The Double-Entry Accounting System

The Double-Entry Accounting System
Chapter Four The Double-Entry Accounting System This chapter explains how to record transactions using double-entry accounting. Let’s get started.

Debit/Credit Terminology
T-account Account Title Debit Credit Part I A T-account looks like the letter T drawn on a piece of paper. The account title is written across the top of the horizontal bar of the T. Part II The left side of any account is the debit side. Part III The right side of any account is the credit side.

Debit = Left Credit = Right Debits and Credits
Asset accounts increase on the left or debit side and decrease on the right or credit side. Liability accounts increase on the right or credit side and decrease on the left or debit side. Equity accounts increase on the right or credit side and decrease on the left or debit side. Part I In every transaction, the total dollar value of all debits equals the total dollar value of all credits. But, what do the terms debit and credit mean? Part II Debit means left and credit means right. That is all. Just as we have all agreed that a red light means stop and a green light means go, accountants have agreed to the use of these special terms to refer to different sides of an account. Part III Asset accounts increase on the left or debit side and decrease on the right or credit side. Part IV Liability accounts increase on the right or credit side and decrease on the left or debit side. This is just opposite of the way assets increase and decrease. Part V Like liability accounts, equity accounts also increase on the right or credit side and decrease on the left or debit side. In every transaction, the total dollar value of all debits equals the total dollar value of all credits.

Double-Entry Accounting
Let’s see how debits and credits work by looking at transactions for Collins Consultants. Let’s see how debits and credits work by looking at transactions for Collins Consultants.

Asset Source Transaction
Event 1: Collins Consultants was established on January 1, 2005, when it acquired $15,000 cash from Collins. Increase assets (cash). Increase equity (common stock). Asset Source Transaction Part I Event one: Collins Consultants was established on January 1, 2005, when it acquired fifteen thousand dollarscash from Collins. Part II This transaction increases the cash asset account and increases the common stock equity account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 2: On February 1, Collins Consultants issued a 12%, $10,000 note payable to the National Bank to borrow cash. Increase assets (cash). Increase liabilities (notes payable). Asset Source Transaction Part I Event two: On February 1, Collins Consultants issued a twelve percent ten thousand dollar note payable to the National Bank to borrow cash. Part II This transaction increases the cash asset account and increases the notes payable liability account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 3: On February 17, Collins Consultants purchased $850 of office supplies on account from Morris Supply Company. Increase assets (supplies). Increase liabilities (accounts payable). Asset Source Transaction Part I Event three: On February 17, Collins Consultants purchased eight hundred fifty dollars of office supplies on account from Morris Supply Company. Part II This transaction increases the supplies asset account and increases the accounts payable liability account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 4: On February 28, Collins Consultants signed a contract to evaluate the internal control system used by Kendall Food Stores. Kendall paid Collins $5,000 in advance for these future services. Increase assets (cash). Increase liabilities (unearned revenue). Asset Source Transaction Part I Event four: On February 28, Collins Consultants signed a contract to evaluate the internal control system used by Kendall Food Stores. Kendall paid Collins five thousand dollars in advance for these future services. Part II This transaction increases the cash asset account and increases the unearned revenue liability account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 5: On March 1, Collins Consultants received $18,000 from signing a contract to provide professional advice to Harwood Corporation over a one-year period. Increase assets (cash). Increase liabilities (unearned revenue). Asset Source Transaction Part I Event five: On March 1, Collins Consultants received eighteen thousand dollars from signing a contract to provide professional advice to Harwood Corporation over a one-year period. Part II This transaction increases the cash asset account and increases the unearned revenue liability account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 6: On April 10, Collins Consultants provided $2,000 of services to Rex Company on account. Increase assets (accounts receivable). Increase equity (consulting revenue). Asset Source Transaction Part I Event six: On April 10, Collins Consultants provided two thousand dollars of services to Rex Company on account. Part II This transaction increases the accounts receivable asset account and increases the consulting revenue equity account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 7: On April 29, Collins Consultants performed services and received $8,400 cash. Increase assets (cash). Increase equity (consulting revenue). Asset Source Transaction Part I Event seven: On April 29, Collins Consultants performed services and received eight thousand four hundred dollars cash. Part II This transaction increases the cash asset account and increases the consulting revenue equity account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Asset Exchange Transaction
Event 8: On May 1, Collins Consultants loaned Reston Company $6,000. Reston issued a 9% note to Collins. Increase assets (notes receivable). Decrease assets (cash). Asset Exchange Transaction Part I Event eight: On May 1, Collins Consultants loaned Reston Company six thousand dollars. Reston issued a nine percent note to Collins. Part II This transaction increases the notes receivable asset account and decreases the cash asset account. It is classified as an asset exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 9: On June 30, Collins purchased office equipment for $42,000 cash. Increase assets (office equipment). Decrease assets (cash). Asset Exchange Transaction Part I Event nine: On June 30, Collins purchased office equipment for forty two thousand dollars cash. Part II This transaction increases the office equipment asset account and decreases the cash asset account. It is classified as an asset exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 10: On July 31, Collins paid $3,600 cash in advance for a one year lease to rent office space for a one-year period beginning August 1. Increase assets (prepaid rent). Decrease assets (cash). Asset Exchange Transaction Part I Event ten: On July 31, Collins paid three thousand six hundred dollars cash in advance for a one year lease to rent office space for a one-year period beginning August 1. Part II This transaction increases the prepaid rent asset account and decreases the cash asset account. It is classified as an asset exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 11: On August 8, Collins Consultants collected $1,200 from Rex Company as partial payment of the accounts receivable (see Event 6). Increase assets (cash). Decrease assets (accounts receivable). Asset Exchange Transaction Part I Event eleven: On August 8, Collins Consultants collected one thousand two hundred dollars from Rex Company as partial payment of the accounts receivable (see Event six). Part II This transaction increases the cash asset account and decreases the accounts receivable asset account. It is classified as an asset exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 12: On September 4, Collins Consultants paid employees who worked for the company $2,400 in salaries. Decrease assets (cash). Decrease equity (salaries expense). Asset Use Transaction Part I Event twelve: On September 4, Collins Consultants paid employees who worked for the company two thousand four hundred dollars in salaries. Part II This transaction increases the cash asset account and decreases equity by increasing the salaries expense account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 13: On September 20, Collins Consultants paid a $1,500 cash dividend to its owner.
Decrease assets (cash). Decrease equity (dividends). Asset Use Transaction Part I Event thirteen: On September 20, Collins Consultants paid a one thousand five hundred dollars cash dividend to its owner. Part II This transaction decreases the cash asset account and decreases equity by increasing the dividends account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 14: On October 10, Collins Consultants paid Morris Supply Company the $850 owed from purchasing office supplies on account (see Event 3). Decrease assets (cash). Decrease liabilities (accounts payable). Asset Use Transaction Part I Event fourteen: On October 10, Collins Consultants paid Morris Supply Company the eight hundred fifty dollars owed from purchasing office supplies on account (see Event three). Part II This transaction decreases the cash asset account and decreases the accounts payable liability account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Claims Exchange Transaction
Event 15: On November 15, Collins completed its consulting evaluation of the internal control system used by Kendall Food Stores (see Event 4). Decrease liabilities (unearned revenue). Increase equity (consulting revenue). Claims Exchange Transaction Part I Event fifteen: On November 15, Collins completed its consulting evaluation of the internal control system used by Kendall Food Stores (see Event four). Part II This transaction decreases the unearned revenue liability account and increases the consulting revenue equity account. It is classified as a claims exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Event 16: On December 18, Collins Consultants received a $900 bill from Creative Ads for advertisements which had appeared in regional magazines. Collins plans to pay the bill later. Increase liabilities (accounts payable). Decrease equity (advertising expense). Claims Exchange Transaction Part I Event sixteen: On December 18, Collins Consultants received a nine hundred dollar bill from Creative Ads for advertisements which had appeared in regional magazines. Collins plans to pay the bill later. Part II This transaction decreases the accounts payable liability account and decreases equity by increasing the advertising expense account. It is classified as a claims exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 1: Collins Consultants recognized accrued interest on the $6,000 note receivable from Reston (see Event 8). Increase assets (interest receivable). Increase equity (interest revenue). Asset Source Transaction Part I Adjustment one: Collins Consultants recognized accrued interest on the six thousand dollars note receivable from Reston (see Event eight). Part II This transaction increases the interest receivable asset account and increases the interest revenue equity account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 2: Collins Consultants recognized accrued interest expense on the $10,000 note payable it issued to National Bank (see Event 2). Increase liabilities (interest payable). Decrease equity (interest expense). Claims Exchange Transaction Part I Adjustment two: Collins Consultants recognized accrued interest expense on the ten thousand dollar note payable it issued to National Bank (see Event two). Part II This transaction increases the interest payable liability account and decreases equity by increasing the interest expense account. It is classified as a claims exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 3: Collins Consultants recognized $800 of accrued but unpaid salaries. Increase liabilities (salaries payable). Decrease equity (salaries expense). Claims Exchange Transaction Part I Adjustment three: Collins Consultants recognized eight hundred dollars of accrued but unpaid salaries. Part II This transaction increases the salaries payable liability account and decreases equity by increasing the salaries expense account. It is classified as a claims exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 4: Collins Consultants recognized $4,000 of depreciation on the office equipment it had purchased on June 30 (see Event 9). Decrease assets (accumulated depreciation). Decrease equity (depreciation expense). Asset Use Transaction Part I Adjustment four: Collins Consultants recognized four thousand dollars of depreciation on the office equipment it had purchased on June 30 (see Event nine). Part II This transaction decreases assets by increasing the accumulated depreciation contra asset account and and decreases equity by increasing the depreciation expense account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 5: Collins Consultants recognized rent expense for the portion of prepaid rent used up since entering the lease agreement on July 31 (see Event 10). Decrease assets (prepaid rent). Decrease equity (rent expense). Asset Use Transaction Part I Adjustment five: Collins Consultants recognized rent expense for the portion of prepaid rent used up since entering the lease agreement on July 31 (see Event ten). Part II This transaction decreases the prepaid rent asset account and and decreases equity by increasing the rent expense account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 6: A physical count at the end of the year indicates that $125 worth of the supplies purchased on February 17 are still on hand (see Event 3). Decrease assets (supplies). Decrease equity (supplies expense). Asset Use Transaction Part I Adjustment six: A physical count at the end of the year indicates that one hundred twenty five dollars worth of the supplies purchased on February 17 are still on hand (see Event three). Part II This transaction decreases the supplies asset account and and decreases equity by increasing the supplies expense account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

Adjustment 7: Collins Consultants adjusted its accounting records to reflect revenue earned to date on the contract to provide services to Harwood Corporation for a one-year period beginning March 1 (see Event 5). Decrease liabilities (unearned revenue). Increase equity (consulting revenue). Claims Exchange Transaction Part I Adjustment seven: Collins Consultants adjusted its accounting records to reflect revenue earned to date on the contract to provide services to Harwood Corporation for a one-year period beginning March 1 (see Event five). Part II This transaction decreases the unearned revenue liability account and and increases the consulting revenue equity account. It is classified as a claims exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV Here is the illustration of the impact on the T-accounts.

The transactions presented in this chapter illustrate the relationships summarized in Panel A of this exhibit. Panel B illustrates these relationships in T-account form. You may want to take a few minutes and review this fundamental information.

Here is a summary of the ledger accounts after recording the transactions for Collins Consultants.

The General Journal Special Journals
Accountants initially record data from source documents into a journal. Part I Accountants initially record data from source documents into a journal. Examples of source documents include invoices, time cards, check stubs, and deposit tickets. Transactions are recorded in journals before they are entered into the ledger accounts. Journals are therefore called books of original entry. Part II A company may use a general journal as well as several special journals. Special journals are used to record specific types of repetitive transactions. For example, a company may use a special journal to record cash receipts, another to record cash payments, a third to record purchases on account, and yet another to record sales on account. Transactions that do not fit in a special journal are recorded in the general journal. For simplicity, this text uses only a general journal format. Part III Here is an example of an entry in the general journal. There are columns for the date, account titles, debit amount and credit amount. Notice that the debit accounts are always written first followed by the credit accounts. The credit account titles are indented slightly.

Here is a summary of the general journal entries for Collins Consultants. After the transactions have been recorded in a journal, the dollar amounts of the debits and credits are transferred to the ledger accounts. The process of transferring information from journals to ledgers is called posting. Take a few minutes and review this information and be sure you are comfortable with it before proceeding.

The account balances from the ledgers provide the information for the financial statements. Here is the familiar income statement.

Here is the statement of changes in stockholders’ equity.

Here is the balance sheet.

Finally, here is the statement of cash flows.

Let’s look at the closing entries for Collins Consultants.
The Closing Process Establishes zero balances in all revenue, expense, and dividend accounts. Let’s look at the closing entries for Collins Consultants. Once again, we will review the closing process. Remember that the closing process establishes zero balances in all revenue, expense, and dividend accounts. Let’s look at the closing entries for Collins Consultants.

Here are the closing entries for Collins Consultants
Here are the closing entries for Collins Consultants. These entries move all the 2003 data from the Revenue, Expense, and Dividend accounts into the Retained Earnings account.

This exhibit illustrates the trial balance for Collins Consultants
This exhibit illustrates the trial balance for Collins Consultants. Companies frequently prepare a trial balance to verify the equality of debits and credits in the ledger. A trial balance lists all accounts with their balances in separate debit and credit columns. If the debits do not equal the credits, the accountant knows to search for an error.

Components of the Annual Report
Notes Management’s Discussion & Analysis The annual report is usually printed on color high quality paper and contains lots of photographs. The annual report includes much more than the financial statements. The notes to the financial statements are detailed explanations that help explain the numbers in the financial statements. Management’s discussion and analysis (M D and A) explains management’s take on the past performance of the company and their future plans. The audit opinion is issued by the independent auditor and expresses an opinion on the fairness of the financial statements. We discussed audit opinions in chapter two. Audit Opinion

The Securities and Exchange Commission
Government Agency Public Companies The annual reports of public companies often differ from those of private companies because public companies are registered with the Securities and Exchange Commission and must follow their specific rules. The Securities and Exchange Commission is a governmental entity authorized to establish and enforce accounting rules for public companies. For example, the M D and A section is required by the Securities and Exchange Commission, but not by generally accepted accounting principles. As a result, annual reports of non- Securities and Exchange Commission companies usually do not include M D and A. SEC Rules

End of Chapter Four This chapter explained how to record transactions using double-entry accounting.

The Double-Entry Accounting System

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