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

1. Debits, Credits, & The Relationship between the Income Statement & the Balance Sheet Your Basic Financial Accounting Guide by Dr. Tanae W. Acolatse

2. Rules of Debits & Credits: Graphic Normal Balances of Accounts 2 Source: Warren, C.S. (2012). Survey of Accounting (6th ed). Mason, OH: South Western, Cengage Learning

3. Rules of Debits & Credits Normal Balances of Accounts The normal balance of an account is the side of the account used to record increases The normal balance of an asset account is a debit balance, while the normal balance of a liability account is a credit balance 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. 3

4. Asset Accounts Asset Accounts: Increased by debits and have a normal debit balance (on the left side of the accounting equation) Exception: Some asset accounts, called contra asset accounts , are increased by credits and have normal credit balances. 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 4

5. Liability & Stockholders’ Equity Accounts Liability and stockholders' equity accounts (on the right side of the accounting equation ) Increased by credits and have normal credit balances 5

6. Dividend Accounts Dividend accounts appear on the right side of the accounting equation and decrease stockholders' equity (retained earnings ) Increased by debits and have a normal debit balance Can be thought of as a type of contra account to retained earnings 6

7. Revenue Accounts Revenue accounts appear on the right side of the accounting equation and increase stockholders' equity (retained earnings ) Increased by credits and have normal credit balances 7

8. Expense Accounts Expense accounts appear on the right side of the accounting equation and decrease stockholders' equity (retained earnings ) Increased by debits and have a normal debit balance Can be thought of as a type of contra account to revenues 8

9. Summary The rules of debit and credit require that for each transaction, the total debits equal the total credits 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. 9

10. Relationship Between Accounts 10 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

11. Relationship Between Accounts (continued) Accounts are connected as follows beginning with Sales: Making sales (and incurring expenses for making sales) requires a business to maintain a working cash balance. Making sales on credit generates accounts receivable. Selling products requires the business to carry an inventory (stock) of products. 11

12. Relationship Between Accounts (continued) Acquiring products involves purchases on credit that generate accounts payable. Depreciation expense is recorded for the use of fixed assets (long-term operating resources). Depreciation is recorded in the accumulated depreciation contra account (instead decreasing the fixed asset account). Amortization expense is recorded for limited-life intangible assets. 12

13. Relationship Between Accounts (continued) Operating expenses is a broad category of costs encompassing selling, administrative, and general expenses: 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. Some of these operating costs involve purchases on credit that generate accounts payable. Some of these operating costs are from recording unpaid expenses in the accrued expenses payable liability . 13

14. Relationship Between Accounts Borrowing money on notes payable causes interest expense. 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. Earning net income increases retained earnings. 14

15. 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 (6 th ed). Mason, OH: South Western, Cengage Learning. 15