On
December 1, 2013 Femi starts his business Fast Delivery, Inc. The first
transaction that Femi will record for his company is his personal investment of
N3million in exchange for 5,000 shares of Fast Delivery's common stock. Fast
Delivery's accounting system will show an increase in its account
Cash from
zero to N3million, and an increase in its stockholders' equity account Common
Stock by N3million. Both of these accounts are balance sheet accounts.
There
are no revenues because no delivery fees were earned by the
company, and there were no expenses.
After
Femi enters this transaction, Fast Delivery's balance sheet will look like
this:
Chima
asks Femi if he can see that the balance sheet is just that-in balance. Femi
looks at the total of N3million on the asset side, and looks at the N3million
on the right side, and says yes, of course, he can see that it is indeed in
balance.
Chima
shows Femi something called the basic accounting equation, which, she
explains, is really the same concept as the balance sheet, it's just presented
in an equation format:
The
accounting equation (and the balance sheet) should always be in balance.
Debits and Credits
Did
the first sample transaction follow the double entry system and affect two or
more accounts? Femi looks at the balance sheet again and answers yes, both Cash
and Common Stock were affected by the transaction.
Chima
introduces the next basic accounting concept: the double entry system requires
that the same dollar amount of the transaction must be entered on both the left
side of one account, and on the right side of another account. Instead
of the word left, accountants use the word debit; and instead of
the word right, accountants use the word credit. (The terms debit
and credit are derived from Latin terms used 500 years ago.)
Here's a Tip
Debit
means left.
Credit
means right.
Femi
asks Chima how he will know which accounts he should debit—meaning he should
enter the numbers on the left side of one account—and which accounts he should
credit—meaning he should enter the numbers on the right side of another
account. Chima points back to the basic accounting equation and tells Femi that
if he memorizes this simple equation, it will be easier to understand the
debits and credits.
Here's a Tip
Memorizing
the simple accounting equation will help you learn the debit and credit rules
for entering amounts into the accounting records.
Let's
take a look at the accounting equation again:
Just
as assets are on the left side (or debit side) of the accounting equation, the
asset accounts in the general ledger have their balances on the left side. To increase an asset account's
balance, you put more on the left side of the asset account. In accounting
jargon, you debit the asset account. To decrease an asset account
balance you credit the account, that is, you enter the amount on the
right side.
Just
as liabilities and stockholders' equity are on the right side (or credit side)
of the accounting equation, the liability and equity accounts in the general
ledger have their balances on the right side. To increase the balance in a liability or stockholders' equity account,
you put more on the right side of the account. In accounting jargon, you credit
the liability or the equity account. To decrease a liability or equity,
you debit the account, that is, you enter the amount on the left side of the
account.
As
with all rules, there are exceptions, but Chima's reference to the accounting
equation may help you to learn whether an account should be debited or
credited.
Since
many transactions involve cash, Chima suggests that Femi memorize how the Cash
account is affected when a transaction involves cash: if Fast Delivery receives
cash, the Cash account is debited; when Fast Delivery pays cash, the
Cash account is credited.
Here's a Tip
When a company receives cash,
the Cash account is debited.
When the company pays cash,
the Cash account is credited.
Chima
refers to the example of December 1. Since Fast Delivery received N3million in
cash from Femi in exchange for 5,000 shares of common stock, one of the
accounts for this transaction is Cash. Since cash was received, the Cash
account will be debited.
In
keeping with double entry, two (or more) accounts need to be involved. Because
the first account (Cash) was debited, the second account needs to be credited.
All Femi needs to do is find the right account to credit. In this case, the
second account is Common Stock. Common stock is part of stockholders' equity,
which is on the right side of the accounting equation. As a result, it should
have a credit balance, and to increase its balance the account needs to be credited.
Accountants
indicate accounts and amounts using the following format:
Accountants
usually first show the account and amount to be debited. On the next line, the
account to be credited is indented and the amount appears further to the right
than the debit amount shown in the line above. This entry format is referred to
as a general journal entry.
(With
the decrease in the price of computers and accounting software, it is rare to
find a small business still using a manual system and making entries by hand.
Accounting software has made the process of recording transactions so much
easier that the general journal is rarely needed. In fact, entries are often
generated automatically when a check or sales invoice is prepared.)
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