GOALS
Your goals for this "information processing" chapter are to learn about:
- Accounts, debits and credits.
- The journal.
- The general ledger.
- The trial balance.
- Computerized processing systems.
- T-Accounts.
DISCUSSION
Accounts, debits and credits
ACCOUNTING SYSTEMS: The previous chapter showed how transactions caused financial statement amounts to change. Message boxes, arrows, before and after examples, etc. were used to develop the illustrations. Imagine if a real business tried to keep up with its affairs this way! Perhaps a giant chalk board could be set up in the accounting department. As transactions occurred, they would be called in to the department and the chalk board would be updated. Chaos would quickly rule. Even if the business could manage to figure out what its financial statements were supposed to contain, it probably could not systematically describe the transactions that produced those results. Obviously, a system is needed.It is imperative that a business develop a reliable accounting system to capture and summarize its voluminous transaction data. The system must be sufficient to fuel the preparation of the financial statements, and be capable of maintaining retrievable documentation for each and every transaction. In other words, some transaction logging process must be in place. In general terms, an accounting system is a system where transactions and events are reliably processed and summarized into useful financial statements and reports. Whether this system is manual or automated, the heart of the system will contain the basic processing tools: accounts, debits and credits, journals, and the general ledger. This chapter will provide insight into these tools and the general structure of a typical accounting system.
ACCOUNTS: The records that are kept for the individual asset, liability, equity, revenue, expense, and dividend components are known as accounts. In other words, a business would maintain an account for cash, another account for inventory, and so forth for every other financial statement element. All accounts, collectively, are said to comprise a firm's general ledger. In a manual processing system, you could imagine the general ledger as nothing more than a notebook, with a separate page for every account. Thus, you could thumb through the notebook to see the "ins" and "outs" of every account, as well as existing balances. An account could be as simple as the following:
This account reveals that cash has a balance of $63,000 as of January 12. By examining the account, you can see the various transactions that caused increases and decreases to the $50,000 beginning of month cash balance. In many respects, this Cash account resembles the "register" you might keep for a wallet style check book. If you were to prepare a balance sheet on January 12, you would include cash for the indicated amount (and, so forth for each of the other accounts comprising the entire financial statements).
DEBITS AND CREDITS: Without a doubt, you have heard or seen a reference to debits and credits; perhaps you have had someone "credit" your account or maybe you have used a "debit" card to buy something. Debits (abbreviated "dr") and credits (abbreviated "cr") are unique accounting tools to describe the change in a particular account that is necessitated by a transaction. In other words, instead of saying that cash is "increased" or "decreased," we say that cash is "debited" or "credited." This method is again traced to Pacioli, the Franciscan monk who is given credit for the development of our enduring accounting model. Why add this complexity -- why not just use plus and minus like in the previous chapter? You will soon discover that there is an ingenious answer to this question!
Understanding the answer to this question begins by taking note of two very important observations (the observations are linked to a pop-up window that includes additional explanatory material that may aid your understanding):
(1) every transaction can be described in debit/credit form
and
(2) for every transaction, debits = credits
THE FALLACY OF "+/-" NOMENCLATURE: The second observation above would not be true for an increase/decrease system. For example, if services are provided to customers for cash, both cash and revenues would increase (a "+/+" outcome). On the other hand, paying an account payable causes a decrease in cash and a decrease in accounts payable (a "-/-" outcome). Finally, some transactions are a mixture of increase/decrease effects; using cash to buy land causes cash to decrease and land to increase (a "-/+" outcome). In the previous chapter, the "+/-" nomenclature was used for the various illustrations. Take time now to quickly navigate through the comprehensive illustration that was provided at the conclusion of Chapter 1. As you do so, be sure to notice the various combinations of pluses and minuses, and that pluses do not necessarily equal minuses for every transaction.
As you can tell by reviewing the illustration, the "+/-" system lacks internal consistency. Therefore, it is easy to get something wrong and be completely unaware that something has gone amiss. On the other hand, the debit/credit system has internal consistency. If one attempts to describe the effects of a transaction in debit/credit form, it will be readily apparent that something is wrong when debits do not equal credits. Even modern computerized systems will challenge or preclude any attempt to enter an "unbalanced" transaction that does not satisfy the condition of debits = credits.
THE DEBIT/CREDIT RULES: At first, it is natural for the debit/credit rules to seem confusing. However, the debit/credit rules are inherently logical (the logic is explained at the linked material). But, memorization usually precedes comprehension. So, you are well advised to memorize the "debit/credit" rules now. If you will thoroughly memorize these rules first, your life will be much easier as you press forward with your studies of accounting.