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2.2: Accounts

  • Page ID
    20073
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    • Contributed by Henry Dauderis and David Annand
    • Athabasca University
    • Sourced from Lyryx Learning

    LO1 – Describe asset, liability, and equity accounts, identifying the effect of debits and credits on each.

    Chapter 1 reviewed the analysis of financial transactions and the resulting impact on the accounting equation. We now expand that discussion by introducing the way transaction is recorded in an account. An account accumulates detailed information regarding the increases and decreases in a specific asset, liability, or equity item. Accounts are maintained in a ledger also referred to as the books. We now review and expand our understanding of asset, liability, and equity accounts.

    Asset Accounts

    Recall that assets are resources that have future economic benefits for the business. The primary purpose of assets is that they be used in day-to-day operating activities in order to generate revenue either directly or indirectly. A separate account is established for each asset. Examples of asset accounts are reviewed below.

    • Cash has future purchasing power. Coins, currency, cheques, and bank account balances are examples of cash.
    • Accounts receivable occur when products or services are sold on account or on credit. When a sale occurs on account or on credit, the customer has not paid cash but promises to pay in the future.
    • Notes receivable are a promise to pay an amount on a specific future date plus a predetermined amount of interest.
    • Office supplies are supplies to be used in the future. If the supplies are used before the end of the accounting period, they are an expense instead of an asset.
    • Merchandise inventory are items to be sold in the future.
    • Prepaid insurance represents an amount paid in advance for insurance. The prepaid insurance will be used in the future.
    • Prepaid rent represents an amount paid in advance for rent. The prepaid rent will be used in the future.
    • Land cost must be in a separate account from any building that might be on the land. Land is used over future periods.
    • Buildings indirectly help a business generate revenue over future accounting periods since they provide space for day-to-day operating activities.

    Liability Accounts

    As explained in Chapter 1, a liability is an obligation to pay for an asset in the future. The primary purpose of liabilities is to finance investing activities that include the purchase of assets like land, buildings, and equipment. Liabilities are also used to finance operating activities involving, for example, accounts payable, unearned revenues, and wages payable. A separate account is created for each liability. Examples of liability accounts are reviewed below.

    • Accounts payable are debts owed to creditors for goods purchased or services received as a result of day-to-day operating activities. An example of a service received on credit might be a plumber billing the business for a repair.
    • Wages payable are wages owed to employees for work performed.
    • Short-term notes payable are a debt owed to a bank or other creditor that is normally paid within one year. Notes payable are different than accounts payable in that notes involve interest.
    • Long-term notes payable are a debt owed to a bank or other creditor that is normally paid beyond one year. Like short-term notes, long-term notes involve interest.
    • Unearned revenues are payments received in advance of the product or service being provided. In other words, the business owes a customer the product/service.

    Equity Accounts

    Chapter 1 explained that equity represents the net assets owned by the owners of a business. In a corporation, the owners are called shareholders. Equity is traditionally one of the more challenging concepts to understand in introductory financial accounting. The difficulty stems from there being different types of equity accounts: share capital, retained earnings, dividends, revenues, and expenses. Share capital represents the investments made by owners into the business and causes equity to increase. Retained earnings is the sum of all net incomes earned over the life of the corporation to date, less any dividends distributed to shareholders over the same time period. Therefore, the Retained Earnings account includes revenues, which cause equity to increase, along with expenses and dividends, which cause equity to decrease. Figure 2.1 summarizes equity accounts.


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    Figure \(\PageIndex{1}\): Composition of Equity Accounts

    T-accounts

    A simplified account, called a T-account, is often used as a teaching/learning tool to show increases and decreases in an account. It is called a T-account because it resembles the letter T. As shown in the T-account below, the left side records debit entries and the right side records credit entries.

    Account Name
    Debit Credit
    (always on left) (always on right)

    The type of account determines whether an increase or a decrease in a particular transaction is represented by a debit or credit. For financial transactions that affect assets, dividends, and expenses, increases are recorded by debits and decreases by credits. This guideline is shown in the following T-account.


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    Figure \(\PageIndex{2}\)

    For financial transactions that affect liabilities, share capital, and revenues, increases are recorded by credits and decreases by debits, as follows:


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    Figure \(\PageIndex{3}\)

    Another way to illustrate the debit and credit rules is based on the accounting equation. Remember that dividends, expenses, revenues, and share capital are equity accounts.

    Assets = Liabilities + Equity
    Increases are recorded as: Debits Credits

    Credits

    (Revenues and the issuance of Share Capital are equity accounts. They cause equity to increase so increases in these account types are recorded as credits.)

    Decreases are recorded as: Credits Debits

    Debits

    (Expenses, and Dividends are equity accounts. They cause equity to decrease. Decreases in equity are always recorded as debits so as expenses and dividends are realized, they are debited.)

    The following summary shows how debits and credits are used to record increases and decreases in various types of accounts.

    ASSETS LIABILITIES
    DIVIDENDS SHARE CAPITAL
    EXPENSES REVENUE
    Increases are DEBITED. Increases are CREDITED.
    Decreases are CREDITED. Decreases are DEBITED.

    This summary will be used in a later section to illustrate the recording of debits and credits regarding the transactions of Big Dog Carworks Corp. introduced in Chapter 1.

    The account balance is determined by adding and subtracting the increases and decreases in an account. Two assumed examples are presented below.

    Cash Accounts Payable
    10,000 3,000 700 5,000
    3,000 3,000
    400 2,400 4,300 Balance
    8,000 2,000
    7,100
    200
    Balance 3,700

    The $3,700 debit balance in the Cash account was calculated by adding all the debits and subtracting the sum of the credits. The $3,700 is recorded on the debit side of the T-account because the debits are greater than the credits. In Accounts Payable, the balance is a $4,300 credit calculated by subtracting the debits from the credits.

    Notice that Cash shows a debit balance while Accounts Payable shows a credit balance. The Cash account is an asset so its normal balance is a debit. A normal balance is the side on which increases occur. Accounts Payable is a liability and because liabilities increase with credits, the normal balance in Accounts Payable is a credit as shown in the T-account above.

    Chart of Accounts

    A business will create a list of accounts called a chart of accounts where each account is assigned both a name and a number. A common practice is to have the accounts arranged in a manner that is compatible with the order of their use in financial statements. For instance, Asset accounts begin with the digit '1', Liability accounts with the digit '2'. Each business will have a unique chart of accounts that corresponds to its specific needs. Big Dog Carworks Corp. uses the following numbering system for its accounts:

    100-199 Asset accounts
    200-299 Liability accounts
    300-399 Share capital, retained earnings, and dividend accounts
    500-599 Revenue accounts
    600-699 Expense accounts
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