Convert the transaction “Purchased office supplies on account” into the language of accounting.
I am going to show you how to remember the rules of debits and credit, so you will know how to prepare financial statements using these rules. So to help you out I have put some information behind me here on the whiteboard. You can start off by writing out the accounting equation which you should all be familiar with assets equals liabilities plus shreholders equity.
- Assets equals Liabilities plus Shareholders equity.
Also to help us understand these rules and remember them, I’m going to use a sample transaction that I have witten at the bottom. The sample transaction is purchased office supplies on account. Again the sample transaction in plain English is purchased office supplies on account.
- Purchased office supplies on account.
I use four steps process to help us take this statement in plain English and convert it into the language of accounting which is a language of debits and credits. So learning debits and credits is like learning a new language. Where after you master this section, you should be able to take any accounting transaction in plain English and convert that into debit and credit which again is the language of accounting.
Increases or decreases of assets, liabilities, equities, expenses and revenues.
So let’s come back to our sample statement, purchased office supplies on account. The first step in our analytical process is to ask ourself, what specific accounts are affected? Again the question is what specific accounts are affected? And the answer would be office supplies and accounts payable.
- What specific accounts are affected?
Why not cash? Because the transaction said you are purchasing office supplies on account which means you are purchasing these office supplies on credit. So if you are purchasing it on credit, there is no exchange of cash at this moment when you are making the purchase. The exchange of cash comes later when you make a payment and that’s a separete transaction, and we will have a separete record-keeping entry for that. So again the two accounts affected are office supplies and accout payable.
The second step in the analysis is to ask yourself, what categories or what families do these two accounts belong to? Again what categories or what families do these two accounts belong to? And the answer is office supplies belongs to the assets family, and accounts payable belongs to the liability family.
- What categories or what families do these two accounts belong to?
Now the third step in our analysis would be take each of these accounts separetely but we will apply the same question and the question is does your office supplies account increase or decrease in value as a result of this transaction? Let me repeat, does your office supplies account increase or decrease as a result of this transaction?
- Does your office supplies account increase or decrease in value as a result of this transaction?
Let’s assume this transaction is for $100 where you bought office supplies for $100. If that’s the case, visualize this you are walking into Office Depot. You are purchasing $100 of supplies. And you sign a piece of paper that says to Office Depot you will pay them later and they have already done a prior credit check on you and so you sign a piece of paper saying you will pay them later is accepted.
Let’s assume that for a moment. So if that’s the case, you are leaving Office Depot now, so when you leave Office Depot you have $100 of office supplies with you that did not own 15 minutes ago before entered Office Depot. So therefore your office supplies account has increased by $100.
Next apply the same question to account payable, has your account payable account increse or decrease as a result of purchasing $100 of office supplies on account.
- Has your account payable account increased or decreased as a result of purchasing $100 of office supplies on account?
And as I just said before you now owe $100 to Office Depot that you did not owe before. So therefore your liability your debt has increased by a $100, and your debt is denoted by which account again, accounts payable. So summarize this last step of the analysis here the third step of the analysis the office supplies increase by $100 and that’s an asset and your account payable liability also increased by $100.
Now for the fourth and final step, where we take this transaction in plain English and we try to express it in debits and credits. To help us understand that let’s go back to the accounting equation.
- Take this transaction in plain English and try to express it in debits and credits.
If you have an asset account increasing in value as we do with office supplies in this transaction, that increase in the asset account is denoted by the word debit, and then the asset account. So you will see down here I have the word debit DR for short, and then I have the account office supplies. So when you combine the word debit with any asset account in this case debit office supplies, it means only one thing, and that is you are telling me that office supplies account has increased in value.
So coming back to the chart I have shown about asset, and I will go up and the word DR it’s just a shorthand version of trying to remember this, then let’s look at the liabilities and the shareholders equity families because both these families on the opposite side of the equation. They will work the opposite of the asset family.
So let’s take liabilities, when you have a transaction again as we have here where a liability account like accounts payable has increased in value, then that increase in the liabiliry account is denoted by the word credit CR for short. Remember the opposite of the way the assets work because when an asset increased in value, we said we would denote it by the word debit. So the liability is working the opposite.
So one more time when a liability account is increasing in value because of a transaction. The increase in the liability account is denoted by the word credit, so down here we have written CR credit accounts payable. So credit accounts payable means only one thing, and that is accounts payable is increasing in value in this case by $100.
Shareholders equity works the same way as liabilities because as I said a few moments ago, both the liabilities and the shareholder equity accounts will work the same way for the purposes of the debit and credit rules, so if you have another transaction where a shareholder equity has increase in value for instance where let’s say your company has issued common stock that’s where your common stock account which is an shareholders equity account increases in value, so you denote that increase by saying credit common stock. So that would means your common stock account is going up in value.
So I have just gone through the rules as it potentially increases for assets, liabilities and shareholders equities. May give a few seconds now to digest this and then I’m going to start talking about the decreases.
Now the decreases, the good news is that the decreases for each of these families will work just the opposite of the increases.
- The decreases for each of these families will work just the opposite of the increases.
So if you remember the increases, then the decreases are the opposite. So let’s take assets, if you have another transaction for instance, where an asset account is reducing is decreasing in value such as when you make a payment.
When you make a payment, what happens to your cash asset account. It decreases isn’t it? So these decreases are denoted by the word credit and then the asset account.
So if I said credit cash, then I am saying that the cash asset account is decreasing and I have shown that here so the credit for an asset means a decrease just the opposite of the increase which would be a debit to the asset account.
Similarly the decreases for shape for liabilities would be a debit and then the liablility account. So if I said debit account payable, I am saying to you that the account payable liability account is going down in value, and similarly shareholders equity a debit to here shareholders equity account will also signify a reduction in your shareholders equity account.
So now we have talked about both the increases and we have talked about decreases for these three families which three families, assets, liabilities and equity. But we are not done yet, we are not done yet because guess what there’s still two more families to talk about revenues and expenses.
OK, so with revenues I have written revenues on the word revenues here on this side. That is to show you that the rules for revenues is the same as the rules for liabilities and equity. That’s the purpose of writting the revenues on this side. And conversely the rules for expenses are the same as assets, so I’ve put it on the asset side.
So that means when you have an increase in an expense account, then that increase in the expense account is denoted by the word debit. So if you say dabit rent expense then you are telling me that the rent expense you are picking up or you are recording a new rent expense for this month.
Conversely for the revenues if you said credit fees earned revenue account or sales would be an example of a revenue account. So if you said credit sales or credit fees earned, you are telling me that your sales has you’re recording a new sales or new fees earned for this period of time.
- Assets + Expenses = Liabilities + Equity + Revenue
So that covers the rules for all the five families assets, liabilities, equity, revenues and expenses. And when you take that statement in plain English in this case again coming back to our original example, purchased office supplies on account. That statement in plain English when you convert it into the language of accounting, you would express that by saying debit office supplies $100 and credit accounts payable $100.
So this statement is called a journal entry. So journal entry is nothing but taking a statement in plain English and accounting transaction in plain English and expressing it in the language of debits and credits. Now where do we make this journal entry. This journal entry is typically recorded in the general journal. The general journal is place where you typically record your journal entries.
And a couple of other things you need to keep in mind about journal entries. Every journal entry must have at least one debit and one credit. As in this case we do have one debit and one credit.
Second the journal entry must have equal dollar values of debit and equal dollar values of credit. So in this case we have $100 of debits and $100 of credits.
Later on you’ll see that there are some more complicated transactions where you could have for instance two debit and one credit on the same transaction. And that’s fine because still meets the test of having one debit and one credit, number 1.
Number 2, as long as the two debits combine the dollar value of the two debits combined should be equal to the dollar vallue of that one credit. So then the journal entry would still be valid as well as in balance. OK that’s a little bit about the rules of debits and credits.