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Exhibit 4

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Debits and Credits for Revenues and Expenses After some practice you will become comfortable using the wordsdebit and credit to signify changes in assets, liabilities, and owners' equity accounts. However, some persons are confused about the proper terms to reflect changes in revenue and expense accounts. Remember that owners' equity is increased by credits and decreased by debits. Revenues increase owners' equity; therefore, revenues are recorded as credits.

Expenses decrease owners' equity; therefore, expenses are recorded as deb­its. In other words, the debit-credit relationship for owners' equity accounts is applied to revenues and expenses, as illustrated in the following T-accounts[5]:

 

Expenses* Owners' Equity Revenue”
Debit Credit Debit Credit Debit Credit
(To record)   - +   (to record)

 

* Decrease in owners' equity.

+ Increase in owners' equity.

 

In summary, the balance features of the fundamental accounting model are:

 

1. Assets = Liabilities + Owners' Equity.

2. Debits = Credits.

 

The next section of this chapter illustrates the use of accounts and emphasizes application of the fundamental accounting model and its dual-balancing feature.

 

Transaction Analysis

 

Transaction analysis is a term frequently used to describe the process of study­ing a transaction to determine its dual effect on the entity in terms of the accounting model. Transaction analysis starts when a business document is available that indicates a completed transaction. Based upon the (a) nature of the transaction and (b) proper application of the fundamental accounting model, the effects of the transaction are recorded in the accounting system.

Application of the fundamental accounting model and accounting principles require that accrual basis accounting be used. This means that assets, liabilities, revenues, expenses, and the other elements should be recognized (i.e., re­corded) when the transaction that caused them was completed. The related cash collected or paid at a later date is recorded as a separate transaction. For example, a sale made on the last day of Year 1, with 30-day credit terms, must be recorded in Year 1, and the cash collection must be recorded in Year 2. In contrast, cash basis accounting, which is not appropriate, would record the sale only in Year 2 when the cash is collected. In contrast, the concept of accrual accounting requires that revenues and expenses be measured and reported in the accounting period in which the transactions occur rather than when the related cash is received or paid.

Now, let's see how each transaction is subjected to transaction analysis to determine (1) its dual economic effect on the entity and (2) how that dual effect is recorded in the accounts (i.e., in terms of the fundamental accounting model).

Recall that for each transaction recorded, two separate balances must be maintained: (1) Assets = Liabilities + Owners' Equity, and (2) Debits = Credits.

Transaction Analysis and Recording

Bass Cleaners, Inc., will be used again to demonstrate transaction analysis and the basic recording process. We analyze each transaction (given in Exhibit 1) and trace the manner in which the dual effect is recorded in the accounting model by using T-accounts (rather than using the simple plus and minus signs shown in Exhibit 1). The transactions (repeated for convenience) are identified with letters for ready reference.

For each transaction, Exhibit 4 gives its (a) nature, (b) analysis, (c) journal entry, and (d) T-account effect. The journal entry is an accounting method of expressing the results of transaction analysis in a Debits = Credits format. Notice that for each transaction (a) the debits are written first, (b) the credits are written below all of the debits, and (c) the credits are indented (both words and amounts).

You should study Exhibit 4 carefully (including the explanations of transac­tion analysis). Careful study is essential to understand (a) application of the fundamental accounting model, (b) transaction analysis, (c) recording the

Exhibit 4

i. Depreciation expense on the truck for one year ($8,000 - 5 years = $1,600).   Transaction analysis—This transaction is caused by the internal use (wear and tear) of an asset owned for operating purposes (rather than for resale). This use is measured in dollars and recorded as depreciation expense. Owners' equity was decreased by this expense, which is recorded as a debit to a separate account for this type of expense, Operating Expenses (alternatively, a separate expense account, called depredation expense, could have been used). Assets (i.e., the delivery truck) were decreased because a part of the cost of the asset was "used up" in operations. Instead of directly crediting (decreasing) the asset account. Delivery Truck, a related contra account, Accumulated Depreciation, Delivery Truck, is credited so that the total amount of depreciation can be kept separate from the cost of the asset. The journal entry summarized is:   (i) Operating expenses (owners' equity)................... 1,600 Accumulated depreciation, delivery truck (contra account).......................................... 1,600   The two accounts affected would appear as follows:    
 
Operating Expenses (owners' equity) Accumulated Depreciation, Delivery Truck (contra account)
Debit Credit Debit Credit
(f) 25,800 (g) 2,000
1,600  
(i)

 

   
1,600  

(i)

 

 

Dual check for accuracy – The entry meets both tests: Assets (-$1,600) = Liabilities (-0-) + Owners’ Equity (-$1,600), and Debits ($1,600) = Credits ($1,600)

dual effects of each transaction, and (d) the dual-balancing system. Exhibit 4 em­phasizes these important aspects of the accounting processing system. Notice that the amounts for each additional entry illustrated are shown in boxes to facilitate your study of this exhibit.

In summary, Exhibit 4 presented the following features of an accounting system:

1. Collecting information about each completed transaction that is neces­sary for accounting purposes.

2. Analyzing each transaction to determine how it affected the fundamen­tal accounting model—Assets = Liabilities + Owners' Equity.

 

Exhibit 4 (concluded)

1. Paid $500 cash on accounts payable in (g),   Transaction analysis—This transaction decreased cash by $500, which is recorded as a credit (decrease) in theCash account; the $500 decrease in liabilities is recorded as a debit (decrease) to theAccounts Payable account. Owners' equity was not affected because there was no revenue or expense involved in this transaction. The journal entry summarized is:   (l) Accounts payable (liability).................. 500 Cash (asset)........................ 500   The two accounts would appear as follows:  
Accounts Payable (liability) Cash (asset)
Debit Credit Debit Credit
 
(i)

 

(g) 2,000 (a) 20,000 (b) 5,000 (d) 40,000 (k) 1,000 (c) 8,000 (l) 25,800 (h) 600 (j) 1,800
 
(i)

 

 

Dual check for accuracy—The entry meets both tests.

 

 

3. Recording the effects of transactions is accomplished in the "journal entry format" commonly used in accounting as follows:

 

Account name (debit)................................. xx

Account name (credit)............................. xx

 

4. Showing the effects in T-accounts which provide for increases and decreases in each account as follows:

 

Assets = Liabilities + Owners' Equity
(Debit) (Credit) (Debit) (Credit) (Debit) (Credit)
+ - - + - +

 

 

5. Preparing periodic financial statements from the data accumulated in the accounts (discussed in Chapter 3).

 

DEMONSTRATION CASE

 

On January 1, 19A, an ambitious university student started the ABC Service Company. The primary purpose was to earn money to complete a university education. Completed transactions (summarized) through December 31, 19A, for ABC Service Company (a sole proprietorship) were:

a) Invested $5,000 cash in the business.

b) Purchased service supplies, $600; paid cash. These supplies were placed in a storeroom to be used as needed.

c) Revenues earned, $32,000, collected in cash, except for $2,000 on credit.

d) Operating expenses incurred, $17,000; paid cash except for $1,000 on credit.

e) Used $500 of the service supplies from the storeroom for operating pur­poses.

f) Owner withdrew $3,000 cash from the business.

g) At year-end purchased a tract of land for a future building site. Paid cash, $2,000, and gave a $5,000, 10%, interest-bearing note payable for the balance.

Requirement 1:

Set up T-accounts for Cash, Accounts Receivable (for services on credit); Service Supplies (for supplies on hand in the storeroom); Land; Accounts Payable (for operating expenses procured on credit); Note Payable; Owner's Equity; Service Revenues; and Operating Expenses. Next, analyze each transaction, prepare journal entries, and then enter the effects on the fundamental accounting model in the appropriate T-accounts. Identify each amount with its letter given above.

Requirement 2:

Refer to the three financial statements illustrated in Chapter 1: income statement (Exhibit 1-4); balance sheet (Exhibit 1-5); and the statement of changes in financial position (Exhibit 1-6). Use the amounts in the T-accounts, prepared in Requirement 1, to prepare these three 19A statements for ABC Service Com­pany. The solutions to these two requirements are shown in Exhibit 2-5.

Preparation of the 19A income statement involved selection of the account balances for all revenues and expenses. The income statement model (page 60) is applied—Revenues — Expenses = Net Income.

The 19A balance sheet required use of the account balances for all assets and liabilities. The balance sheet model (page 60) is applied—Assets = Liabilities + Owners' Equity. Notice that owner's equity includes the net income amount ($14,500) reported on the income statement because it increased owner's equity.

The 19A statement of changes in financial position requires an analysis of the Cash account. The model for this statement (page 29)—Cash sources (inflows) from operations and financing and investing activities - Cash uses (outflows).

Uses of cash include the $2,000 cash paid on the $7,000 cost of the land (investing) because the remaining $5,000 was on credit, and the $3,000 withdrawn_by the owner for personal use (financing).

 

 

Exhibit 5 Transaction analysis, journal entries, T-accounts, and financial statements – a demonstration case

 

Requirement 1- Transaction analysis and journal entries:
a. Increase cash, $5,000; increase owner’s equity account, $5,000. Journal entry:
Cash Owner’s equity 5,000   5,000
b. Increase asset, service supplies, $600; decrease cash, $600 (supplies are not an expensive unit used). Journal entry:
Service supplies Cash    
c. Increase assets, cash, $30,000, and accounts receivable, $2,000; increase service revenues (an owner’s equity account), $32,000. Journal entry:
Cash Accounts receivable Service revenues 30,000 2,000     32,000
d. Decrease asset, cash, $16,000; increase liability, accounts payable, $1,000; increase operating expenses, $17,000 (which decreases owner’s equity). Journal entry:
Operating expenses Cash Accounts payable 17,000   16,000 1,000
e. Decrease asset, service supplies, $500; increase operating expenses, $500 (which decreases owner’s equity). Journal entry:
Operating expenses Service supplies    
f. Decrease asset, cash, $3,000; decrease owner’s equity account, $3,000. Journal entry:
Owner’s equity Cash 3,000   3,000
g. Increase assets, land, $7,000; decrease asset, cash, $2,000; increase liability note payable, $5,000. Journal entry:
Land Cash Note payable 7,000   2,000 5,000

 

 


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