Chapter 2: Recording business transactions

Chapter 1 analysed transactions with plus and minus signs in the accounting equation. Real companies record thousands of transactions, so they need a system. This chapter introduces that system: accounts, debits and credits, the journal, the ledger and the trial balance. This is the double-entry bookkeeping that has been used for more than five centuries, and it is the technique behind almost every calculation question in the financial part of the exam.

Accounts

An account is the detailed record of all increases and decreases in one item during a period. The list of all accounts of a company is its chart of accounts. Common accounts:

Category	Accounts and meaning
Assets	Cash (bank balances, coins, cheques); Accounts receivable (a customer's promise to pay later, "on account"); Notes receivable (a written, more formal promise including interest); Prepaid expenses (paid in advance, such as prepaid rent, prepaid insurance, office supplies: an asset because the benefit lies in the future); Land; Building; Equipment, furniture and fixtures
Liabilities	Accounts payable (a promise to pay a supplier, from a purchase on credit); Notes payable (a written promise, usually with interest); Accrued liabilities (owed but not yet paid: taxes payable, rent payable, salaries payable); Unearned revenue (cash received before the product or service has been delivered)
Equity	Common stock (contributions of stockholders, increases equity); Dividends (distributions, decrease equity); Revenues (service revenue, rent revenue: increase equity); Expenses (rent expense, salaries expense, utilities expense: decrease equity)

Double-entry accounting: debits and credits

Every transaction affects at least two accounts. The double-entry system records both effects. Buying office supplies for cash, for example, increases Office supplies and decreases Cash.

A simple picture of an account is the T-account: the account name on top, the left side is called the debit side and the right side the credit side. Debit and credit simply mean left and right; they do not mean good or bad. Whether a debit increases or decreases an account depends on the type of account:

Account type	Increase	Decrease	Normal balance
Assets	Debit	Credit	Debit
Liabilities	Credit	Debit	Credit
Common stock	Credit	Debit	Credit
Revenues	Credit	Debit	Credit
Expenses	Debit	Credit	Debit
Dividends	Debit	Credit	Debit

The logic follows from the equation. Assets are on the left of A = L + E and increase on the left (debit); liabilities and equity are on the right and increase on the right (credit). Revenues increase equity, so they increase with a credit. Expenses and dividends decrease equity, so they increase with a debit. The normal balance of an account is on its increase side. In every journal entry, total debits equal total credits, so the equation always stays in balance.

Memory aid

Debit increases: Dividends, Expenses, Assets. Credit increases: Liabilities, Revenues, Common stock (equity). If you know these two groups, you can journalize every transaction in this course.

The balance of a T-account is the difference between its debit total and credit total, shown on the side with the larger total.

From source document to ledger

Transactions start with source documents that prove they happened: sales invoices, purchase invoices, bank cheques, receipts. The accountant then:

identifies the accounts involved and their type (asset, liability, equity);
decides whether each account increases or decreases and applies the debit and credit rules;
records the transaction in the journal, the chronological record of all transactions (date, accounts, debit amount, credit amount, short explanation);
posts the journal entry to the ledger, the collection of all accounts with their balances;
checks that the accounting equation is still in balance.

Journal entries for Smart Touch Learning

The nine transactions of chapter 1 as journal entries (by convention the debit line comes first and the credited account is indented):

Account	Debit	Credit
1. Cash	30,000
Common stock		30,000
2. Land	20,000
Cash		20,000
3. Office supplies	500
Accounts payable		500
4. Cash	5,500
Service revenue		5,500
5. Accounts receivable	3,000
Service revenue		3,000
6. Rent expense	2,000
Salaries expense	1,200
Cash		3,200
7. Accounts payable	300
Cash		300
8. Cash	2,000
Accounts receivable		2,000
9. Dividends	5,000
Cash		5,000

Entry 6 is a compound journal entry: it has more than one debit (or credit). In December the company records more transactions that show other typical entries:

It prepays three months' rent of $3,000: Dr Prepaid rent 3,000, Cr Cash 3,000. The prepayment is an asset, not yet an expense.
It buys a $60,000 building in exchange for a note: Dr Building 60,000, Cr Notes payable 60,000.
The owner contributes furniture with a fair market value of $18,000 for stock: Dr Furniture 18,000, Cr Common stock 18,000. Non-cash contributions are recorded at market value.
It receives a $100 telephone bill to be paid next month: Dr Utilities expense 100, Cr Utilities payable 100. The expense belongs to December even though cash is paid later.
A law firm pays $600 in advance for future services: Dr Cash 600, Cr Unearned revenue 600. The company owes the service, so this is a liability.

After all November and December entries, total assets are $114,700, total liabilities $60,900 and equity $53,800: the equation balances.

The trial balance

A trial balance lists all ledger accounts with their balances at a point in time: assets first, then liabilities, then equity (common stock, dividends, revenues, expenses). It checks whether total debits equal total credits, and it is the starting point for the financial statements.

A trial balance in balance does not prove the books are correct. It does not detect a transaction that was never recorded, a transaction recorded twice, or an amount posted to the wrong account on the correct side. It does detect one-sided errors. A typical exam trick: if a $2,000 debit to accounts receivable is posted as a credit, the account is wrong by twice the amount, $4,000, because the debit is missing and an unjustified credit was added.

Exercise from the solutions: correcting a trial balance

A company's trial balance does not balance. Some of the errors found: cash understated by $4,000; a $2,000 debit to accounts receivable posted as a credit; a $1,200 purchase of supplies on account never recorded; equipment transferred as $88,000 instead of $87,700; a $100 cash dividend recorded as $1,000; a $2,000 debit to prepaid insurance posted as a credit. Corrections: cash +4,000; accounts receivable +4,000 (twice 2,000); supplies and accounts payable each +1,200; equipment −300; dividends −900 and cash +900; prepaid insurance +4,000. After all corrections the totals are equal at $117,700.

Evaluating performance: the debt ratio

The debt ratio shows the proportion of assets financed with debt. It indicates whether the company can pay its debts and whether it carries so much debt that it is risky.

Debt ratio = \frac{Total liabilities}{Total assets}

Kohl's reported total liabilities of $6,942 million and total assets of $12,469 million: debt ratio = 6,942 / 12,469 = 0.557, so about 56% of its assets are financed by creditors and 44% by stockholders. The higher the ratio, the higher the financial risk.

For the exam

Be able to journalize any basic transaction instantly. Ask: which accounts, which type, increase or decrease?
Prepaid expenses are assets; unearned revenue is a liability; dividends have a debit balance but are not an expense.
A balanced trial balance can still contain errors; a debit posted as a credit causes an error of twice the amount.
Debt ratio = total liabilities / total assets (no averages).

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