Accounting 1 Instructor Notes

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1 Accounting 1 Instructor Notes CHAPTER TWO ANALYZING TRANSACTIONS How do you organize your daily life? Is it with your computer? Is it with your IPhone or Blackberry? What ever you use, there is a process to organizing. Maybe you set up a folder for deleted files? Maybe you have folders set up on your computer for various categories of files? Business also have to organize their transactions. Every transaction that happens (like the purchase of supplies on account) affects at least two accounts. In order to keep track of these balances, the transaction has to be written. This is where we get into GAAP (Generally Accepted Accounting Principles). Like the IRS tells us how to prepare our tax return, GAAP has rules for us to follow when writing our transactions and preparing the financial statements. In this chapter we will learn about Debits and Credits and making sure it all balances out! 1. Introduction Accountants use the accounting equation Assets = Liabilities + Owners Equity to record transactions. In order to keep everything straight, they use a separate record (called a ledger) for each item that appears on the financial statements. For examples, there is a ledger for fees earned, supplies, cash, etc. These accounts are used to record increases and decreases to these accounts, and are summarized periodically. It is also important to note that we are dealing with a service business in these first few chapters. Therefore the Revenue account is called Fees, Fees earned, or Professional Fees, in most cases. Later when we get to Merchandising businesses we will call the Revenue account Sales. Whatever it is called from the above list, it is still considered Revenue and appears on the Income Statement.

2 2. ASSETS, LIABILITIES, OWNER'S EQUITY, REVENUE, EXPENSES ASSETS 1. Any physical thing (tangible) or right (intangible) that has a monetary value is an asset. 2. Grouped first by Current (used within the year or less) and from most liquid to least liquid, so generally in this order: Cash Accounts Receivable Supplies Prepaids 3. Then grouped by Property Plant and Equipment for those assets kept for more than a year: Land Building (less accumulated depreciation) Equipment (less accumulated depreciation) LIABILITIES 1. Debts owed to outsiders, CURRENT AND LONG TERM. Current liabilities are expected to be paid out of current assets. 2. When a long term payment (i.e. a notes payable or a mortgage) is on the balance sheet, the current payments are listed under current liabilities, and the remainder under long term liabilities. OWNER'S EQUITY 1. CAPITAL - is owner's equity in a sole proprietorship and a partnership. 2. AWINGS - drawings are amounts withdrawn by sole proprietorships and partnerships.

3 REVENUES 1. Gross income resulting from operations Can be: Sale of services or merchandise (fees, commissions, fees earned, sales) Interest revenue Rent revenue If have more than one, need to separate those two. EXPENSES Costs that have been consumed in the process of producing revenue. NATURE OF AN ACCOUNT Three parts 1. Title 2. Space for recording increases 3. Space for recording decreases 3. CHARACTERISTICS OF AN ACCOUNT THE T-ACCOUNT TITLE Left Side Right Side debit credit (the left side is always debit, the right side is always credit). The side for increases and decreases depends on the type of account.

4 BALANCE SHEET ACCOUNTS debit credit Increase in assets (+) Decrease in asset (-) Decrease in liability (-) Increase in Liability (+) Decrease in O.E. (-) Increase in O.E. (+) EXPENSES debit for credit for increases decreases REVENUE debit for credit for decreases increases So for an asset accounts you would put an increase in an asset on the plus or Debit side (left side), and a decrease in an asset would be on the minus or credit side (right side). For Liabilities the - (decreases) on the left or still debit side, and + (increases) on the right or still the credit side. As you charge something, think of it as increasing what you owe, so it would be a credit (or +) as you buy something on account. When you pay towards what you owe, it is a debit (or -) because what you owe goes down. Capital and Revenues are the same as liabilities (Increases or + on the credit side, decreases or - on the debit side). Revenues and capital will almost always be a credit entry. One exception would be you would debit a revenue account for a refund. Expenses when they occur appear on the Debit side. The expense account is almost always debited. One exception would be if you received a refund. REMEMBER: the + and - may change sides but the left is always debit and the right is always credit no matter what type of account it is. Abbreviations are and for credit and debit.

5 4. ANAYLZING AND SUMMARIZING TRANSACTIONS (important summary illustration of debits and credits). Look at the examples. Place each entry into a T-account then make a journal entry. T- Accounts and Journal Entry Illustration In a T-account, the left side is always the debit () side, the right side is always the credit () side. Which side the increases in an account (indicated by a +) or decreases in an account (indicated by a -) appear on depends on the type of account. In my examples, the dollar amounts will just be made up. I am just trying to show you which account to debit and which to credit. For example an asset (like cash, AR, supplies, prepaids, equipment), has increases (+) on the debit side and decreases (-) on the credit side. Expenses and drawing are normally always debited, and are also + on the Debit side and on the credit side. I know it seems strange to put an expense in as a + instead of a -, but think of it as adding all your expenses together first, then you will subtract them at the end in your income statement + Asset - + Expense - + Drawing - For Liabilities, Capital, and Revenues, the decrease (-) is on the debit side (left) and the increase (+) is on the credit side (right). Liabilities go up as you owe or charge something on account (because you owe more money) and go down as you pay them off. Revenues are almost always credited. - Liability (AP) + - Capital + - Revenue (fees earned) +

6 In a transaction, it should affect at least two accounts. Both accounts can go up, both can go down, or one account can go up and another go down. However, you must always have a debit and equal credit entry (an equally entry on the left and right side of a T-account). Let us look at some examples. 1. The owner invests $15,000 cash into the business. Both cash and capital go up. + Cash - - Capital + 15,000 15,000 Both are entered on the + side since both go up, but one is a debit and the other is a credit. In this case, Cash is the Debit since it has increases on the left side, and Capital is the Credit since it has increases on the right side. This information helps you to write it out as a journal entry. You need to write the debit entry first, followed by the credit entry indented about ½ inch. Cash 15,000 Capital 15, What if we purchased some supplies on AP? Both would go up because we would be buying supplies and the amount we owe goes up. So it would look like this: + Supplies - - AP + 5,000 5,000 Again, we have both going up, and we have a debit and a credit. The journal entry would look like this: Supplies 5,000 AP 5,000 I won t write out any more of the journal entries but there are examples in the textbook of journal entries for many transactions. I will just concentrate on showing what you should debit and what you should credit. With all these transactions, you write the debit entry first, then indent and write the credit entry second.

7 3. What if we bought some land for cash, cash would go down and land would go up. But we would still have a debit and credit entry. + Cash - + Land - 2,000 2,000 So we debit Land and credit cash. Land would be written first in a journal entry. 4. What if we paid in cash for a rent expense, it would look like this: + Cash - + Rent Exp. - 2,000 2,000 We would debit the expense account, and credit cash. Remember expenses are almost always debited. Expenses go up as we have increased the amount of expenses that have incurred (we will subtract the expenses from Revenues but not until we do the income statement) and cash goes down because we paid these expenses in cash. The only time you would have a credit to an expense would be in the case of a refund/overcharge or in closing entries (not until we get to chapter 4). 5. Assume we earned Fees for cash, it would look like this: + Cash - - Fees Earned + 1,000 1,000 Both Cash and Fees Earned go up, so Cash is debited and Fees earned is credited. Revenue accounts (like Fees earned or Sales) are almost always credited. The exception would be a refund given or closing entry.

8 6. Assume we earn Fees on Account, it would look like this: + AR - - Fees Earned + 1,000 1,000 Both AR and Fees earned go up, so AR is debited and Fees earned is credited. 7. What if we make a payment on our AP. AP would go down and we would pay this with cash, so cash would also go down. It would look like this: + Cash - - AP What if a customer paid off the amount owed to us which we had previously sold on account. This amount was previously recorded as a debit to AR, and a credit to Fees Earned. We do not want to record it in Fees Earned again, we just want to show the receiving of cash (which goes up) and that AR goes down (because the customer no longer owes us the money). + Cash - + AR - 1,000 1,000 IMPORTANT: When you write a journal entry. Notice that the Debit entry is written first and the credit entry is always written second. The credit entry should be indented in ½ inch from the date line. Then indent in another ½ inch a short explanation. If you are in the same month, you only need to put the day in the date column, not month and year again.

9 5. ILLUSTRATION OF ANAYLZING AND SUMMARIZING TRANSACTIONS See examples in textbook for how to post journal entries to ledgers, and on the following pages in the textbook at the end of chapter 2, is an illustration of everything in this chapter put together in a problem. After all the postings are done, you then do a Trial Balance, illustrated on in textbook. A. NORMAL BALANCES OF ACCOUNTS Easiest way to remember normal balance is that it is generally on the + side, or the side you record increases. Therefore, the normal balance for Assets, Expenses and Drawing is the Debit side. The normal balance for Liabilities, Revenues and Capital is the Credit side. More accounts will be introduced in later Chapters. B. JOURNALS AND POSTING TO ACCOUNTS After you have written your journal entry you must post each Debit and Credit entry individually to the ledger. There is a ledger for each account (like Cash, Accounts Payable, Fees earned). If you wrote a Debit entry in the journal, write it as a Debit entry in the Ledger. Ledgers need to have a continuous balance kept. If you have a debit balance and a debit entry, add them together and record the balance. Same if you have two credits. If you have one of each, like a Debit Balance but a new Credit entry, Subtract and put the balance on the larger side. View Chapter 2 power point slides for illustrations of posting. NEW ACCOUNT They introduce Unearned in this chapter. An unearned (compared to a prepaid) is when someone pays you revenue in advance (before you have actually earned it). Therefore, since you have not actually earned it, we call it a liability. C. TRIAL BALANCE Equality of debits and credits in the ledger are verified at the end of each accounting period. To see if debits and credits equal, a form is prepared. This is called the Trial Balance. Compare to Balance sheet and the Trial Balance. Balance sheet list by Assets, Liabilities and Owner s equity. Trial Balance is by Debits and Credits.

10 6. DISCOVERY AND CORRECTION OF ERRORS Example of error Both debit and credit are wrong: We purchased Equipment on account for $500. It was recorded like this: Cash 500 Equipment 500 In this case both parts are wrong as it should be a debit to Equipment and a credit to AP. So I would reverse the entry (reverse the debit and credit), then write the correct entry. To correct: Equipment 500 Cash 500 (to reverse entry from before) Equipment 500 AP 500 (to write correct entry) Example of error Either the debit or the credit is wrong: We purchased Equipment on Account and it was recorded as: Equipment 500 Cash 500 Just the credit is wrong as it should be AP, not cash. So to correct, we will debit cash to zero out the cash, then credit AP (the correct account). Cash 500 AP 500

11 TEST NUMBER 1 -- There is a lot to the chapter. You need to have a clear understanding of the following before moving on. This is the type of items you can expect on Test 1. Understanding Increases and Decreases in Accounts Income Statement Statement of Owner s Equity Balance Sheet Debit Vs. Credit T-Accounts Writing Journal Entries Posting Journal entries to Ledgers Balancing Ledgers Preparing Trial Balance Correcting Entries Your homework and the chapter notes from chapters 1 and 2 will be your best study source.

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