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Chapter 3

Capturing Economic Events


General Ledger
Debits and Credits
Normal Account Balances
Journal Entries
The Income Statement

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

• Prepare common journal entries


• Post to the Ledger accounts
• Prepare a basic Income Statement

Accounting Cycle - sequence of procedures used to record, classify and summarize


accounting information in financial reports, on a regular basis.

Steps in the Accounting Cycle


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

General Journal and Journal Entries


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

Journal entries should be made contemporaneously with the event they are recording, or
reasonably soon after the event. Keep in mind that a journal is a chronological record of
events. A contemporaneous writing is one that takes place at the same time as the event.
This is the best time to record an event, because the facts and details are still fresh in our
minds. Necessary documents, conversations, calculations, etc., are readily available to
create a correct record of the event. If we wait too long, the event will be much more
difficult to reconstruct.
In a legal sense, a contemporaneous writing carries much more weight than a writing
made at a later date. And a writing carries much more weight than a mere
recollection of events, months or years after the event has taken place. The courts
recognize that people's memories about events are much clearer right after the event has
taken place. As to the sale of real estate, state laws require a contemporaneous writing, to
establish the exact terms and conditions of the sale. In contract law, this is called a
“meeting of the minds,” and must be present for a valid contract to exist.

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

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

Posting - journal entries are copied to the accounts in the Ledger.


After posting, the balance in each account is updated. Accounts always carry the most
current balance.

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

Books & Bookkeeping


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

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

Debits and Credits


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

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.

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

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. We will always assume that we
are using the US Dollar in all transactions, journals, ledgers and financial statements.

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

When do we use Debit or Credit?


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

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

Remember the Accounting Equation?

Assets = Liabilities+Owners' Equity


Left side Right Side
Debit side Credit Side

Debit = Increase Credit = Increase


Credit = Decrease Debit = Decrease

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

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

Normal Account Balances


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

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

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

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

Type of entry Do this


Record a sale credit a revenue account
Record an expense debit an expense account
Record a credit sale debit Accounts Receivable
Record a cash sale debit Cash
Buy supplies on credit credit Accounts Payable

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

A funny accounting story (yes, there are accountant jokes)


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

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

The old accountant took the younger one into his office and opened his desk drawer.
There was a 3" x 5" index card. It said: "Debits on the Left, Credits on the Right"
-----------

When you are just learning how to make journal entries, a little reminder or hint can
make the task much easier. Don't try and reason out every journal entry. If you are going
to replace the oil in your car, you don't have to know everything about how the engine
works. You only have to find the one bolt to turn to let the oil out. Don't make the job any
more difficult than it is.
As an accounting student I kept these little reminders around all the time. As a
professional I've done the same thing, except with more complex issues. This is just good
practice. Many of the tasks we do are very mechanical in nature. Follow a few simple
rules, refer to the hints and tips.

About my student, Al (a true story)


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

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

And then there was Mary (another true story)


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

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

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

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

In the field of accounting, our terminology IS widely used. Millions of people use the
same terms and concepts daily to mean the same thing. This is part of the concept of
"generally accepted" - the part of GAAP that refers to common practices. Take a little
time to understand the terminology you learn in this course, and it will help you for many
years to come.
Accounting is nothing more than a way to organize information, so it is useful to people
who have to make financial and business decisions. A large number of people use the
same concepts, methods, etc. on a daily basis. You can too.

Easy Method to journal entries.


Follow these simple steps. Ask yourself these questions:

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

2) Was Cash received or paid?

Cash Received = Increase = Debit Column = Left Column

Cash Paid = Decrease = Credit Column = Right Column

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

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


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

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

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

..............
The Cash account is equivalent to the company's checking account. The balance goes up
when money is deposited in the account, and the balance goes down when checks are
written. It works just like your checking account!
So now you know that Cash is an Asset account, is on the Left side of the accounting
equation, and the balance can go up or down. The rules you use for the Cash account will
be the same for all asset accounts. Now you know how to make journal entries for all
asset accounts. Wasn't that easy?

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

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

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

1) Is Cash used in this transaction? Yes.


2) Was Cash received or paid? Received. [Increase = Debit Column]
--- enter the Cash portion of the journal entry

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.

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, tighten your thinking
bolts and select the correct account for the second part. This is a sale, so we will use
Sales Revenue for the Credit side of the journal entry.

Date Account Debit Credit


Mar-20 Cash $100
Sales Revenue $100

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

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

Date Account Debit Credit


Apr-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.

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

Date Account Debit Credit


Apr-1 Rent Expense $500
Cash $500
..............
Another example .... without cash. April 20, the company opens a charge account
at Office Emporium. They buy a $1000 computer, and say "charge it!"

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

Date
Account
Debit
Credit

Apr-20

$1000

cash

$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, tighten your
thinking bolts and select the correct account for the second part. This is an
example of buying equipment, in this case we will use the account Office
Equipment.

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

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