T Accounts, Debits, and Credits

Ch. 2: T Accounts, Debits, Credits 1

Chapter 2

T Accounts, Debits, and Credits

In this chapter you will continue learning about the process of accounting. You will see how the accounting system maintains the equality of the accounting equation.

The Accounting Equation

As discussed in Chapter 1, resources and where they come from are at the heart of modern financial accounting systems. In business terminology, resources are called assets. Sources of borrowed resources are called liabilities. Sources of resources invested by owners and generated by management and retained in the company are called stockholders' equity. The relationship between resources and their sources is represented by the accounting equation:

Assets / = / Liabilities / + / Stockholders' Equity

Remember, stockholders' equity includes both the dollar amount of resources invested by owners and the dollar amount of resources generated through management operations and retained in the company because owners have a right to the amount of resources they invest and the amount of resources generated by management.

The correct use of the accounting equation guarantees logical financial statements even if events are incorrectly analyzed. That is, as long as the equality of assets to liabilities plus stockholders' equity is maintained, the income statement will properly relate to the statement of retained earnings, the statement of retained earnings will properly relate to the balance sheet, and the balance sheet will balance. If the accounting equation does not balance, the balance sheet will not balance. If the financial statements are not logical, they cannot be relied upon for information about a company's resources.

Logical financial statements do not automatically contain useful information, however. Maintaining the equality of the accounting equation is necessary for useful financial statements, but it is not the only requirement. This and the following chapters will examine the requirements of accounting systems that produce useful information.

** You now have the background to do exercise 2.1.

Maintaining the Equality

of the Accounting Equation

In order for the accounting system to provide useful information, one important requirement is that the accounting equation must always balance. Thus, it is imperative we have a system that will constantly maintain the accounting equation's equality.

Remember the system examined in Chapter 1. In that system we analyzed events of the Parks Computer Service Corporation, determined the effects of the events on specific resources, such as cash and supplies, and sources of resources, such as accounts payable and retained earnings. We used a plus (+) sign to show an increase in an account or a minus (-) sign to show a decrease. In order to determine if the accounting equation was in balance we had to take the following two steps.

Step 1:First we had to determine the balance in each account. For example, to determine the cash balance we had to add all of the plus dollar amounts and subtract all of the minus dollar amounts in the cash account.

Step 2:Once we determined the balance in each account, we had to add all the asset account balances to determine the total assets dollar amount, and then add all the liabilities and stockholders' equity account balances to determine the total liabilities and stockholders' equity dollar amount.

After taking these two steps we could determine if total assets equaled total liabilities and stockholders' equity. Until we completed both steps, we could not be sure the accounting equation was in balance.

What we need is a more efficient way to make sure the accounting equation is always in balance. We need a system that will maintain the balance of the accounting equation without requiring each account balance to be determined and without requiring total assets and total liabilities and stockholders' equity to be calculated after each event.

A more efficient way of maintaining the equality of the accounting equation was developed hundreds of years ago and is known as the double-entry system. It was first presented in a book written in 1494 by a Franciscan monk, Fra Luca Pacioli.

The double-entry system was developed in response to the mathematical problem: how can individual items in the accounting equation change while always maintaining the assets = liabilities + stockholders' equity equation? Today the solution appears to be quite simple. If the left side of the equation (assets) increases, then the right side (liabilities and stockholders' equity) must also increase by the same dollar amount. Similarly, if the left side of the equation decreases, the right side must also decrease by the same dollar amount. From this reasoning, the following simple guidelines evolved.

If an asset increases, one of the following must occur:

(1)another asset must decrease by the same amount. As a result, total assets remain constant and assets = liabilities + stockholders' equity. For example, if supplies increase by $50 and cash decreases by $50, total assets remain unchanged. The accounting equation is still in balance.

(2)a liability must increase by the same amount. As a result, total assets and total liabilities increase by the same amount and assets = liabilities + stockholders' equity. For example, if supplies increase by $125 and accounts payable increase by $125, total assets increase by $125 and total liabilities and stockholders' equity increase by $125. The accounting equation is still in balance.

(3)stockholders' equity must increase by the same amount. As a result, total assets and total stockholders' equity increase by the same amount and assets = liabilities + stockholders' equity. For example, if cash increases by $1,000 and common stock increases by $1,000, total assets increase by $1,000 and total liabilities and stockholders' equity increase by $1,000. The accounting equation is still in balance.

From this basic mathematical process, it can be concluded that each event affecting a business has two parts. One part results in a change in one asset, liability, or stockholders' equity account and the other part results in an equal change in another asset, liability, or stockholders' equity account. It is impossible for an event to result in only an increase or decrease in one account, because the result would be an unbalanced accounting equation. For example, if cash increased by $100 and everything else remained unchanged, assets would no longer equal liabilities plus stockholders' equity. Assets would be $100 larger than liabilities plus stockholders' equity. Remember from Chapter 1, an unbalanced accounting equation results in unreliable information.

The T Account

The basic element of the double-entry system is the T account. T accounts are used to record each event's two parts discussed in the previous paragraphs. As you can see from the illustration below, it is fairly obvious where the name T account came from: the account strongly resembles the letter T. The left side of a T account is called the debit side (from the Latin debere) and the right side is the credit side (from the Latin credere). Remember, this system and its terminology have been in existence for hundreds of years!

Account Name
Debit
(Left side) / Credit
(Right side)

The double-entry system makes use of the T account to make sure both parts of each event are accounted for. Remember, when both parts of each event are accounted for, the accounting equation must balance, as the following section illustrates.

Using T Accounts

To see how the double-entry system makes use of T accounts, let us again consider the July events of the Parks Computer Service Corporation discussed in Chapter 1. We will see how the double-entry system guarantees the accounting equation is always in balance.

Getting resources from the owner On July 1, Nick Parks invests $5,000 cash in his new company, Parks Computer Service Corporation. Nick invests his cash by opening a checking account in the company's name at the Somerville National Bank. As you remember from Chapter 1, an owner's $5,000 cash investment in a company results in a $5,000 increase in the company's resources and a $5,000 increase in its sources of resources. The resource that increases is cash. Since the resource comes from the owner, the source of resources that increases is stockholders' equity, in this case common stock.

Total Resources / = / Sources of Borrowed Resources / + / Sources of Owner Invested Resources / + / Sources of Management Generated Resources
Assets / = / Liabilities / + / Stockholders' Equity
+ $5,000 / = / + $5,000

The company's cash and common stock both increase by $5,000. This event will have the following effects on the company's T accounts.

Assets / = / Liabilities / + / Stockholders' Equity
Event / Cash / = / Common Stock
Owner's cash investment / 5,000 / 5,000
Balances / 5,000 / 5,000
[- $5,000 -] / = / [------$5,000 ------]

Notice the $5,000 increase in cash was entered on the left, or debit, side of the cash T account. In other words, the $5,000 was entered as a debit to cash. Since this is the first event we analyzed, we could have entered it as either a debit or a credit. Since we entered it as a debit, we have developed an accounting rule: assets increase through debits. Notice, however, the increase in common stock was entered as a credit (right side) to the common stock account. We have just developed another accounting rule: stockholders' equity increases through credits. The two rules we developed agree with the accounting process used in modern financial accounting systems.

Why did we enter the increase in assets as a debit and the increase in stockholders' equity as a credit? Remember what we are trying to do. We are trying to develop a system that will constantly maintain the equality of the accounting equation after each event. Does entering equal dollar amounts of debits and credits keep the accounting equation in balance? Consider this first event of the Parks Computer Service Corporation. Cash was debited for $5,000 and common stock was credited for $5,000. Clearly, debits equaled credits: debits were $5,000 and credits were $5,000. Did assets = liabilities + stockholders' equity? After the event, assets (cash) were $5,000 and liabilities + stockholders' equity (common stock) were $5,000. Thus, using the double-entry method of recording equal dollar amounts of debits and credits enabled us to easily maintain the equality of the accounting equation!

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Stockholders’ equity increases through credits.

Using resources to buy other resources On July 3, the company pays $25 cash for supplies to be used to repair and service computers. This event both increases the company's resources when the supplies are bought and decreases its resources when the cash is paid. The supplies resource increases and the cash resource decreases. Since total resources do not change, total sources of resources do not change.

The company's supplies account increases by $25 while its cash account decreases by $25. These effects would be shown in the company's T accounts as follows.

Assets / = / Liabilities / + / Stockholders' Equity
Event / Cash / + / Supplies / = / Common Stock
Owner's cash investment / 5,000 / 5,000
Supplies purchased for cash / 25 / 25
Balances / 4,975 / 25 / 5,000
[------$5,000 ------] / = / [------$5,,000 ------]

Notice the $25 increase in supplies was recorded as a debit (left side) to the supplies account. This agrees with the rule we developed earlier, that assets increase with debits. But what about the decrease in cash? If assets increase with debits, should they decrease with credits? This seems logical and it is the reason the cash account was credited (right side) for $25 above. We have just developed another accounting rule: assets decrease through credits.

After we entered debits and credits of $25 each, does our accounting equation still balance? After the supplies purchase, the company has assets of $5,000 (cash of $4,975 and supplies of $25) and liabilities and stockholders' equity of $5,000 (common stock). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

Notice also in the above cash account, the $4,975 debit balance resulted from subtracting the $25 credit from the $5,000 debit. The $4,975 balance is shown as a debit because the debit dollar amounts total ($5,000) was greater than the total credit dollar amounts ($25). If the credit dollar amounts total had been larger than the total debit dollar amounts, the balance would have been shown as a credit balance.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Stockholders’ equity increases through credits.

Borrowing resources On July 7, the company buys additional supplies of $135. The company does not immediately pay cash for the supplies, but agrees to pay cash within the next 30 days. When the Parks Computer Service Corporation buys the supplies by agreeing to pay for them later, its resources and sources of resources both increase by $135. The supplies resource increases. Since the supplies are not paid for immediately, the source of resources that increases is liabilities, in this case accounts payable. Remember, since the company does not pay for the supplies immediately, in effect they are borrowed.

As the company buys supplies, its assets increase. Assets increase with debits, so the supplies T account should show a $135 debit. Because the supplies must be paid for in the future, the liability accounts payable should also be increased. Using the debits equal credits rule and remembering we have already debited supplies for $135, the accounts payable T account should show a $135 credit, which represents an increase in the account. We have just developed another accounting rule: liabilities increase through credits. The result of this transaction can be seen as follows.

Assets / = / Liabilities / + / Stockholders' Equity
Event / Cash / + / Supplies / = / Accounts
Payable / + / Common Stock
Owner's cash investment / 5,000 / 5,000
Supplies purchased for cash / 25 / 25
Supplies purchased on account / 135 / 135
Balances / 4,975 / 160 / 135 / 5,000
[------$5,135 ------] / = / [------$5,135 ------]

After we entered debits and credits of $135 each, does our accounting equation still balance? After the supplies purchase, the company has assets of $5,135 (cash of $4,975 and supplies of $160) and liabilities and stockholders' equity of $5,135 (accounts payable of $135 and common stock of $5,000). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Stockholders’ equity increases through credits.

Generating resources through management operations On July 10, Nick advises a customer on the customer's needs for a computer system. In return for this service, the Parks Computer Service Corporation receives $200 cash. The act of providing service to a customer and receiving cash increases the company's resources and sources of resources by $200. The cash resource increases. Since the cash came from the efforts of management, the source of resources that increases is stockholders' equity, in this case retained earnings. Remember, owners have rights to resources generated by management and owners' rights are shown in stockholders' equity.

When the company receives the cash, its assets (cash) increase and its stockholders' equity increases through retained earnings. Since assets increase with debits, the cash account should now show a debit of $200. Because stockholders' equity increases with credits, the retained earnings account should show a credit of $200. These effects can be seen below.

Assets / = / Liabilities / + / Stockholders' Equity
Event / Cash / + / Supplies / = / Accounts
Payable / + / Common Stock / + / Retained Earnings
Owner's cash investment / 5,000 / 5,000
Supplies purchased for cash / 25 / 25
Supplies purchased on account / 135 / 135
Service provided to customer / 200 / 200
Balances / 5,175 / 160 / 135 / 5,000 / 200
[------$5,335 ------] / = / [------$5,335 ------]

Once we entered debits and credits of $200 each, our accounting equation still balances. After providing the service, the company has assets of $5,335 (cash of $5,175 and supplies of $160) and liabilities and stockholders' equity of $5,335 (accounts payable of $135, common stock of $5,000, and retained earnings of $200). Thus, once again, if we record each event in such a way that the total dollar amount of debits equals the total dollar amount of credits, we easily maintain the equality of the accounting equation.

In business terminology, when assets (resources) increase through the process of providing services to customers, the increase in retained earnings is called a revenue. The $200 increase in retained earnings from providing service to a customer would be called Fees Revenue. As revenues get larger, part of the effect is to increase retained earnings: an increase in revenues is an increase in retained earnings. Remember, revenues increase retained earnings because owners have a right to the additional resources generated by management providing services to customers. In debit and credit terms, how should we record an increase in a revenue? Since revenues increase retained earnings and retained earnings increases with credits, we should record increases in revenues as credits. So now we have developed another rule: revenues increase through credits.

So far, the following debit and credit rules have been developed.

Assets increase through debits.

Assets decrease through credits.

Liabilities increase through credits.

Stockholders’ equity increases through credits.

Revenues increase through credits.

Paying for borrowed resources On July 16, the company pays $70 of the $135 owed for supplies purchased on July 7. The remaining $65 will be paid in August. This cash payment of an amount owed to a supplier reduces the company's resources and its sources of resources by $70. The cash resource decreases. The source of resources that decreases is liabilities, in this case accounts payable. By paying $70 to the supplier, the amount owed to the supplier (accounts payable) decreases by $70.