Debits, credits, & the relationship between the income statement & the balance sheet

Debits, Credits, & The Relationship between the Income Statement & the Balance Sheet

Your Basic Financial Accounting Guide

by Dr. Tanae W. Acolatse

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Rules of Debits & Credits: Graphic Normal Balances of Accounts

Source: Warren, C.S. (2012). Survey of Accounting (6th ed). Mason, OH: South Western, Cengage Learning

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Rules of Debits & CreditsNormal Balances of Accounts

O The normal balance of an account is the side of the account used to record increases

O The normal balance of an asset account is a debit balance, while the normal balance of a liability account is a credit balance

O Useful in detecting errors in the recording process. If an account normally having a debit balance

actually has a credit balance, or vice versa, an error has occurred or an unusual situation exists.

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Asset Accounts

Asset Accounts: Increased by debits and have a normal debit balance (on the left side of the accounting equation)

O Exception: Some asset accounts, called contra asset accounts, are increased by credits and have normal credit balances.

O As the words contra asset imply, these accounts offset the normal debit balances of asset accounts

Example: Accumulated depreciation, an offset to plant assets, is increased by credits and has a normal credit balance. Thus, accumulated depreciation is a contra asset account

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Liability & Stockholders’ Equity Accounts

O Liability and stockholders' equity accounts (on the right side of the accounting equation)

O Increased by credits and have normal credit balances

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Dividend Accounts

O Dividend accounts appear on the right side of the accounting equation and decrease stockholders' equity (retained earnings)

O Increased by debits and have a normal debit balance

O Can be thought of as a type of contra account to retained earnings

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Revenue Accounts

ORevenue accounts appear on the right side of the accounting equation and increase stockholders' equity (retained earnings)

O Increased by credits and have normal credit balances

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Expense Accounts

O Expense accounts appear on the right side of the accounting equation and decrease stockholders' equity (retained earnings)

O Increased by debits and have a normal debit balance

O Can be thought of as a type of contra account to revenues

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Summary

O The rules of debit and credit require that for each transaction, the total debits equal the total credits

O Each transaction must be recorded so that the total debits for the transaction equal the total credits.

Example: Assume that a company pays cash of $500 for supplies.

Asset Account: Supplies is debited (increased) by $500

Asset Account: Cash is credited (decreased) by $500

Example: If the company provides services and receives $2,000 from customers

Asset Account: Cash is debited (increased) by $2,000

Revenue Account: Fees Earned is credited (increased) by $2,000 transactions.

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Relationship Between Accounts

Source: Tracy, J. A. (n.d.) Connecting the Income Statement and Balance Sheet. Retrieved from http://www.dummies.com/how-to/content/connecting-the-income-statement-and-balance-sheet.html

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Relationship Between Accounts (continued)

Accounts are connected as follows beginning with Sales:

O Making sales (and incurring expenses for making sales) requires a business to maintain a working cash balance.

O Making sales on credit generates accounts receivable.

O Selling products requires the business to carry an inventory (stock) of products.

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Relationship Between Accounts (continued)

O Acquiring products involves purchases on credit that generate accounts payable.

O Depreciation expense is recorded for the use of fixed assets (long-term operating resources).

O Depreciation is recorded in the accumulated depreciation contra account (instead decreasing the fixed asset account).

O Amortization expense is recorded for limited-life intangible assets.

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Relationship Between Accounts (continued)

O Operating expenses is a broad category of costs encompassing selling, administrative, and general expenses:

O Some of these operating costs are prepaid before the expense is recorded, and until the expense is recorded, the cost stays in the prepaid expenses asset account.

O Some of these operating costs involve purchases on credit that generate accounts payable.

O Some of these operating costs are from recording unpaid expenses in the accrued expenses payable liability.

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Relationship Between Accounts

O Borrowing money on notes payable causes interest expense.

O A portion (usually relatively small) of income tax expense for the year is unpaid at year-end, which is recorded in the accrued expenses payable liability.

O Earning net income increases retained earnings.

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References

Tracy, J. A. (n.d.). Connecting the income statement and balance sheet. Retrieved from http://www.dummies.com/how-to/content/connecting-the-income-statement-and-balance-sheet.html.

Warren, C.S. (2012). Survey of Accounting (6th ed). Mason, OH: South Western, Cengage Learning.