T Accounts, Ledgers and Journals
Each part of the accounting equation consists of accounts. An account is a record that shows an increase or decrease in the financial statements. In its siimplest form, an account consists of three parts. The first is the title, which is the name of the item recorded in the account. The second is a space for recording increases in the amount of the item. The third is a space for recording decreases in the amount of the item.
Increases and decreases are recorded as credits and debits. The type of account determines whether the account is increased or decreased by a credit and increased or decreased by a credit. Whether it increases or decreases the account, debits are always recorded on the left side and credits on the right. Assets, expense accounts and dividends are all increased by debits. Liabilities, capital stock, retained earnings and revenue are all increased by credits.
A simple way to illustrate an account is with a T account. It is called a T account because it resembles the letter T. The title of the account is listed at the top. Debits are listed on the left side, and credits are listed on the right.
When entering transactions into the T account, each transaction is entered separately as either a debit or credit, depending on if it increases or decreases the account. After all transactions are entered, the difference between the debit and credit side will leave the Balance of Account. This is inserted at the bottom of the positive side, either the debit or credit column depending on the account. For example, since Cash is increased by a debit, the balance of account would be listed on the debit side.
A group of accounts for a business entity is called a ledger. The listing of the accounts in the ledger is called a chart of accounts. These are usually listed in the order in which they apper in the financial statements. The balance sheet accounts are usually listed first in the order of assets, liabilities and stockholder's equity.. The income statement accounts are then listed in the order of revenues and expenses.
Every transaction affects at least two accounts. The entries of the transactions are entered into a record called a journal. The title of the amount to be debited is listed first, followed by the amount to be debited. The title of the account to be credited is listed below and to the right of the debit, followed by the amount to be credited. This process of recording the transactions is called journaling. The form of recording the transaction is called a journal entry. Because two accounts are affected, the entries are recorded in both accounts. This system of recording transactions is called the double-entry accounting system.
Businesses use a variety of formats for recording journal entries. If a business is using an all-purpose journal, then it is using a two-column journal. The journals may be part of eitehr a manual accounting system, or a computerized accounting system.
Journal entries are processed in chronological order. Periodically, these entries are transferred to the accounts in the ledger. The process of transferring the debits and credits from the journal to the ledger is called posting.
When posting the debits and credits into the ledger, it is possible to make errors. One way to check for an error is to determine the equality of debits and credits. This is done through a Trial Balance. The trial balance is the listing of each account with the balance of account listed. Since the accounts that have the balance of account in the debit section would be offset by the accounts that have the balance of account in the credit section, the totals of the debit and credit columns should add to the same amount. If they do not, then there has been an error in posting the debits and credits.
Just because the two columns balance does not mean that the ledger is correct. Missing entries would not be accounted for. Entries that were entered twice would not be accounted for either. Also, if something was entered incorrectly as a debit instead of a credit, and the offsetting entry was incorrect, then the two columns would still add to the same total - but be incorrect. The two most common errors are transposition (changing the order of the digits) and slide (where the entire number is moved over one decimal place). The correction of errors depends upon when the errors are found. Some can simply be corrected. Others will require additional entries in order to correct.
The Adjusting Process
The economic life of a business can be divided into time periods (monthly, quarterly or yearly). This is known as the accounting period concept. Some businesses operate under the cash basis of accounting. under this basis, revenues and expenses are reported in the income statement in the period in which cash is received or paid. This is mostly done by small businesses that have few receivables and payables, so their financial statements will be similar to if they had used the accrual basis of accounting.
The accrual basis of accounting is required through GAAP. Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned, whether or not cash was received in that period. The accounting concept that supports this repotting is called revenue recognition concept. Expenses are reported in the same period as the revenues to which they relate, using the matching concept.
At the end of an accounting period, many of the balances of accounts in the ledger can be reported without change in the financial statements. Under the accrual basis, however, some accounts require updating. The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. Journal entries that bring the accounts up to date are called adjusting entries.
All adjusting entries will affect a revenue or an expense account, and an asset or a liability account. There are four basic types of accounts that require adjusting entries: prepaid expenses, unearned revenues, accrued revenues and accrued expenses.
Prepaid expenses are sometimes referred to as deferred expenses. These are items that are initally recorded as assets, but are expected to become expenses over time or through normal business operation. Supplies and prepaid insurance are two examples of this.
Unearned revenues are sometimes referred to as deferred revenues. These are items that are initially recorded as liabilities but are expected to become revenues over time or through nomral business operation. Unearned rent, school tuition received in advance by a school, annual retainer fee received by an attorney and magazine subscriptions received in advance by a publisher are examples of this.
Prepaid expenses and unearned revenue are created from transactions involving receipt or payment of cash.
Accrued revenues are sometimes referred to as accrued assets. These are revenues that have been earned but have not been recorded in the accounts. Fees for services that an attorney has provided but not yet billed and unbilled commissions by a travel agent are two examples of this.
Accrued expenses are sometimes referred to as accrued liabilities. These are expenss that have been incurred but have not been recorded in the accounts. Accrued wages owed to employees at the end of a period and accrued taxes are two examples of this.
Accrued revenues and accrued expenses are created from unrecorded revenue that has been earned or an unrecorded expense that has been incurred.
Physical assets that are owned and used by a business and are permanent or have a long life are called fixed assets. Another term for fixed assets is PP&E, or Plant Property and Equipment. Because of their nature and long life, they are discussed separetly from other prepaid expenses.
All fixed assets, except for land, lose their ability to provide useful service over time. This decrease in usefulness is called depreciation. A portion of the cost of a fixed asset is recorded as an expense each year of its useful life. This is called a depreciation expense. Methods of computing depreciation will be discussed in later articles.
The adjusting entries for fixed assets are done through accumulated depreciation accounts. Accumulated deprecitaion accounts are called contra accounts, or contra asset accounts. These are credited in the adjusting entry. The account debited is a depreciation expense account.
Normal titles for fixed asset accounts and their related contra asset accounts are:
|Fixed Asset||Contra Asset|
|Land || None - Land is not depreciated|
|Buildings || Accumulated Depreciation - Buildings|
|Store Equipment || Accumulated Depreciation - Store Equipment|
|Office Equipment || Accumulated Depreciation - Office Equipment|
Depreciation uses the allocation method. That means that it does not attempt to measure changes in market values which may vary significantly from year to year. Instead, depreciation allocates the cost of a fixed asset to expense over its estimated life.