22E00100 - Financial Statement Analysis, 25.02.2019-10.04.2019
Kurssiasetusten perusteella kurssi on päättynyt 10.04.2019 Etsi kursseja: 22E00100
Quiz 1: Understanding Debits and Credits
QUIZ (this quiz is not part of the course grade) Required: Provide journal entries for Transactions 1−8 and Adjusting Entries 1−7. |
REVIEW OF ACCOUNTING PROCEDURES AND T-ACCOUNT ANALYSIS
The basic accounting equation is the foundation of financial reporting:
A = L + OE
The basic accounting equation says that at all times, the euro sum of a firm’s assets (A) must be equal to the euro sum of the firm’s liabilities (L) plus its owners’ equity (OE). To understand why this equality must always hold, keep two things in mind:
Assets don’t materialize out of the air; they have to be financed from somewhere.
Only two parties can provide financing for a firm’s assets:
Creditors of the company―for example, when a supplier ships inventory to a firm on credit (an asset―inventory―is received).
Owners of the company―for example, when owners buy newly issued shares directly from the firm (an asset―cash―is received).
Putting these two things together explains why the two sides of the basic accounting equation must be equal. The equation says the total resources a firm owns or controls (its assets) must, by definition, be equal to the total of the financial claims against those assets held by either creditor or owners.
We’ll now use the basic accounting equation to show how various transactions affect its components. Notice that each transaction maintains the basic equality; for example, any increase in an asset must be offset by (1) a corresponding increase in a liability or owners’ equity account or (2) decrease in some other asset.
Assume that Chicago Corporation sells office furniture and provides office design consulting services. It is incorporated on January 1, 2011, and issues €1 million of stocks to investors for cash. Here’s how this and subsequent transactions will affect the basic accounting equation:
Transaction 1
Assets |
= |
Liabilities |
+ |
Owners’ equity |
+€1,000,000 Cash |
|
|
|
+€1,000,000 Common stock |
On the next day, Chicago Corporation buys a combination office building and warehouse for €330,000, paying €30,000 in cash and taking out a €300,000 loan at 8% interest per year.
Transaction 2
Assets |
= |
Liabilities |
+ |
Owners’ equity |
−€30,000 Cash +€330,000 Building |
|
+€300,000 Loan payable |
|
|
Suppliers ship a wide assortment of inventory costing €97,000 to the firm on credit on January 11.
Transaction 3
Assets |
= |
Liabilities |
+ |
Owners’ equity |
+€97,000 Inventory |
|
+€97,000 Accounts payable |
|
|
On January 15, Chicago Corporation sells a portion of its inventory costing €50,000 to several customers for €76,000 on account.
Transaction 4
Assets |
= |
Liabilities |
+ |
Owners’ equity |
+€76,000 Accounts receivable −€50,000 Inventory |
|
|
|
+€76,000 Sales revenue −€50,000 Cost of goods sold |
A sale causes assets to flow into the company. Who benefits from this inflow of assets? The owners do. That’s why owners’ equity increased by €76,000 in Transaction 4. The source of this increase is labeled; in this case, the source of the increase is Sales revenue. But in making a sale, the firm must relinquish an asset, Inventory. Whose claims are reduced as a result of this outflow of assets? The owners’. That’s why owners’ equity decreased by €50,000 in the second part of Transaction 4. Again, the reason for the decrease in owners’ equity is labeled; in this case, the need to deliver inventory to the customer reduces owners’ equity claims on the firm’s assets by €50,000, the Cost of goods sold.
In addition to the balance sheet (which follows the balancing format of the basic accounting equation), there is another financial statement called the income statement. Recollect that Sales revenue is the top line of the income statement and that Cost of goods sold is deducted from revenues. So Transaction 4, which was illustrated in a basic accounting equation (that is, balance sheet) format, really includes income statement account. Another way to say the same thing is that the revenue and expense accounts that appear on the income statement are really owners’ equity accounts. Revenues are owners’ equity increases; expenses are owners’ equity decreases. (Later in this assignment, we’ll show how these accounts are closed in to Retained earnings, a component of owners’ equity, as part of the adjusting and closing process.)
Understanding Debits and Credits
Keeping track of transactions using the basic accounting equation as we did in Transaction 1−4 is cumbersome. For this reason, a streamlined approach is used to record how transactions either increase or decrease financial statement accounts. Increases and decreases on accounts are based on the convention of debits and credits. Debit (abbreviated DR) means left side of accounts, and credit (abbreviated CR) means right side of accounts.
We now depict the basic accounting equation in T-account form and show the rules for how debits and credits operate to reflect increases or decreases to various accounts.
Asset accounts |
= |
Liability accounts |
+ |
Owners’ equity accounts |
|||
Debits |
Credits |
|
Debits |
Credits |
|
Debits |
Credits |
(DR) |
(CR) |
|
(DR) |
(CR) |
|
(DR) |
(CR) |
increase the account balance |
decrease the account balance |
|
decrease the account balance |
increase the account balance |
|
decrease the account balance |
increase the account balance |
Because Transaction 4 showed us that revenue accounts increase owners’ equity and expense accounts decrease it, the DR and CR rules treat revenue and expense accounts just like any other owners’ equity account.
Let’s elaborate on the debit and credit rules for expense accounts. Expense accounts are increased by debits. An increase in an expense decreases owners’ equity. Owners’ equity is decreased by debits. That’s why increases in an expense account (which decrease owners’ equity) are debits.
The basic accounting equation must always be “in balance”―that is, the total of the assets must always equal the total of the liabilities plus owners’ equity. Similarly, for each transaction, the euro total of the debits must equal the euro total of the credits. Adherence to the debit and credit rules for each transaction automatically keeps the basic accounting equation in balance.
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