the net dollar amount by which the company's resources increased through management operations in January.

Exercise 2.7: Statement of Retained Earnings

The Almeida Corporation's statement of retained earnings for the month ended January 31, is shown below.

|Almeida Corporation |

|Statement of Retained Earnings |

|For the Month Ended January 31 |

|Beginning Balance |$43,000 |

|Net Income |$9,000 |

|Subtotal |$52,000 |

|Dividends |$3,000 |

|Ending Balance |$49,000 |

1. Determine the dollar amount of resources generated through management operations and retained in the company prior to January 1.

2. Determine the net dollar amount by which the company's resources increased through management operations in January.

3. Determine the dollar amount of resources paid to owners in January.

4. Determine the dollar amount of resources generated through management operations and retained in the company by January 31.

Exercise 2.8: Balance Sheet

The Almeida Corporation's balance sheet on January 31, is shown below.

|Almeida Corporation |

|Balance Sheet |

|January 31 |

|Assets | | |Liabilities | |

|Cash |$55,000 | |Accounts Payable |$27,000 |

|Accounts Receivable |$32,000 | |Stockholders' Equity | |

|Supplies |$6,000 | |Common Stock |$17,000 |

|Total Assets |$93,000 | |Retained Earnings |$49,000 |

| | | |Total Liab. & Stock. Eq. |$93,000 |

1. Determine the dollar amount of resources on January 31.

2. Determine the dollar amount of borrowed resources.

3. Determine the dollar amount of resources invested by owners.

4. Determine the dollar amount of resources generated through management operations and retained in the company as of January 31.

Chapter Two Problem

Problem 2.1: Transactions, Accounts, and Financial Statements

Henderson Corporation engaged in the following transactions during April.

April 1 Rebecca Henderson invested $6,000 in the company and received 6,000 shares of $1 par common stock.

April 4 Henderson Corporation provided $300 services to a client and received full payment in cash.

April 7 Henderson Corporation purchased $500 supplies on account. The supplies will be paid in full by May 7.

April 10 Henderson Corporation provided $200 services to a client who agreed to pay on April 19.

April 15 Henderson Corporation paid $125 to an employee for work done in the first two weeks of April.

April 18 Henderson Corporation paid $300 cash for additional supplies.

April 19 Henderson Corporation received full payment from the customer serviced on April 10.

April 22 Henderson Corporation paid $250 as partial payment for the supplies purchased on April 7.

April 25 Henderson Corporation paid a $100 cash dividend to its owner.

April 28 Henderson Corporation provided $400 services to a client who agreed to pay on May 5.

April 30 A review of supplies revealed $225 of supplies had been used up by the end of April.

1. By addition and subtraction, show the effects of the transactions on Henderson Corporation's resources and sources of resources. Notice the first transaction has been processed for you.

| | | |Sources of Owner Invested |Sources of Management |

| | |Sources of Borrowed |Resources |Generated Resources |

| | |Resources | | |

| |Resources | | | |

| |Assets |Liabilities |Stockholders’ Equity |

|April 1 |+ $6,000 |_______ |+ $6,000 |_______ |

|April 4 |________ |_______ |________ |_______ |

|April 7 |________ |_______ |________ |_______ |

|April 10 |________ |_______ |________ |_______ |

|Subtotals |__$7,000 |___$500 |__$6,000 |___$500 |

|April 15 |________ |_______ |________ |_______ |

|April 18 |________ |_______ |________ |_______ |

|April 19 |________ |_______ |________ |_______ |

|Subtotals |__$6,875 |___$500 |__$6,000 |___$375 |

| | | |Sources of Owner Invested |Sources of Management |

| | |Sources of Borrowed |Resources |Generated Resources |

| | |Resources | | |

| |Resources | | | |

| |Assets |Liabilities |Stockholders’ Equity |

|Subtotals |__$6,875 |___$500 |__$6,000 |___$375 |

|April 22 |________ |_______ |________ |_______ |

|April 25 |________ |_______ |________ |_______ |

|April 28 |________ |_______ |________ |_______ |

|April 30 |________ |_______ |________ |_______ |

|Totals |__$6,700 |___$250 |__$6,000 |___$450 |

2. By addition and subtraction, show the effects of the April transactions on the T accounts of the Henderson Corporation. Notice the first transaction has been processed for you. Calculate the balance in each T account at the end of April.

| |Assets |= |Liabilities |+ |Stockholders' Equity |

| |

|Date |

|Revenues |$_________ |

|Expenses |$_________ |

|Net Income |$_________ |

|Henderson Corporation |

|Statement of Retained Earnings |

|For the Month Ended April 30 |

|Retained Earnings, April 1 |$________0 |

|Net Income |$_________ |

|Subtotal |$_________ |

|Dividends |$_________ |

|Retained Earnings, April 30 |$______450 |

|Henderson Corporation |

|Balance Sheet |

|April 30 |

|Assets | | |Liabilities | |

|Cash |$_________ | |Accounts Payable |$_________ |

|Accounts Receivable |$_________ | |Stockholders' Equity | |

|Supplies |$_________ | |Common Stock |$_________ |

|Total Assets |$____6,700 | |Retained Earnings |$_________ |

| | | |Total Liab. & Stock. Eq. |$_________ |

4. The dollar amount of Henderson Corporation's total resources at the end of April is $_______________.

5. The dollar amount of resources on hand at the end of April that Henderson Corporation obtained through borrowing is $_______________.

6. The dollar amount of resources on hand at the end of April that Henderson Corporation obtained through owner's investments is $_______________.

7. The net dollar amount of resources Henderson Corporation generated through management operations in April is $_______________.

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