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Part 2. Information Processing

6. Accounts, Debits, and Credits

The previous chapter showed how transactions caused financial statement amounts to change. "Before" and "after" examples, etc. was 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.

6.1. 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:

ACCOUNT: Cash

Date

Description

Increase

Decrease

Balance

Jan. 1, 20X3

Balance forward

$ 50,000

Jan. 2, 20X3

Collected receivable

.......................................................

$ 10,000

60,000

Jan. 3, 20X3

Cash sale

5,000

65,000

Jan. 5, 20X3

Paid rent

$ 7,000

58,000

Jan. 7, 20X3

Paid salary

3,000

55,000

Jan. 8, 20X3

Cash sale

4,000

59,000

Jan. 8, 20X3

Paid bills

2,000

57,000

Jan. 10, 20X3

Paid tax

1,000

56,000

Jan. 12, 20X3

Collected receivable

7,000

63,000

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).

6.2. 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:

(1) every transaction can be described in debit/credit form

and

(2) for every transaction, debits = credits

 
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