Accounts, Debits, and Credits

The earlier chapter showed how transactions caused financial statement amounts to amend. "After" and "Before" the inferences, etc. was made in use to develop the illustrations. Visualize if a real business tried to keep up with its dealings this way! Possibly a giant chalk board could be set up in the office department. As transactions happen, they would be called in to the section and the chalk board would be updated. Chaos would rapidly rule. Even if the business could handle to figure out what its financial statements were supposed to hold, it possibly could not systematically explain the transactions that produced those results. Obviously, a system is required.

It is imperative that a business expand a reliable accounting system to capture and summarize its capacious transaction data. The system should be sufficient to fuel the preparation of the financial statements, and be competent of maintaining retrievable documentation for every transaction In other words we can say that some transaction logging process should be in place. In common terms, an accounting system is a system where transactions and events are reliably processed and summarized into helpful financial statements and the reports. Whether the system is manual or automated, the heart of the system will consist the basic processing tools: debits, accounts and credits, journals, and the common ledger. This chapter will give us insight into these tools and the common structure of a typical accounting system.

1.  Accounts

The records and files that are kept for the individual asset, revenue, liability, equity, expense, and dividend components are called as accounts. In other words we can say a business would maintain an account for cash, another account for the inventory, and so forth for the every other financial statement element. All accounts, together, are said to comprise a firm's common ledger. In a manual dealing out system, you could imagine the common ledger as nothing more than the notebook, with a different page for every account. Thus, you can thumb through the notebook to see the "ins" and "outs" of the each every account, as well as active balances. An account could be as straightforward as the shown below:

This account reveals that money has a balance of $63,000 as of January 12. By investigating the account, you can see the number of transactions that caused rise and decreases to the $50,000 starting of month cash balance. In many respects, this money account resembles the "register" you might keep for a folder style check book. If you were to make a balance sheet on January 12, you would take in cash for the indicated quantity (and, so forth for each of the other accounts consists of the entire financial statements.

This balance sheet reveals that money has a balance of $63,000 as of January 12. By investigative the account, you can see the number of transactions that caused rise and decreases to the $50,000 starting of month cash balance. In many respects, this Cash account is similar to the "register" you may keep for a folder style check book. If you were to make a balance sheet on January 12, you would include cash for the indicated quantity (and, so forth for each of the other accounts consisting the total financial statements).

2. Debits and Credits

Without a doubt, you have heard or seen a reference to debits and credits; possibly you have had someone "credit" your account or may have made use of a "debit" card to buy anything. Debits (abbreviated "dr") and credits (abbreviated "cr") are distinctive accounting tools to explain the change in a particular account that is necessitated by a transaction. In other words, instead of saying that cash is "increased" or "decreased," we say that cash is "debited" or "credited." This technique is again traced to Pacioli, the Franciscan monk who is given credit for the growth of our enduring accounting model. Why add this difficulty -- why not just use plus and minus like in the earlier chapter? You will soon come to know that there is a clever answer to this question!

Understanding the solution to this question starts by taking note of two very significant observations: (1) each and every transaction can be described in debit/credit form

and

(2) for each andevery transaction, debits = credits

3. The Fallacy of "+/-" Nomenclature

The second inspection above would not be true for an increase or decrease system. For example, if services are provided to clientele for cash, both cash and revenues would raise (a "+/+" outcome). On the other hand, paying an account to be paid causes reduce in cash and reduce in accounts payable (a "-/-" outcome). Finally, several transactions are a mixture of increase/decrease the effects; using cash to buy land causes cash to reduce and land to increase (a "-/+" outcome). In the earlier chapter, the "+/-" nomenclature was used for the different illustrations.

As you can tell by reviewing the explanation in Part 1, the "+/-" system lacks internal consistency. Hence it is easy to get something wrong and be completely unaware that something has gone amiss. Conversely, the debit/credit system has internal consistency. If one attempts to describe the effects of a transaction in debit/credit form, it will be readily apparent that something is wrong when debits do not equal credits. Even modern computerized systems will challenge or preclude any effort to enter an "unbalanced" transaction that does not convince the condition of debits = credits.

4. The Debit/Credit Rules

At first, it is natural for the debit/credit rules to seem highly confusing. However, the debit/credit rules are inherently reasonable (the logic is discussed at linked material in the online account of the text). But, memorization generally precedes comprehension. So, you are well advised to remember the "debit/ credit" rules now. If you will thoroughly learn these rules first, your life will be much simpler as you press forward with your studies in the field of accounting.

5. Assets/Expanses Dividends

As shown at right, these three types of accounts go after the same set of debit/credit rules. Debits increase these accounts and credits decline these accounts. These accounts usually carry a debit balance. To aid your recall, you may rely on this Slightly off-colour mnemonic: D-E-A-D = debits increase expenses, resources, and dividends.

6. Liabilities/Revenues/Equity

These three types of accounts follow the norms that are the opposite of those just explained. Credits increase liabilities, equity and revenue while debits result in decreases. These accounts generally carry a credit balance.

7. Analysis of Transactions and Events

You now know that dealings and events can be expressed in “debit/credit” terminology. In essence, accountants have their own exclusive shorthand to portray the financial statement consequence for each recordable event. This means that as transactions happen, it is important to perform an analysis to determine
 (a) what accounts are impacted
 (b) how these are impacted (increased or decreased).
 Then, debits and credits are applied to the accounts, making use of the rules set forth in the preceding paragraphs.

Generally, a recordable transaction will be evidenced by a number of “source documents” that supports the fundamental transaction. A cash disbursement will be helped by the issuance of a check. A sale may be supported by an invoice issued to a client. Receipts may be taken to show the reason for a particular spending. A time report may sustain payroll costs. A tax statement may document the quantity paid for taxes. A cash register tape might show the cash sales. A bank deposit slip might show the collections of client receivables. Suffice it to say, there are number of potential source documents, and this is just a little sample. Source documents generally serve as the trigger for initiating the recording of the transaction. The source documents are analyzed to decide the nature of a transaction and what balance sheet is impacted. Source documents should be taken (perhaps in electronic form) as a significant part of the records supporting the variety of debits and credits that are entered into the accounting records. A properly planned accounting system will have controls to make sure that all transactions are fully captured. It will not perform for transactions to slip by the cracks and go unrecorded. There are number of such safeguards that can be put in place, including use of renumbered documents and usual reconciliations. For example, you probably keep a check book where you record your cash disbursements. Hopefully, you maintain up with all of the checks (by check number) and carry out a monthly reconciliation to make sure that your check book accounting system has accurately reflected all of your disbursements. A business should engage in similar activities to make sure that all transactions and events are recorded accurately. Good controls are necessary to business success.

8. Determining an Account’s Balance

The balance of a definite account can be examined by considering its starting (of period) balance, and then offsetting or netting all of the additional debits and credits to that account during the period. Prior, an illustration for a Cash account was offered. That illustration was obtained before you were introduced to debits and credits cards. Now, you know that accounts are more possible maintained by using the debit/credit cards. So, the Cash account is repeated lower, except that the increase/decrease columns have been replaced with the number of traditional debit/credit column leadings. A typical Cash account will look similar to this illustration: 

9. A Common Misunderstanding about Credits

Many people mistakenly assume that credits always decrease an account balance. Hear a quick review of the debit/credit rules reveals that this is not right. Where does this concept which is stated above come from?

Perhaps because of the common phrase "we will make your account." This wording is often used when you return goods purchased on credit; but, cautiously consider that your account (with the store) is on the store's books as a benefit account (specifically, an account receivable). Hence, the store is decreasing its accounts receivable asset account (with a credit) when it agrees to "credit the account."

On the other hand, some may suppose that a credit always raise an account. This incorrect concept may originate with general banking terminology. Suppose that Matthew made a deposit to his

Account at Monalo Bank. Monalo's balance sheet would involve an obligation ("liability") to Matthew or the amount of money on the deposit. This responsibility would be credited each time Matthew adds to his account. Thus, Matthew is said that his account is being "credited" when he makes certain deposit.

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