Chapter 2: Business Transactions (Accounting Interactive Video Textbook)

Debits and Credits

As you saw in the videos, it is too bothersome to record every increase and decrease of an account. We must come up with a better way to make our lives easier. Well, we don’t have to because somebody has already come up with a great way. All we must do is to learn it.

Debits and Credits Video Lecture

Let’s see another comprehensive explanation of debits and credits.

Debits and Credits Second Video Lecture

There is something that we call normal balance. Normal balance can be either a debit or a credit, depending on the account. The account’s normal balance tells us that with that balance we increase the account. Look at the figure below. 

T-Account-Accounting-Equation.png

When I insert the accounting equation on top of the account (only for instructional purposes), you can see the normal balances. The normal balance of assets is debit. The normal balance of liabilities and stockholders’ equity is credit. This means that we increase all assets with a debit (and decrease them with a credit), and we increase all liabilities and stockholders’ equity accounts with a credit (and decrease them with a debit).

In the following lectures, we will learn more about normal balances of specific accounts, the process of journalizing (recording journal entries) and posting to the general ledger.

Journalizing and Posting

Before we learn how to journalize and post, we need to learn more about the Stockholders’ Equity account.

Equity-T-Account.png

We know that stockholders’ equity normal balance is a credit. That means we increase it with a credit, and decrease it with a debit. However, there are 4 accounts that affect equity. Common Stock and Revenues increase the equity, and Expenses and Dividends decrease the equity. 

all equity.JPG

If common stock increase equity (and equity is increased with a credit), the normal balance of common stock must also be credit. If revenues increase equity (and equity is increased with a credit), the normal balance of revenues must also be credit.

If dividends decrease equity (and equity is decreased with a debit), the normal balance of dividends must also be debit. If expenses decrease equity (and equity is decreased with a debit), the normal balance of expenses must also be debit.

Think about this analogy and watch the videos. It is very important that you understand and know these concepts.

Journal entries are recorded in the journal and then all transactions are posted to the general ledger. This is a very simple process. Follow the entire journalizing and posting process in the following video.


Journalizing and Posting Video Lecture

Account Balances (Normal Balance)

There is something that we call normal balance. Normal balance can be either a debit or a credit, depending on the account (as we saw in previous lessons). The account’s normal balance tells us that with that balance we increase the account. To calculate the balance of every account, we must follow the steps in the video below.

Account Balances Lecture Video

If we want to calculate the balances of all accounts from the "Journalizing and Posting Video Lecture", we need to do the following:

Asset Accounts Balances

The asset accounts in the "Journalizing and Posting Video Lecture" are: Cash, Accounts Receivable, Supplies, Prepaid Insurance, Prepaid Rent, and Equipment.

  • For the Cash account, we add all debits and subtract all credits (since the normal balance of Cash is debit). Debits ($90,000+$5,000+$5,000) minus credits ($8,000+$11,000+$4,800+$4,000+$500) is $71,700 Debit Balance.
  • For the Accounts Receivable account, we add all debits and subtract all credits (since the normal balance of A/R is debit). Debits ($7,000+$3,000) minus credits ($5,000) is $5,000 Debit Balance.
  • For the Supplies account, we add all debits and subtract all credits (since the normal balance of Supplies is debit). Debits ($4,000+$700) minus credits ($0) is $4,700 Debit Balance.
  • For the Prepaid Insurance account, we add all debits and subtract all credits (since the normal balance of Prepaid Insurance is debit). Debits ($4,800) minus credits ($0) is $4,800 Debit Balance.
  • For the Prepaid Rent account, we add all debits and subtract all credits (since the normal balance of Prepaid Rent is debit). Debits ($8,000) minus credits ($0) is $8,000 Debit Balance.
  • For the Equipment account, we add all debits and subtract all credits (since the normal balance of Equipment is debit). Debits ($20,000+$7,000) minus credits ($0) is $27,000 Debit Balance. 

Important Note: Anything Prepaid is actually an asset account. It means that we bought something of value. 

To insert the balance of an account in the T-Account, we simply put a line on the normal balance side and write the balance. Look at the figure below:

all assets.JPGAsset Accounts Balances

Liability Accounts Balances

The only liability account we have in the "Journalizing and Posting Video Lecture" is Accounts Payable.

  • For the Accounts Payable account, we add all credits and subtract all debits (since the normal balance of Accounts Payable is credit). Credits ($11,000+$700) minus debits ($11,000) is $700 Credit Balance.

Finding the balance for the liability accounts in the T-Account will look like the figure below.

all liabilities.JPG

Liability Account Balance

Stockholders' Equity Accounts Balances

The stockholders' equity accounts we have in the "Journalizing and Posting Video Lecture" are: Common Stock, Dividends, Revenues, and Utilities Expense.

  • For the Common Stock account, we add all credits and subtract all debits (since the normal balance of Common Stock is credit). Credits ($110,000) minus debits ($0) is $110,000 Credit Balance.
  • For the Dividends account, we add all debits and subtract all credits (since the normal balance of Dividends is debit). Debits ($4,000) minus credits ($0) is $4,000 Debit Balance.
  • For the Revenue account, we add all credits and subtract all debits (since the normal balance of Revenue is credit). Credits ($5,000+$7,000+$3,000) minus debits ($0) is $15,000 Credit Balance.
  • For the Utilities Expense account, we add all debits and subtract all credits (since the normal balance of Expenses is debit). Debits ($500) minus credits ($0) is $4,000 Debit Balance. 

Finding the balance for the stockholders' equity accounts in the T-Accounts will look like the figure below.

all equity accounts.JPG


Trial Balance

The nest step in the accounting cycle, after finding the account balances, is to prepare the Trial Balance. The Trial Balance is simply a list of all accounts showing their balances. It looks like the figure below.

Trial Balance sample.JPG

Trial Balance

As you can notice, the trial balance lists all the accounts we have. The order in which we list the accounts resembles the accounting equation. First, we list all the asset accounts, then the liability accounts, and finally, the stockholders' equity accounts. 

The total debits equal the total of the credits. This is a great assurance that we have done a good job recording the journal entries. However, it is not a guarantee. Mistakes could still be present. For example, if you have failed to record an entry, that will not disturb the debit and credit balance. Additionally, you might have recorded either the debit or the credit to a wrong account. That would be another mistake that the trial balance would fail to detect.

Financial Statements

If we use the information from the Trial Balance, we can prepare the Income Statement, the Statement of Retained Earnings, and the Balance Sheet. The Income Statement will look like this:

The income statement is consisted of all revenues and expenses. There are other items too, but, however, we only focus on these in this chapter. The Statement of Retained Earnings will look like this:

Since we assume that we just started this company, the beginning balance of the retained earnings is 0 (zero). Next year's beginning balance will be $10,500. If we have a Net Loss instead of Net Income, we need to subtract that net loss. The Balance Sheet will look like this:

As you can notice, the accounting equation is in balance. Total Assets equal Total Liabilities + Stockholders' Equity.

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