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Recording Transactions

Accounting requires very specific methods of recording transactions. Generally, transactions are recorded through the use of accounts. These accounts are actually places within accounting systems in which changes in assets, liabilities, owner's equity, revenues, and expenses are recorded. The changes reflect increases or decreases in these accounts over a given time period.

In its simplest form, an account looks very much like the letter "T", hence the name "T-Account"

                                                               "Account Name"

                          Debit                                                                                 Credit

The left side of the T-Account is called the debit side, while the right side is called the credit side. Therefore, if we enter amounts on the left side, we are debiting; on the right side we are crediting.

Debits and Credits have opposite effects.  Depending on the type of account, one will cause an increase, the other a decrease and vice versa.  To explain further, here are the debit and credit rules:

For Assets

For Liabilities

For Owner's Equity

ASSETS = LIABILITIES + OWNER'S EQUITY    ("ALOE")

Further rules for Debits and Credits are as follows:

Credit all revenues to revenue accounts, as they represent an increase in owner's equity.

Debit all expenses to expense accounts, as they represent a decrease in owner's equity.

 

Double-Accounting

Every transaction affects, and is recorded in, two accounts. Consider the following:

Bill invests $1,000 in his company.

First, we debit Cash to show an increase of an asset, and we credit owner's equity to show the increase of capital.

                                                                Cash

  Debit                                  Credit

                                                                Owner's Equity

                                                 Debit                                    Credit

T-Accounts are useful tools when recording transactions. However, to avoid errors, a more thorough approach must be taken. This involves the introduction of the General Journal, the transfer of data to the Ledger, and the creation of the Unadjusted Trial Balance.

The General Journal

The General Journal is the first stage of recording a transaction. Each journal entry requires several pieces of information for each transaction that is to be recorded. These include:

1. The date of the transaction.

2. The names of the accounts which are affected.

3. The amount that is to be debited/credited.

4. An explanation as to what the transaction involves.

 

Below are several events and their corresponding journal entries:

Events: In December 2000, John Smith:

1. Invested $9,000 in a law practice.

2. Purchased books (for law library) for $2,500 cash.

3. Purchased office equipment for $5,600 cash.

4. Purchased law library items for $380 and office equipment for $1,280 all on account.

The General Journal below shows how you would record the information given above:

An example of a General Journal is displayed in the Financials example, Table 1.   Once you finish the General Journal, you then take all entries and transfer them to the Ledger.

Ledger

The general ledger contains the sum of all T-Accounts. For example, the cash account would look like this:

                                 Dr.                                  Cash                                      Cr.

In the cash account, we entered all cash inflows and outflows, for the period, into our T-account under either debit or credit. Then we added each side together, and came up with a debit balance of $900. This means that during this period, we brought in $900 more than we sent out.   An example of a ledger is displayed in the Financials example, Table 2.  Once we complete the rest of the ledger (for the rest of the T-Accounts), we can move forward to the Unadjusted Trial Balance.

Unadjusted Trial Balance

The unadjusted trial balance is a summary of the ledger. It displays the totals for each account that were determined previously. For example, the cash account would show a $900 debit balance. In essence, all accounts are summarized in the unadjusted trial balance in an easy-to-understand, simple manner.   An example of an unadjusted trial balance is shown in the Financials Example, Table 3.

Adjusting Accounts

Financial statements are prepared for each accounting period. Transactions are journalized and placed into the ledger. Once all accounts are totaled, the unadjusted trial balance is created. However, there are normally adjustments that need to be made. For example:

A firm has $2400 in Prepaid Insurance. The policy is good for 2 years. If our unadjusted trial balance is as of December 1, 2000, and our accounting period actually does not end until December 31, 2000, we have to account for the month that has elapsed in our policy. We know that in one month, our policy will decrease in value by $100 ($2400/24 months). The journal entry for this is as follows:

Dr. Insurance Expense         $100

            Cr. Prepaid Insurance         $100

-To account for one month of insurance policy expired.

The above transaction accounts for the expiration of one month of insurance, and is an adjustment.  Once all adjustments have been accounted for, the adjusted trial balance is prepared.  An example of adjustments, and the adjusted trial balance is shown in the Financials example, Table 3.

Summary

As you can see from the above material, recording transactions is a long process. Even after the information has been recorded, further steps must be taken in order to complete the accounting cycle. These include the adjusted trial balance, the income statement, the statement of changes in owner’s equity, and the balance sheet (all of which are explained in the Financial Statements section). Probably the best way to illustrate the idea of recording transactions and preparing financial statements is to work through an example.  Example A was created with that purpose in mind.

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