Guide to Accrual Accounting for Ohio s Rural Transit Systems

Transcription

1 Guide to Accrual Accounting for Ohio s Rural Transit Systems March 2009 Prepared For The Ohio Department of Transportation (ODOT) Office of Transit Prepared By

2 Table of Contents Page No. Section 1 Why Accrual Accounting 1 Federal Transit Administration (FTA) Requirement 1 Ohio Department of Transportation (ODOT) Requirement 2 Cash vs. Accrual Accounting 3 Good Business Practice 6 Recap Why the Accounting Method Matters 7 Section 2 Basic Accounting Principles 8 Overview 8 Bookkeeping vs. Accounting 10 Accounting Equation (Assets = Liabilities + Owner s Equity) 11 Revenue Recognition and Matching Principles 13 Chart of Accounts Normal Balances 14 Debits and Credits 16 Accounting Cycle 18 o Record (Journalize) Transactions 18 o Post Journal Entries to Ledger Accounts 25 o Prepare a Trial Balance 28 o Make Adjusting Entries & Prepare Adjusted Trial Balance 29 i o Prepare Financial Statements 32 o Journalize & Post Closing Entries & Prepare Closing Trial 40 Balance Section 3 Ohio Rural Transit Systems & ODOT Quarterly Invoice Report Revenue Transactions 41 o Transportation Revenues 41 o Non-Transportation Revenues 42 Expense Transactions 43 o Labor (Wages) 43 o Fringe Benefits 44 o Services 44 o Materials & Supplies 45 o Utilities 45 o Casualty & Liability Costs 46 o Taxes 46 o Purchased Transportation Services 46 o Miscellaneous Expenses 46 o Interest Expense 47 41

3 o Leases & Rentals 47 o Depreciation 47 o Other Costs 47 Section 4 Accrual Accounting Options 48 Manual Systems 48 Off-the-Shelf Software 48 Conversion of Cash Data to Accrual Format at End of Each 49 Quarter Professional Assistance 49 Section 5 Exhibits & Samples 50 ODOT Chart of Accounts 50 Steps for Completing the ODOT Quarterly Invoice 50 Accrual Accounting - Class Exercise 58 ii

4 Section One Why Accrual Accounting Federal Transit Administration (FTA) Requirement For calendar year 2008 and beyond, the FTA began to require all transit systems (urban and rural) to report data using the accrual method of accounting. For rural systems this was a change because in the past they were permitted to report on a cash basis. This regulation issued in April of 2007 can be found in FTA Circular # C F which states Costs incurred and available balances are reported annually on an accrual basis, on the Financial Status Report in FTA s Transportation Electron Award Management (TEAM) System U.S. Department of Transportation Federal Transit Administration CIRCULAR FTA C F April 1, 2007 Subject: NONURBANIZED AREA FORMULA PROGRAM GUIDANCE AND GRANT APPLICATION INSTRUCTIONS 1. PURPOSE. This circular is a re-issuance of guidance on the administration of the transit assistance program for nonurbanized areas under 49 U.S.C. 5311, and guidance for the preparation of grant applications. This revision incorporates provisions of the Safe, Accountable, Flexible, Efficient, Transportation Equity Act: A Legacy for Users (SAFETEA LU), and includes the most up-to-date available guidance for the program. 2. CANCELLATION. This circular cancels Federal Transit Administration (FTA) Circular E, Nonurbanized Area Formula Program Guidance and Grant Application Instructions, dated October 1, Chapter VI, financial Management 6.b (2) on page VI-7 (1) Costs incurred and available balances are reported annually on an accrual basis, on the Financial Status Report in FTA s Transportation Electronic Award Management (TEAM) System. 1

5 Ohio Department of Transportation (ODOT) Requirement In Ohio, ODOT Office of Transit distributes federal funds to rural transit systems. ODOT is required to comply with all federal regulations associated with federal transit funds as well as ensure that all transit systems receiving federal funds are in compliance with applicable federal regulations. One such requirement is that rural transit systems report their financial data in an accrual accounting format to ODOT, who in turn must compile that data and provide reports to the FTA. ODOT is required to enforce this reporting requirement to assure compliance with FTA regulations. As a consequence, Ohio rural transit systems must now report their quarterly data to ODOT on an accrual basis. Accrual accounting reporting offers the advantage of allowing for more relevant statewide comparisons of system operations, and will assist ODOT in providing accurate and timely reports as requested from FTA, State legislators, other State departments, and other interested parties. During the fall of 2007, ODOT provided basic training on accrual accounting. This manual is intended to further assist Ohio rural transit systems in meeting the accrual accounting requirement by offering basic accounting information as well as specific accrual accounting applications and examples to assist in understanding and compliance. 2

6 Cash vs. Accrual Accounting Usually the first question on everyone s mind is: 3 Q: Can you explain the basic difference between cash and accrual accounting and tell me how it impacts the bottom line? A: Officially, there are two types of accounting methods, which dictate how a company's transactions are recorded in the company's financial books: cashbasis accounting and accrual accounting. The key difference between the two types is how and when they record financial transactions. Cash-basis accounting In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hands or, more likely, in a bank account. Accrual accounting If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn't yet paid. Expenses are handled in the same way. The company records any expenses when they're incurred, even if it hasn't yet paid for the supplies or services. For example, when a transit system buys fuel for its buses they may very likely do so on account and not actually lay out the cash for the fuel until a month or so later when they get the bill. Under accrual accounting the fuel expense would be booked in the accounting period in which the fuel was used (this matches the expense with the service performed) not in a future period when the bill is actually paid. The next question is often: Q. Which method is better? A. For accounting and business planning purposes, the best method regardless of the type of business (except possibly a very, very, very, small business) is the accrual-based method. Cash-based accounting can distort the true operations of your business and incorrectly reflect income and expenses. Accrual accounting takes into account when something happens (not just when cash changed hands) and in today s business world where most companies extend and receive

7 credit, the actual exchange of cash may take place months after the actual work was done, goods received, wages earned, etc. These are simple answers to more complex questions so lets look at the differences in more detail. Two Types of Financial Record Keeping Cash & Accrual There are two types of accounting systems or methods available to business owners or non-profits to keep track of their financial records: cash accounting and accrual accounting. These two accounting methods are important to understand, because a business is required to use one or the other consistently in record-keeping for business and tax purposes. Here s a definition of each: Cash Accounting In the cash accounting method, debits and credits are recorded to accounts only when money actually changes hands. For example, let s assume a transit agency provides contracted service during December 2007, but doesn't get paid for the service until the following year, January In this simple example (if we assume that is the only transaction and the expenses associated with providing the service were paid in 2007), the agency reports a loss in 2007 because they paid for the wages, fringes, fuel and other expenses associated with providing the service in Conversely, the agency reports a huge profit in 2008 because they collected the revenue for the services previously provided and had no expenses (because all expenses were booked the prior year). Benefits of Cash Accounting 1. Working under a cash accounting model can be easier for small business owners in the sense of time spent. It is not much different that keeping a simple check book. 2. It s often easier for small business owners to understand basic cash flow, as opposed to more complex asset and liability accounts. Drawbacks of Cash Accounting 1. The business or agency does not have a clear picture of who owes you money, or whom you owe money. 2. It makes it difficult, if not impossible, to easily evaluate a business financial success or failure. 4

8 Accrual Accounting In the accrual accounting method, debits and credits are recorded to accounts when the transaction itself takes place, regardless of when cash actually exchanges hands (with cash meaning any kind of payment for goods or services rendered). The actual transaction actually consists of several parts: the transaction would first be accounted for in a receivables account (money owed to the company, as an asset); and the receivables account would be subsequently decreased when the cash account is increased once the payment was actually made (later in time). In our simple example used above, the transit agency would record contract revenue in December 2007, even though they have not as yet received payment. When the agency prepares their December financial statements, the expenses and the associated revenues are in the same time period as the service provided so a true picture of what they earned or lost that month exists. It can be said that the revenues match the expenses which is known as the matching principle discussed later in this manual. Benefits of Accrual Accounting 1. Expenses and revenues are more closely matched in the time period for which the work was performed. 2. Leads to more comprehensive record keeping and account evaluation when looking at an agency s current financial situation (cash on hand, amounts owed to others, cash owed to the business, etc.), which can help in determining the success or failure of a business. Drawbacks of Accrual Accounting 1. None! (just kidding). It is more challenging to master and may require some professional training, or assistance. 5

9 Good Business Practice The majority of United States companies and non-profits now use accrual accounting. In fact, all incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP). This requirement now assures that persons reviewing a corporation's financial reports are able to make meaningful comparisons. Cash accounting is used mainly by very small family type business and some governments (although most governments are now also required to convert their year-end books to an accrual basis for basic reporting). In transit, FTA has likewise adopted this accrual accounting reporting requirement in order to improve state and national reporting, public understanding, and the ability to make relevant comparisons among agencies. The good news is that once a transit agency meets this regulation (the accounts are properly set-up and used), the agency will have access to information that can lead to better business practices, more consistent financial reporting, and may assist with future business planning, service development and operational decision making. For your own internal reporting the use of accrual accounting will make your data both more relevant and consistent. For example, let s assume that you operate the same route for two months at a cost of $15,000 per month and you provide 5,000 trips each month. If you use accrual accounting you would have expenses of $15,000 each month because the expenses are booked, or accounted for, in the month the service took place. If you report cost per trip, it would be $3 for each month. Under cash accounting things could look much different. Let s assume that in the first month cash is tight -- so you only pay $5,000 of the bills. Consequently, the only cash expenses reported for that month are $5,000 so your cost per trip is $1. Now in the following month you receive some cash so you are able to pay the $10,000 from the previous month along with the $15,000 from the current month so your cash expenses for the month are $25,000. This amount divided by the 5,000 trips gives you cost per trip of $5, which is a large change from the $1 reported from the previous month. This simple example shows how cash accounting can lead to major swings in reporting statistical data that may be misinterpreted by your Board, a local government, or even the press! By reporting on accrual accounting, your expenses more closely match the services provided, resulting in more consistent statistics and data reporting. It just makes good business sense! 6

10 Recap - Why the Method Matters The accounting method a business uses can have a major impact on the revenues and expenses reported in a given period, and consequently on the reported bottom line. Here's how: Cash-basis accounting: Expenses and revenues aren't carefully matched on a monthto-month basis. Expenses aren't recognized until the money is actually paid out, even if the expenses are incurred in previous months. Revenues earned in previous months aren't recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual cash available. Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it's spending each month to operate and how much profit it's making (or money it s losing). Expenses are recorded (or accrued) in the month incurred, even if the cash isn't paid out until the next month. Revenues are recorded in the month the project is complete or the product is shipped, even if the company hasn't yet received the cash from the customer. Accurate financial statements can easily be prepared showing what is owed to the company, what the company owes others, and if the business is profitable. The use of accrual accounting by rural transit systems is both a federal and state reporting requirement. But keep in mind that this reporting requirement offers you and your agency many benefits as well. Once you take the time to set up and master an accrual accounting reporting system, you will find that your financial data is more organized, you can prepare relevant financial reports more easily, make more informed operational decisions, and make meaningful comparisons to other agencies. 7

11 Section Two Basic Accounting Principles Overview Let s start by looking at a few quick definitions and accounting tidbits: Accounting - The bookkeeping methods involved in making a written financial record of business transactions and in the preparation of statements concerning the assets, liabilities, and operating results of a business using those records. Accounting System - the people, procedures, and resources used to gather, record, classify, summarize and report the financial information of a business, government or other financial entity. Bookkeeping vs. Accounting In general, bookkeeping is the recording of financial transactions into financial forms and systems. Accounting is the sorting, reporting, and analysis of this data. Accounting Equation: Assets = Liabilities + Owner s Equity. Revenue Recognition and Matching Principle The process of ensuring that revenues and expenses are recorded in the same accounting period in which the work was performed or goods received. There are five types of accounts: 1. Assets 2. Liabilities 3. Owners' Equity (Stockholders' Equity for a corporation) 4. Revenues 5. Expenses Chart of Accounts - All the accounts used in an accounting system are listed in a Chart of Accounts. They are listed in the order of the five accounts shown above. This helps us prepare financial statements by conveniently organizing accounts in the same order they will be used in the financial statements. Generally speaking, most companies set up their chart of accounts numbering sequence using the numbers corresponding to the five types of accounts listed above (i.e., asset accounts begin with a 1, revenue accounts begin with a 4, etc.). Double-entry bookkeeping (debits & credits) - the practice of recording a business transaction in two equal parts, called debit and credit entries. Debit refers to the left column and credit refers to the right column, in an accounting journal. 8

12 In accounting we are simply taking all the financial transactions related to a business and recoding data from each transaction into a set of accounts that can be later used to tell us things we will need to know to operate our business effectively. The accounting process in a nutshell: 1. Capture and record a business transaction, 2. Classify the transaction into appropriate accounts, 3. Post transactions to their individual ledger accounts, and 4. Summarize and report the balances of ledger accounts in financial statements. Forms and Tools used in Accounting Financial transactions are recorded as journal entries in the general journal book, which are chronological listings of financial events and transactions. These are separated by account and then posted in ledger books, which provide a summary of each unique account. Financial Statements The most common financial statements are: The Balance Sheet which lists the balances in all Asset, Liability and Owners' Equity accounts. This shows the business worth at any given moment in time. The Income Statement lists the balances in all Revenue and Expense accounts. This reflects whether or not a business in making a profit (or operating at a loss) over any given range in time.. The Balance Sheet and Income Statement must accompany each other in order to comply with Generally Accepted Accounting Principles (GAAP). Financial statements presented separately do not comply with GAAP. This is necessary so financial statement users get a true and complete financial picture of the company. All accounts are used in one or the other statement, but not both. All accounts are used once, and only once, in the financial statements. The Balance Sheet shows account balances at a particular date. The Income Statement shows the accumulation in the Revenue and Expense accounts, for a given period of time, generally one year. The Income Statement can be prepared for any span of time, and companies often prepare them monthly or quarterly. Now lets look at accrual accounting in more detail! 9

13 Bookkeeping vs. Accounting Am I an Accountant or a Bookkeeper? What is the difference? This is a common question. Most people, even accountants, don't know the answer to this question. And in most cases the answer doesn't matter. But in those cases where someone wants to be technically correct, the answer lies in what services a person performs. If a person is doing bookkeeping, then they are a bookkeeper. If they are doing accounting, then they are an accountant. What is Bookkeeping? There are many steps to the bookkeeping cycle. A bookkeeper is a person that performs one or more of these steps. In large companies, for instance, the bookkeeping cycle might be divided into departments such as Accounts Receivable, Accounts Payable, or Payroll. While most often these people are referred to as "clerks", they might also be considered bookkeepers as they are "keeping the books" for a company. In small companies, the bookkeeper may perform the entire bookkeeping process, or might just enter data to give to the "accountant". All bookkeeping steps are mechanical in nature. Bookkeeping is a regimented process usually occurring in monthly cycles consisting of entering transactions into the journals, making adjustments, and preparing reports. The Accounts Receivable Clerk may be assigned to enter all sales on account, and all payments from the customers. The Accounts Payable Clerk's responsibility would be to enter purchase orders and checks. A full-charge bookkeeper is someone who can do it all - including compiling the data into the General Ledger and preparing financial statements. What is Accounting? Someone has to set up the bookkeeping system, monitor it, and interpret the results. These processes are called "Accounting." The accounting process is much less mechanical and more subjective. It begins with designing a system that will benefit the business, by capturing the financial information in a useful manner without being overly burdensome to the bookkeeper. Once set up, the accountant monitors the system to ensure it's doing what it's suppose to do. And finally, on a regular basis (typically monthly), the accountant presents the financial statements to management in such a way that decisions can be made. Since accounting requires an understanding of the bookkeeping process, accountants typically supervise the bookkeepers. In a large corporation there may be several, possibly even thousands of accountants. One will be designated as the "Controller" who oversees the entire accounting and bookkeeping system. In a small business, one person, often a freelancer (a contract accountant) will perform all the phases of accounting and bookkeeping for a company. Since "Accountant" is the more prestigious title, most small business jack-of-all-trades call themselves an "Accountant". 10

14 Accounting Equation (Assets = Liabilities + Owners Equity) The Accounting Equation - You may have heard someone say "the books are in balance" when referring to a company's accounting records. This refers to the use of the double-entry system of accounting, which uses equal entries in two or more accounts to record each business transaction. Because the dollar amounts are equal we say the transaction is "in balance." The accounting equation uses "simple math" and involves only addition and subtraction. In fact, almost all the math you will do in basic accrual is simple math. You will occasionally use multiplication and division in splitting transactions between accounting periods when required to do so, but all changes to basic accounts will be addition or subtraction. Think for a moment about a new company. It's accounting system consists of a new, "fresh" set of books, no entries have ever been made, all accounts have a zero balance. Assets = Liabilities + Owners' Equity $0 = $0 + $0 The books are in balance!! If each and every transaction is a entered as a "balanced" entry, the books will stay in balance. The accounting equation can be expressed in three ways: Assets = Liabilities + Owners' Equity; Liabilities = Assets - Owners' Equity; and Owners' Equity = Assets Liabilities. In order to maintain a set of balanced books each accounting transaction will impact an account (or accounts) on both sides of the accounting equation. The following outline describes in greater detail the three major divisions of the accounting equation or General Ledger. Balance Sheet Accounts: ASSETS WHAT WE OWN (Debit balance accounts) Current Accounts that show assets with continued activity and turnover within the year. Also known as short term. Items such as: checking, savings, accounts receivable, petty cash, etc. 11

15 Property, Plant and Equipment Accounts reflecting assets owned but not intended to have a quick turnover. These items are marked down (depreciated) gradually over a number of years specified by the IRS, FTA, or ODOT. Items in this category include service vehicles, buses, facilities, equipment, etc. Other Assets that do not have a quick turnover and that are not depreciated. Items in this category might include long-term investments (CD s, Bonds, etc.). LIABILITIES WHAT WE OWE (Credit balance accounts) Current Liabilities with continual activity and turnover within the year. Items such as accounts payable, wages/benefits payable, etc. are examples of current liabilities. Long-Term Contracts payable beyond one year. If you borrow money to finance a facility, that would be considered a long term liability. EQUITY or CAPITAL (Credit balance accounts) These accounts represent the initial investment in the business. In addition to this initial investment, the annual profits or losses are included in this section. A simple way to illustrate the accounting equation and the relationship to double entry accounting is to look at what happens if a government loans your system $25,000 in funds for operations on March 1 st. You would debit cash, an asset (which you received) and credit loans payable, a liability (to record on your books that you owe the government those funds). You made and entry on each side of the equation so you are still in balance. Assets = Liabilities + Owners' Equity $25,000 Cash Received = $25,000 Loan from Govt. + $0 At this point you might be asking yourself how revenues and expenses impact the accounting equation and the balance sheet good question. The simple answer is that at the end of each accounting period the difference between revenues and expenses (or the profit or loss) is booked to the equity account. Net income would increase equity and a loss would decrease equity. More on this later. 12

16 Revenue Recognition and Matching Principles Determining the amount of revenues and expenses to report in a given accounting period can be challenging. Proper reporting requires an understanding of the nature of the company s business as well as careful monitoring of the accounting periods. Two principles are used as guidelines: Revenue Recognition Principle Matching Principle The revenue recognition principle requires that revenue be recognized in the accounting period in which it is earned (which often times will differ from the accounting period in which it was actually collected). For example, a transit agency recognizes (records) revenue when the services are performed. Let s assume the agency provides $1,000 in contract transit service during the last two weeks of March. The agency would record $1,000 in revenue for March since that is when the service was performed and the revenue actually earned. The fact that the agency will most likely not collect the $1,000 in cash from the customer until April is not relevant. The matching principle requires that efforts (expenses) be matched with accomplishments (revenues). The critical issue is determining when the expense makes its contribution to revenue. In the above example think about the wages for the operators driving the buses during the last two weeks in March. Even though they are actually given their paychecks the first week in April, the expenses of their labor and fringes would be booked in March because that is the month for which they performed the service. If we assume that the cost of providing this contract service was $800, then once the March financial statements are processed they would show a profit of $200 ($1,000 in revenue, offset by $800 in expenses). This represents a true picture of what happened with the transit system in March, even though the actual wages and fringes have not been paid, or the revenue collected. The unpaid wages and fringes are booked as a payable/liability (something owed to another) and the uncollected revenue is booked as a receivable/asset (something owed to the transit system). These items would be reflected on the balance sheet. 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 when the service was performed or goods received. 13

17 Chart of Accounts Normal Balances An Account is a record used to summarize increases and decreases in a particular asset or liability, revenue or expense, or in owners equity. Accounts often have very simple and generic titles such as Cash, Accounts Payable, Sales, and Inventory. These are simple and descriptive terms under which many different transactions can be recorded. Each account should be identified by a unique number along with a basic description. In the business world, there are no set rules on account names and you may set up your list of accounts to best fit your business needs. However, most industries, including public transit, start with some basic standards or templates. Accounts are organized into a Chart of Accounts, a simple list of account titles and numbers (if used) presented in the following order: Assets, Liabilities, Equity, Revenue, and Expenses. Organizing accounts in the correct order makes it much easier to prepare financial statements and enter transactions. Here is a sample Chart of Accounts, showing account sections in the correct order. ABC Company, Inc. Chart of Accounts Balance Sheet Accounts ---- Asset Accounts ---- Cash Accounts Receivable Prepaid Expenses Supplies Inventory Land Buildings Vehicles & Equipment Accumulated Depreciation Other Assets ---- Liability Accounts ---- Accounts Payable Notes Payable - Current Notes Payable - Long Term Income Statement Accounts ---- Revenue Accounts ---- Sales Revenue Sales Returns & Allowances Sales Discounts Interest Income ---- Expense Accounts ---- Advertising Expense Bank Fees Depreciation Expense Payroll Expense Payroll Tax Expense Rent Expense Income Tax Expense Telephone Expense Utilities Expense ---- Stockholders' Equity Accounts ---- Owners/Agency Equity Retained Earnings 14

18 What accounts should you use? FTA and ODOT have established accounts that should be used as the basic building blocks in setting up your chart of accounts. FTA FTA has developed a Uniform System of Accounts (USOA) for use by FTA funded transit agencies. The FTA Chart of Accounts includes basic account numbers as well as descriptions of what items should be posted to each of these accounts. The USOA can be downloaded at the following web address: ODOT ODOT has created a scaled-down version of the FTA USOA for use by Ohio rural transit systems. The ODOT Chart of Accounts highlights the accounts, numbers, and descriptions which rural systems should use for reporting revenues and expenses on their quarterly reports. This can be found on the ODOT website in the Rural Transit Manual, Attachment 5-A as well as in Section 5 of this manual. You should use the ODOT revenue and expense accounts, along with the FTA USOA accounts (for assets, liabilities, and equity) in setting up your chart of accounts. Some systems may find that they need to track data in more detail and they may create subaccounts that then would roll-up (add together) into the ODOT/FTA main accounts. For example you might want to track expenses by route so you would have an operator wage account for each route. These would then roll-up at month end into the main operator wage account for reporting purposes. A sample of this might look as follows: Main Account Operator s Salaries and Wages Sub Accounts A Main Street Route B North Loop C South Loop You could then prepare internal reports by route and when it comes time to prepare your Quarterly ODOT invoice, you would roll-up the sub-accounts and report the total under the main account. Also keep in mind that on the ODOT invoice, you must report expenses under the proper function (010, 041, 042, 160, and 199) and some expenses might fall under multiple functions so you should consider setting up unique accounts for each relevant function. Section 5 provides information on accessing the actual ODOT issued Chart of Accounts for use by Ohio rural transit systems and Section 3 contains a listing of the ODOT revenue and expense accounts along with hints and considerations when reporting based on accrual accounting. Complete descriptions of what items should be booked to each account are included in the USOA and the ODOT prepared Chart of Accounts for rural systems as discussed above. It is highly recommended that you become familiar with both the USOA and the ODOT Chart of Accounts. 15

19 Debits and Credits What is the difference between Debits and Credits? When you deposit money in the bank, the cashier will tell you "I'll credit your account." You might assume that cash is a credit, and so credits are good. Unfortunately, this conditioning that we receive at the bank causes real confusion in the accounting world. Why? Because in accounting we understand that our bank account is a debit account, and that debts (money we owe someone) are credit accounts - just the opposite of what most people would expect. The banks can confuse us because they are telling us the entry to their liability account. When you deposit money into your bank account, their liability to you increases since they are holding your money! Since liabilities are credit accounts, they are crediting our account or recording that they have a liability to us. When they reduce their liability they have to us (when we take funds out), they are debiting their liability account. Confused Yet? One of the best ways to understand debits and credits is to identify two components of each transaction: 1) what did you receive; and, 2) where did it come from. The debit is what you received, and the credit is the source of the item or service you received. For instance, imagine that you purchased a computer with your credit card. Since the computer is what you received, it's going to result in a debit to the asset account for your computer. The credit will be applied to the credit card liability account (showing money you owe someone) for the amount also of the purchase. If you can identify what you received and where it came from in every transaction you will have the concept of debits and credits mastered. When do we use Debit or Credit? When to use a debit or credit to record a journal entry is one of the biggest hurdles for non-accountants. 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? Assets = Liabilities + Owners' Equity Left side Debit side Debit = Increase Credit = Decrease Right Side Credit Side Credit = Increase Debit = Decrease 16

20 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. 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. You will save a lot of time making journal entries if you remember the normal balance for the accounts. Account type Normal Balance Example Revenue Accounts Credit Sales Revenue Expense Accounts Debit Rent Expense Asset Accounts Debit Cash, Accounts Receivable Liability Accounts Credit Accounts Payable Owners' Equity Accounts Credit Capital Stock When recording a sale, or other income transaction, you would credit the revenue account, and debit some other account (cash or accounts receivable). When recording an expense, you would debit the expense account, and credit some other account such as accounts payable or cash. 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 vs. credit sale. Type of entry Record a sale Record an expense Record a credit sale Record a cash sale Buy supplies on credit Do this Credit a revenue account Debit an expense account Debit Accounts Receivable Debit Cash Credit Accounts Payable If you refer to these charts before starting a journal entry it will be much easier until you have mastered the concepts. 17

21 Accounting Cycle 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 & prepare an adjusted trial balance; 5. Prepare financial statements; and 6. Journalize and post closing entries & prepare after-closing trial balance. Let s take a closer look at each of these steps. 1. Record (Journalize) Transactions 18 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 & credit. Journal entries should be made in conjunction with the event they are recording, or reasonably soon after that event. Keep in mind that a journal is a chronological record of events. 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. You should use verifiable, tangible evidence whenever it exists. Tangible evidence has a physical existence we can touch it, fold, staple, copy and file it. You should 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. There are three general types of transactions and entries: 1. Routine, daily operating events - represents over 99% of all transactions; 2. Occasional events involving major assets, liabilities and owners' equity transactions; and 3. Adjusting and closing entries - made to prepare statements and close the books at the end of the year.

22 Sample General Journal page Date Account Debit Credit Debit = Left column Credit = Right column We enter dollar amounts in the Debit and Credit columns. The totals in the Debit and Credit columns must be equal. 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 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. 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. 19

23 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 two sides to the Accounting Equation, there are only two possibilities. Pretty simple. Let's try an easy example using the 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: On March 20th, the transit system collected cash fares of $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 Date Account Debit Credit Mar-20 Cash $100 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. 20

24 3) Enter the balancing dollar amount in the opposite column from Cash. Date Account Debit Credit Mar-20 Cash $100 $100 Almost done... 4) Refer to the information given, check the Chart of Accounts and select the correct account for the second part. This is a sale, so we will use Passenger Fares for the Credit side of the journal entry. Date Account Debit Credit Mar-20 Cash $100 Passenger Fares $100 The journal entry is in balance, and is complete. A memorandum (or note) 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. On March 1st, the transit system paid rent of $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. Date Account Debit Credit Mar-1 $500 Cash $500 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. 21

25 4) Refer to the information given, check the Chart of Accounts and select the correct account for the second part. This is an example of paying an expense, in this case Leases & Rental Expense. Date Account Debit Credit Mar-1 Leases & Rental Expense (Other General Admin. Facilities) $500 Cash $500 Another example. On March 20th, the transit system purchased $1,000 in office equipment on credit. 1) Is Cash used in this transaction? No. ( You will use cash as a temporary holder.) 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. Date Account Debit Credit Mar-20 $1000 cash (used as a temp. holder) $1000 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 and select the correct account for the second part. This is an example of buying equipment, in this case we will use the account Other Materials & Supplies. 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. 22

26 In this case, we will use Accounts Payable, one of the most frequently used accounts. Accounts Payable represents what we owe others. Date Account Debit Credit Mar-20 Other Materials & Supplies $1000 Accounts Payable $1000 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. On March 5th, the transit system buys a bus and van for $100,000. They make a down payment of $20,000 and sign a loan note with their bank for the balance. The bus was purchased used for $75,000 and the van was new at a cost of $25,000 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. Date Account Debit Credit March-5 Notes Payable $80,000 Cash $20,000 23

27 3) Enter the balancing dollar amount in the opposite column. 4) Refer to the information given, check the Chart of Accounts and select the correct account for the second part. I left 2 blank lines because I knew we had both a bus and a van, which should be entered separately for future tracking purposes. Date Account Debit Credit June-5 Vehicle Bus $75,000 Vehicle - Van $25,000 Notes Payable $80,000 Cash $20, Total $100,000 $100,000 In this example you should total the columns to show that the journal entry is in balance. You have now seen samples of simple and complex journal entries. Now let s take the information from these journals and post them to ledger accounts. 24

28 2. Post Journal Entries to Ledgers (or T ) Accounts Posting to the Ledger Journal entries must be posted to the individual ledger accounts on a regular basis. In computer based systems this is done automatically whenever journal entries are made. In a manual system the journal entries must be 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, use the correct dollar amounts, and enter the dollar amounts in the correct column of the correct account. Needless to say, use of a manual system does introduce the possibility of human error, so you should be as careful as possible during this process. Sample ledger page Account Title Date Description Debit Credit Balance 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 $500 Credit balance. Accounts Payable Date Description Debit Credit Balance Jan-1 Balance forward from Dec-31 (500) The dollar sign ($) is usually omitted in actual practice. Entries are transferred (posted) from the journal to the ledger pages on a regular basis. Accounting is nothing more than a way to organize information so it is useful to persons responsible for making financial and business decisions. A large number of people use the same concepts, methods, etc. on a daily basis. You can too. 25

29 Now let s post sample transactions to the individual ledger accounts: Cash Date Description Debit Credit Balance March-1 Loan from Government 25,000 25,000 March-1 Payment of Rent ,500 March-5 Purchase of Vehicles 20,000 4,500 March-20 Collected Fares 100 4,600 Vehicles Date Description Debit Credit Balance March 5 Purchase of Vehicles - Bus 75,000 75, Purchase of Vehicles Van 25, ,000 Accounts Payable Date Description Debit Credit Balance March-20 Purchase of Supplies on Account 1,000 (1,000) Loans/Notes Payable Date Description Debit Credit Balance March-1 Loan from Government 25,000 (25,000) March-5 Purchase of Vehicles Bank Loan 80,000 (105,000) Passenger Fares Date Description Debit Credit Balance March-20 Collected Fares 100 (100) Leases & Rental Expense Date Description Debit Credit Balance March-1 Payment of Rent Other Materials & Supplies Expense Date Description Debit Credit Balance March-20 Purchase of Supplies 1,000 1,000 Keep in mind that this is a simple example. In an actual ledger book, each account would have it s own page or group of pages depending on the number of projected transactions during the year. Some small companies also find using simple T accounts works best for their situation.

30 Using T-Accounts A T-Account is just a simple way to represent a ledger account. It's handy for basic accounting because you can make quite a few T-Accounts on one page, and post journal entries quickly. 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. 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. T-Accounts can only be used successfully if you have very limited transactions or you are trying to convert cash books to accrual books for reporting purposes. Accountants record increases in asset, expense, and owners equity accounts on the debit side, and they record increases in liability, revenue, and owners equity accounts on the credit side. An account's assigned normal balance is on the side where increases go because the increases in any account are usually greater than the decreases. Therefore, asset, expense, and owner's drawing accounts normally have debit balances. Liability, revenue, and owner's capital (equity) accounts normally have credit balances. To determine the correct entry, identify the accounts affected by a transaction, which category each account falls into, and whether the transaction increases or decreases the account's balance. You may find the following chart helpful as a reference. Occasionally, an account can differ from what would be a normal balance. For example, a company's checking account (an asset) would have a credit balance if the account is overdrawn. 27