68 Chapter 2 Processing Transactions

TEST YOUR
Classify the following items according to their type: asset, liability, or equity:
UNDERSTANDING 2.1
(a) Interest expense
Classification of
Accounts (b) Commission income
(c) Prepaid rent
(d) Office supplies
(e) Proprietor's drawings
(f) Fines paid
(g) Advances to suppliers
(h) Unearned insurance premium
(i) Income tax expense
(j) Income tax payable
(k) Dividend paid
(I) Dividend income
(m) Advances from customers

Recognition is the process of incorporating an item that meets the definition of

an element (revenue, expense, asset, liability, or equity). Derecognition is the process
of removing an item that no longer meets the definition of an element.
DECISION-MAKING Accounting systems provide information to internal and external users of financial statements. There is no
How Can You Balance one-size-fits-all system that would suit every business organization. The system should not only fulfil an
the Costs and Benefits of organization's current and anticipated information needs but also be cost-effective and relatively hassle-free.
an Accounting System? Suppose that a mid-sized listed company engages you to design a new accounting system for it. Your
first task is-to list a set of -issues, For example:
• What should be the objectives of the proposed accounting system?
• Who would be the users of the output of the system?
• What information will they need?
• How will the system benefit the users and the organization?
• What are the technology choices for the system?
• What will be the estimated set-up and running costs of the system?
• How should the accounting system be integrated with the other organizational systems?
Prepare a short presentation on your proposed accounting system to the company's board of directors
and auditors.

The Double-entry System: The Basis of Modern Accounting

Learning Objective In Chapter 1, we analyzed the effect of a transaction on the accounting equation .
Describe the Recall that each transaction affects two columns. For example, receiving cash
• • double-entry .• from customers for past invoices increases cash and decreases trade receivables.
system and apply
Thus, we record each transaction in two accounts so that the accounting equation,
the rules for debit
Assets = Liabilities + Equity, is always in balance. This balancing is as important
and credit.
to the accountant as safe landing is to an airline pilot: the number of times an aircraft
takes off must equal the number of times it lands. This principle of duality is valid
regardless of the complexity of a transaction. The double-entry system records every
transaction with equal debits and credits. As a result, the total of debits must equal
the total of credits. Luca Pacioli (pronounced pot-chee-oh-lee), an Italian monk, first
articulated the double-entry system in 1494 in his book titled Summa de Arithmetica,
Geometria, Proportioni et Proportionalita (which means "Everything about Arithmetic,
Geometry, and Proportions'L''

2 Luca P)cioli was the best friend and a teacher of Leonardo da Vinci, the renowned painter,
scientist and inventor, and taught him mathematics and geometry. Pacioli is believed to have
helped the artist with the painting of The Last Supper. Interestingly, Pacioli also penned the
world's oldest magic text, De Viribus Quantitatis (On the Powers of Numbers). It would appear
that accounting skill and sleight of hand have had something in common for a long time.
 The Double-entry System: The Basis of Modern Accounting 69

The T Account
The common form of an account has three parts:
1. A title that describes the name of the asset, liability, or equity account;
2. A left side, or the debit side; and
3. A right side, or the credit side.
This form of account is called a T account because it looks like the letter T, as
shown below.

Title of Account
------1
Left = Debit Right = Credit

Debits and credits Accountants use the terms debit and credit, respectively, to refer
to the left side and right side of an account. To debit an account is to enter an amount
on the left side of the account and to credit an account is to enter an amount on the
right side of the account. It must be noted that, in accounting, debit and credit do not
have any value connotations such as bad or good and unfavourable or favourable. They
are simply the accountant's terms for left and right - and nothing more.
The T Account explained In Chapter 1, Softomation had several transactions
involving receipt or payment of cash. When we record these transactions in the cash
account, the cash receipts appear on the left or debit side of the account and the cash
payments on the right or credit side, as shown below:

Cash
20XX 20XX
March 1 50,000 March 3 58,000
2 20,000 21 2,000
19 12,000 29 5,200
31 3,500
Total 82,000 Total 68,700
Balance 13,300

The totals - cash receipts ~82,000, and cash payments, ~68,700 - are in bold so
as to'"distinguish them from the transaction entries. The debit and credit totals, or
footings in accounting lingo, are merely an intermediate step in determining the cash
on hand at the end of the month. The difference in amounts between the total debits
and the total 'credits in an account is the balance.
• If the total debits exceed the total credits, the account has a debit balance.
• If the total credits exceed the total debits, the account has a credit balance.
The cash account of Softomation has a debit balance of ~13,300 ~82,000 - ~68,700).
This balance represents the cash available with Softomation on March 31.

Standard Form of Account

The T account described earlier is, no doubt, a convenient way to explain the effects
of transactions on individual accounts. In practice, accountants draw up accounts in
a form known as the standard form, similar to the one in Exhibit 2.2. The standard
form shows the balance after every transaction and is, therefore, even more useful
and efficient to use than the)' account. Your bank statement is an everyday example
of the standard form.
70 Chapter 2 Processing Transactions

EXHIBIT 2.2 The standard form is a better alternative to the T account. The bank statement follows the standard form.
Standard Form of
Account Cash

Date Explanation Post. Ref. Debit Credit Balance

20XX
March 1 50,000 50,000
2 20,000 70,000
3 58,000 12,000
19 12,000 24,000
21 2,000 22,000
29 5,200 16,800
31 3,500 13,300

.You would have observed that the cash account has the same information as that
in the cash column in Exhibit 1.4. It is just that receipts and payments appear on
separate columns.

LEARNING AID
Here is a common question that comes up in the early stages of an accounting course:
Opposite Entries We record receipts as debits and payments as credits in the cash account. But the bank credits our account
when we deposit money and debits our account when we withdraw money. It is confusing, isn't it?
Answer: The cash account in our records is the mirror image of our deposit account kept by the bank. While
our deposits with the bank are our assets, they are the bank's liabilities. The bank credits our account when we
deposit cash because it owes us that much more; it debits our account for withdrawals because it owes us less.

Debit and Credit Rules

Under the double-entry system, we enter increases in assets on the debit side of the
account, and increases in liabilities and equity on the credit side. Figure 2.1 describes
the recording procedure in terms of the accounting equation:
Figure 2.1
DEBIT AND CREDIT RULES
Assets Liabilities Equity
Debit and credit rules
for assets are the mirror
image of those for
liabilities ~nd equity.
+
I ·. '. .
•••••
'. .
The rules for debit and credit for assets, liabilities, and equity are as follows:
1. Assets Debit increase in asset to asset account. Credit decrease in asset to
asset account.
2. Liabilities and equity Credit increase in liability or equity to liability
or equity account. Debit decrease in liability or equity to liability or equity
account.
From Chapter 1, you know the expanded form of the accounting equation:
Assets = Liabilities + Capital + Revenues - Expenses - Drawings (or Dividends)
We can rewrite this equation as follows:
Assets + Expenses + Drawings (or Dividends) = Liabilities + Capital + Revenues
We can now extend the rules for recording increase and decrease in equity to revenues,
expenseasdrawings, and dividends. Thus, we credit revenues to increase them; we debit
expenses, drawings, and dividends to increase them. Exhibit 2.3 summarizes the rules
for debit and credit.
Comprehensive Illustration: Fashion Concepts Company 71

EXHIBIT 2.3
Effect Assets, Expense, Drawings, Dividends· Liabilities, Capital, Revenues
Debit and Credit Rules
Increase Debit Credit
Decrease Credit Debit

The double-entry system is the workhorse of accounting. Shortly, you will be able
to appreciate its great value in organizing and processing information. However, the
significance of the double-entry system goes far beyond its usefulness as a system
of accounting mechanics. The German economic historian, Werner Sombart, praised
accounting and its bookkeeping tool saying:"
One can scarcely conceive of capitalism without double-entry bookkeeping; they are
related as are form and content. It is difficult to decide, however, whether in double-
entry bookkeeping, capitalism provided itself with a tool to make it more effective, or
whether capitalism derives from the 'spirit' of double-entry bookkeeping.
Remember that knowing debits and credits is a big help in communicating with
accounting professionals,
TEST YOUR
Mahesh Pherwani started Pherwani Photoshop Ltd., a photography service. The following accounts contain eight transactions
keyed together with leiters. Write a short description of each transaction with the amount(s) involved. UNDERSTANDING 2.2
Figuring out
Photography Equipment
Transactions from
(a) 9,000 Accounts
(e) 2,000
Photography Supplies
(b) 1,400
-, ,
Trade Receivables
(9) 8,100
Cash
(a) 3,100 (c) 1,600
(d) 4,700 (f) 550
(h) 1,700
Prepaid Rent
(c) 1,600
Trade Payables
(f) 550 (b) 1,400
Non-trade Payables
(e) 2,000
Share Capital
...• (a) 12,100
Revenue from Services
(d) 4,700
(g) 8,100
Salaries Expense
(h) 1,700

Comprehensive Illustration: Fashion Concepts Company

Learning Objective
To illustrate the procedure for recording transactions, let us take up a company that
we call Fashion Concepts Company, a business that supplies new designs for dresses. Analyze the effect
In this illustration, you will learn how to record a transaction in terms of debits and • .' of business
transactions using
credits. We have the following four steps for each transaction:
debits and
credits.
3 Quotedin Joel Demski, John Fellingham, Yuji Ijiri, and Shyam Sunder, Some thoughts on the
intellectual foundations of accounting, Accounting Horizons, June 2003, pp. 157-168.
80 Chapter 2 Processing Transactions

Revenue - Expenses - Dividends

Revenue from services.... 11,000 Salaries expense . 800 Dividends . 2,200
Electricity expense . 150
Telephone expense . 200
Rent expense . 1,500
11,000 - 2,650 2,200

FINANCIAL VIEW Suppose that you want to inform your company's chief executive that the net profit for quarter 4 of year 2015
XBRL is ~1,000,000. So you transmit the number 1,000,000 from your computer. The receiving computer should be
programmed to receive the number as net profit, and not as sales revenue or salaries expense. Also, it should
recognize the currency as Indian rupee, and not as US dollars. It should see it as related to quarter 4 of 2015,
not some other quarter or year. Suppose that you can send "information about information", i.e. the amount is
"net profit", it is in "Indian rupee", and it pertains to "quarter 4" of "year 2015". Then the chief executive can read
it as "net profit of ~1,000,000 for the fourth quarter of 2015".
XBRL (eXtensible Business Reporting Language) is a specification that allows the expression of financial and
business reporting concepts using XML (eXtensible Markup Language) technology. It is a computer programming
add-on that tags each segment of computerized business information with an identification code or marker. It is
a bar coding system for items appearing in the financial statements. Financial statements become an interactive
database in XBRL.
A name is assigned to every information item, along with a defined relationship between the various items.
The resulting list, called taxonomy, enables a business organization to report according to an accepted accounting
system with the ability to produce financial statements marked up in XBRL. The ID markers remain with the data
when they are moved or changed. No matter how a browser or application software formats or rearranges the
information, the markers stay glued to it. Typical labels include financial IDs such as assets, current assets and
receivables. If the XBRL program does not contain ID markers that meet the needs of a business, the user can
create own markers and add them because the program is fully customizable - or extensible (with ex as the X
in XBRL).
Business organizations provide information in different formats such as credit applications to banks, regulatory
filings, tax returns, statements in print, statements in pdf, and statements on the Internet. With XBRL, a document
can be transformed into any required report from the raw data. XBRL taxonomies have been developed for IGAAP,
US GAAP and IFRS. XBRL does not change what is being reported; it only changes how it is being reported.
It provides benefits to all members of the financial information supply chain: companies that prepare financial
statements, auditors, investors, analysts, lenders, regulators, financial publishers, data aggregators, and software
developers. By facilitating transporting data between disparate software applications, XBRL has the potential to
greatly enhance the information liquidity in the business reporting supply chain. Specific benefits of XBRL include:
• No rewrites of financial reports;
• Fast, accurate searches on the Internet;
• Drilling down to the data source and to the related authoritative professional literature that supports the
s: data; and
• Less need to re-enter data.
For financial year beginning on or after April 1, 2011, listed companies and certain other classes of companies
.,. must file their financial statements using the XBRL taxonomy .
XBRL is an open standard and does not require any licence fee for use. XBRL is maintained by XBRL
International, an international consortium. It coordinates with national [urisdicfions.

Learning Objective
Record transactions
•
• in the journal.
(Recording Transactions )
~. ----------
The Journal
The journal is a chronological record of an enterprise's transactions. The word 'journal'
derives from the Latin word diurnalis meaning "diurnal" which implies "of or during
the day time". The journal is called the book of original entry or primary book because
this is the accounting record where we first record transactions. It provides in one place
a complete record of all transactions with necessary explanations. A journal entry has
the transaj;tion date, the individual accounts and the related debit and credit amounts,
and a brief explanation of the transaction. Journalizing is the process of recording
transactions in the journal.
 Recording Transactions 81

Drug companies paid US doctors over $1 billion in 2012. The payments were for entertainment, IN PRACTICE
consulting and research. New US "sunshine" legislation has made such disclosure mandatory. Payments Detecting Questionable
are also made in the form of royalties for medical devices that the doctors helped develop. The Payments
amounts paid came down in 2013 because of the disclosure requirement, as also over doubts about the
effectiveness of such payments. Critics argue that doctors receiving payments may be influenced into ~ •• I
prescribing the medicines of the drug companies. Companies need well-designed accounting systems
that can provide information to respond to legal and other requirements.
Source: Andrew Jack, US doctors paid $1 billion by top drug companies, Financial Times, May 22,2013.
.@;
The General Journal
Companies usually maintain several kinds of journals. The nature of operations and the
frequency of a particular type of transaction in a company determine the number and
design of journals. In this chapter, we use the general journal, the most commonly
used type of journal. It has separate columns to record the following information about
each transaction:
1. Date;
2. Individual accounts;
3. Debit and credit amounts;
4. Brief explanation of the transaction; and
5. Posting reference.
Exhibit 2.5 illustrates the general journal using two transactions of Fashion
Concepts Company.

The generaljournalhas coluQ1ns

for date,debitand creditaccounts,and relatedamounts. EXHIBIT 2.5
FASHION CONCEPTS
GeneralJournal Page 1 COMPANY:
The General Journal
Date Description Post. Ref. -- Debit Credit

20XX

June 1~ cash[JJ 50,000[JJ

Sharecapital[JJ 50,000[JJ

Investedcash~

l.§.:mpound entry

4~ Officeequipment[JJ 9,000[JJ
.,.

Cash[JJ 3,000[JJ

Creditors[JJ 6,000[JJ

Purchaseof officeequipmenton part payment~

The procedure for recording transactions in the general journal is as follows:
1. Enter the year, month, and date of the transaction in the Date column.
• There is no need to repeat the year and month for subsequent entries until
the start of a new page, or a new month.
2. Write the account titles under the Description column.
• Enter the account to debit on the first line of the entry next to the left margin.
If there are several accounts to debit, enter them one after the other.
• Enter the account-to credit on the line below the account(s) to debit and
indent it to set the account apart from the account(s) to debit. If there are
several accounts to credit, enter them one after the other.
• Use the account titles from the company's chart of accounts.
82 Chapter 2 Processing Transactions

•
A compound entry is a journal entry that has more than one debit and/or
credit items.
3. Enter the amount of the debit in the Debit column alongside the account to
debit and the amount of the credit in the Credit column alongside the account
to credit.
4. Write a brief explanation of the transaction.
5. The Post. Ref. (Posting Reference) is left blank at the time of making the
journal entry.

Transferring Information to the Ledger

learning Objective Posting is the process of transferring information from the journal to the ledger.
Post entries from We enter each amount in the Debit column in the journal on the debit side of the
•• the journal to the
• appropriate account and each amount on the Credit column on the credit side of the
ledger.
appropriate account. The frequency of posting could be daily, weekly, or monthly,
depending on the number of transactions.
Posting has the following steps:
1. Locate in the ledger the account(s) debited in the journal entry.
2. Enter the date of the transaction in the account.
3. Enter the relevant journal page number in the Post. Ref. column of the account.
4. Enter the debit amount appearing in the journal in the Debit column of the
account.
5. Enter the account code or the ledger page number in the Post. Ref. column of
the journal.
6. Repeat steps 1 to 5 for the account(s) credited in the journal entry.
Exhibit 2.6 illustrates these steps separately for the debit and credit parts of a journal
entry. Entering the account code in the "Post. Ref." column of the journal is the last
step in posting. It indicates that the accountant has transferred all the information
in the journal entry to the ledger. In addition, the account codes in this column are a
convenient means for locating any additional information about an amount appearing
in an account. Since this book does not use account codes, you do not have to complete
this column.
EXHIBIT2.6
Posting a journal entry involves five steps.
FASHION~CONCEPTS
COMPANY: . General Journal Page 1
Transferring Date Description Post. Ref. Debit Credit
Information to the .•
20XX
Ledger
~tep51
June 1 Cash 112 50,000

~tep51
Share capital 301 50,000
Invested cash

• Cash'
Date..
-
< I-~..,~
Posting the debit:

.':-
'<

Explanation
~
• •
<,

;
J'
•
'.' '.

>,

~
-

• :
••
General Ledger

,-<,;'" - ,.,;" ", .. -

,
-'-..
..
,"
•. ~:

-
P~st.~Ref.
.~)- .••
'" ., .

Debit
,
,'
Account No. 112
Credit Balance

20XX Jt

~tep21 ~tep41
June 1 50,000 50,000
Trial Balance 83

Posting the credit:

Share Capital ••• Account No. 301

Date Explanation Post. Ref. Debit Credit Balance

20XX
I!tep 2 I I!tep 4 I
June 1 50,000 50,000

The next step in the recording process is the preparation of a trial balance.
LEARNING AID
For a beginner in accounting, recording the effect of a transaction can be confusing at times. Recall that an
account is a record of increases and decreases in an item. We use journal entries to record changes in an account.
Transaction and
To illustrate, suppose that a business has cash of ~2,100 and a receivable of n,ooo from a customer, besides Balance
other items. The customer pays ~600, a part of. the receivable of ~l,OOO. The journal entry, Debit Cash 600;
Credit Trade Receivables 600, records this transaction. As a result, Cash increases by ~600 and Trade Receivables
decreases by ~600. The new lialance of Trade Receivables is ~400, i.e. beginning balance, n,ooo - collection,
~600. The new balance of Cash is ~2,700 i.e. beginning balance, ~2,100 + collection, ~600. We do not record
a journal entry for the balance amount. The balance is the difference between the debit and the credit totals.
Transaction entries record delta (ll), the mathematical shorthand for change. So remember that journal entries
record changes, not balances.

(~T_ri_a_I_B_a_la_n_c_e )
Under the double-entry system.rthe debit arid credit amounts must be equal. The trial Learning Objective
balance is a device for verifying the equality of debits and credits. Pacioli is said to Prepare a trial
have advised that a person should not go to sleep at night until the debits equalled • balance and know
•
its limitations.
the credits. Exhibit 2.7 shows a trial balance for Fashion Concepts Company. The trial
balance lists each account in the ledger that appears in Exhibit 2.4, with the debit
balances in the left column, and the credit balances in the right column. Each column
has a total, and the two totals must be equal. When this happens, the trial balance
is said to be "in balance."

EXHIBIT 2.7
The trial balance lists ledger balances on a specified date. It is a basic check on bookkeeping.
FASHION CONCEPTS
Equipment . ~ 9,000 COMPANY: Trial
Office supplies . 5,500
Balance, June 30, 20XX
Trade receivables ..................................................................................................................................•...... 5,000
Cash . 45,080
Prepaid insurance :~ . 720
Non·trade payables . ~ 5,000
Trade payables . 2,500
Unearned revenue . 1,500
Electricity expense payable : . 150
Share capital . 50,000
Dividends . 2,200
Revenue from services ...........................•................................................•.................................................... 11,000
Salaries expense . 800
Electricity expense . 150
Telephone expense '" . 200
Rent expense . 1,500
70,150 70,150

.ir
The equality of the debit and credit totals of the trial balance proves that we have
recorded equal debits and credits in the accounts. Further, it verifies that we have