debits, credits, & the relationship between the income statement & the balance sheet
DESCRIPTION
An introduction to financial accounting which includes an overview of concept of debits and credits and the relationship between the income statement and the balance sheetTRANSCRIPT
Debits, Credits, & The
Relationship between the Income Statement & the
Balance Sheet
Your Basic Financial Accounting Guide
by
Dr. Tanae W. Acolatse
Rules of Debits & Credits: Graphic Normal Balances of Accounts
2 Source: Warren, C.S. (2012). Survey of Accounting (6th ed). Mason, OH: South Western, Cengage Learning
Rules of Debits & Credits Normal Balances of Accounts
O The normal balance of an account is the side
of the account used to record increases
O The normal balance of an asset account is a debit balance, while the normal balance of a liability account is a credit balance
O Useful in detecting errors in the recording process.
If an account normally having a debit balance actually has a credit balance, or vice versa, an error has occurred or an unusual situation exists.
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Asset Accounts
Asset Accounts: Increased by debits and have a normal
debit balance (on the left side of the accounting equation)
O Exception: Some asset accounts, called contra asset
accounts, are increased by credits and have normal credit
balances.
O As the words contra asset imply, these accounts offset the
normal debit balances of asset accounts
Example: Accumulated depreciation, an offset to plant assets,
is increased by credits and has a normal credit balance.
Thus, accumulated depreciation is a contra asset account 4
Liability & Stockholders’ Equity Accounts
O Liability and stockholders' equity
accounts (on the right side of the
accounting equation)
O Increased by credits and have
normal credit balances
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Dividend Accounts
O Dividend accounts appear on the right side of the accounting equation and decrease stockholders' equity (retained earnings)
O Increased by debits and have a normal debit balance
O Can be thought of as a type of contra account to retained earnings
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Revenue Accounts
O Revenue accounts appear on the right side of the accounting equation and increase stockholders' equity (retained earnings)
O Increased by credits and have normal credit balances
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Expense Accounts
O Expense accounts appear on the
right side of the accounting equation
and decrease stockholders' equity
(retained earnings)
O Increased by debits and have a
normal debit balance
O Can be thought of as a type of
contra account to revenues
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Summary O The rules of debit and credit require that for each transaction, the
total debits equal the total credits
O Each transaction must be recorded so that the total debits for the
transaction equal the total credits.
Example: Assume that a company pays cash of $500 for supplies.
Asset Account: Supplies is debited (increased) by $500
Asset Account: Cash is credited (decreased) by $500
Example: If the company provides services and receives $2,000
from customers
Asset Account: Cash is debited (increased) by $2,000
Revenue Account: Fees Earned is credited (increased) by $2,000
transactions. 9
Relationship Between Accounts
10 Source: Tracy, J. A. (n.d.) Connecting the Income Statement and Balance Sheet. Retrieved from http://www.dummies.com/how-
to/content/connecting-the-income-statement-and-balance-sheet.html
Relationship Between Accounts (continued)
Accounts are connected as follows beginning with Sales:
O Making sales (and incurring expenses for making sales)
requires a business to maintain a working cash balance.
O Making sales on credit generates accounts receivable.
O Selling products requires the business to carry an
inventory (stock) of products.
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Relationship Between Accounts (continued)
O Acquiring products involves purchases on credit that generate accounts payable.
O Depreciation expense is recorded for the use of fixed assets (long-term operating resources).
O Depreciation is recorded in the accumulated depreciation contra account (instead decreasing the fixed asset account).
O Amortization expense is recorded for limited-life intangible assets. 12
Relationship Between Accounts (continued)
O Operating expenses is a broad category of costs
encompassing selling, administrative, and general
expenses:
O Some of these operating costs are prepaid before the
expense is recorded, and until the expense is
recorded, the cost stays in the prepaid expenses
asset account.
O Some of these operating costs involve purchases on
credit that generate accounts payable.
O Some of these operating costs are from recording
unpaid expenses in the accrued expenses payable
liability.
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Relationship Between Accounts
O Borrowing money on notes payable causes interest expense.
O A portion (usually relatively small) of income tax expense for the year is unpaid at year-end, which is recorded in the accrued expenses payable liability.
O Earning net income increases retained earnings.
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References
Tracy, J. A. (n.d.). Connecting the income
statement and balance sheet. Retrieved
from http://www.dummies.com/how-
to/content/connecting-the-income-
statement-and-balance-sheet.html.
Warren, C.S. (2012). Survey of Accounting
(6th ed). Mason, OH: South Western,
Cengage Learning.
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