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Accounting Mnemonics Dr Cr Rules

HRM (Addis Ababa University)

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Rules of debit and credits

Debits and credits are the opposing sides of an accounting journal entry. They are used to
change the ending balances in the general ledger accounts. The rules governing the use of
debits and credits in a journal entry are as follows:

Rule 1: All accounts that normally contain a debit balance will increase in amount when a debit
(left column) is added to them, and reduced when a credit (right column) is added to them. The
types of accounts to which this rule applies are expenses, assets, and dividends.

Rule 2: All accounts that normally contain a credit balance will increase in amount when a credit
(right column) is added to them, and reduced when a debit (left column) is added to them. The
types of accounts to which this rule applies are liabilities, revenues, and equity.

Rule 3: Contra accounts reduce the balances of the accounts with which they are paired. This
means that (for example) a contra account paired with an asset account behaves as though it
were a liability account.

Rule 4: The total amount of debits must equal the total amount of credits in a transaction.
Otherwise, a transaction is said to be unbalanced, and the financial statements from which a
transaction is constructed will be inherently incorrect. An accounting software package will flag
any journal entries that are unbalanced.

By following these debit and credit rules, you will be assured of making entries in the general
ledger that are technically correct, which eliminates the risk of having an unbalanced trial
balance. However, just following the rules does not guarantee that the resulting entries will be
correct in substance, since that also requires a knowledge of how to record transactions within
the applicable accounting framework (such as Generally Accepted Accounting Principles or
International Financial Reporting Standards).

Introduction to financial accounting

Learning objectives:

1. What are the different types or branches of accounting? What is the function of each
branch?
2. Who are the users of accounting information?
3. Define and explanation accounting equation. What an accounting equation tells us?
4. What is double entry system of accounting? What are advantages and disadvantages of
double entry system?

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5. What is chart of accounts? What is the purpose of preparing a chart of accounts?

6. How do you classify accounts? Explain modern and traditional classification of accounts.
7. What is a business transaction? What are different types of business transactions?
8. Explain the rules of debit and credit. How the rules of debit and credit are applied to the
accounts in business transaction?

Types or branches of accounting

As a result of technology advancements and industrial and economic development, various types
of accounting have evolved over time. Some popular types or branches of accounting are
briefly discussed below:

1. Financial accounting
2. Management accounting

3. Cost accounting

4. Tax accounting

5. Project accounting

6. Not-for-profit accounting

7. International accounting

8. Government accounting

9. Social accounting

10. Forensic accounting

11. Fiduciary accounting

12. Auditing

1. Financial accounting

Financial accounting is concerned with the preparation of periodic financial reports by using
historical data of a business enterprise. The basic purpose of these reports is to provide useful
and timely information about an entity’s financial position and its operating results to owners,
managers, investors, creditors and government agencies etc. Financial position refers to the
resources and obligations of a business at any given point of time and operating results means the
net profit earned or net loss incurred by a business enterprise during a particular period of time.

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There are certain rules known as “generally accepted accounting principles (GAAP)” that each
business enterprise must follow while preparing its financial reports to ensure that the financial
information published by it is useful, reliable and comparable with other companies.

Financial accounting is also termed as the “general purpose accounting” because the
information generated by it is published for the use of every one connected with the business
enterprise.

2. Management accounting

Management accounting system uses historical as well as estimated data to generate useful
reports and information to be used by internal management for decision making purpose. Unlike
financial accounting, the information generated by management accounting is not published for
external parties but is used by managers to perform their core functions such as evaluation of
various products and departments in terms of profitability, selection of the best available
alternatives and making other business decisions to achieve organizational goals. As the reports
generated by management accounting are not used by any external party, the business enterprises
don’t need to take care of GAAP.

3. Cost accounting

The cost accounting is concerned with categorizing, tracing and collecting manufacturing costs
of a business enterprise. The cost data collected so is used by management in planning and
control. A well established cost accounting system is essential for every business enterprise to
have a proper control over costs.

4. Tax accounting

Tax accounting deals with the tax related matters of a business enterprise. It includes
computation of taxable income and presentation of financial or other information to
tax authorities required by tax laws and regulations of a country.

The reports and information generated by financial accounting system satisfy the needs of
external parties to great extent. However, the rules and methods followed by a company for
preparing its financial accounting reports may slightly differ from those required by tax laws.
The work of a tax accountant is to adjust the net operating results and rearrange the information
generated by financial accounting to conform with the tax reporting requirements of a country.
Besides it, tax accountants also help companies minimize their tax obligations. Because of these
functions, tax accountants need to have an updated knowledge about tax laws and regulations.

Tax accounting is also important for managers because taxes usually have a significant impact on
the expected outcomes of proposed decisions.

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5. Project accounting

Project accounting is a component of overall project management. It is a specially designed

accounting system that prepares financial reports at appropriate time intervals to track the
financial progress of a project. These reports provide vital information to project managers in
performing their project management function. The use of project accounting is very common
among companies involved in construction contracts.

6. Not-for-profit accounting

Not-for-profit accounting is concerned with recording events, preparing reports, and planning
operations of not-for-profit organizations such as charities, churches, educational institutions,
and government agencies etc.

7. International accounting

Intentional accounting deals with the issues and complications involved in doing trade in world
markets. Many companies have expanded their business internationally. Such companies employ
accountants who possess detailed knowledge about custom and taxation laws of various
countries.

8. Government accounting

Government accounting is concerned with the allocation and utilization of government budgets.
It ensures that the central or state government funds released for various purposes are being
utilized efficiently. The proper record keeping makes the audit of completed projects possible.

9. Social accounting

Social accounting is concerned with analyzing and evaluating organizational impact on society
and its environment. It measures the social costs and benefits of various organizational activities.
For example, accountants in this area might analyze and evaluate the use of federal and state land
or the use of welfare funds in a large city. Other accountants might analyze and evaluate the
environmental impact of acid rain.

10. Forensic accounting

Forensic accounting deals with legal issues faced by business enterprises. Accountants in this
area uses their knowledge, skills and techniques to deal with legal matters such as dispute
resolution, claim settlement, fraud investigation, court and litigation cases etc.

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11. Fiduciary accounting

Fiduciary accounting refers to the management of financial records by a person to whom the
custody and management of some property has been entrusted for the benefit of another person.
Estate accounting, trust accounting, and receivership are some examples of fiduciary accounting.

12. Auditing

The term auditing generally refers to review, examination, verification, evaluation or inspection
of historical data, records or events belonging to an entity. The person who performs the work of
audit is known as auditor. In accounting and business, there are two types of auditing – external
auditing and internal auditing.

External auditing refers to the independent examination of an entity’s financial statements and
other accounting records that an entity publishes for the use of external parties. The auditor gives
his opinion about the fairness of all accounting information examined by him. An important
element of “fairness” is the compliance of financial statements with the generally accepted
accounting principles (GAAP).

Internal auditing is performed to determine whether or not the policies and procedures set by
management are being followed. An important purpose of internal auditing is to evaluate whether
the activities performed by the employees at various levels are in line with the goals set by
management. Internal auditing may be performed by the existing accountants, however many
companies employ special staff for this purpose.

Users of accounting information

Accounting information of a business enterprise is used by a number of parties. Different parties
use accounting information for different purposes depending on their needs. Therefore, the
accounting information system of a business enterprise must be designed in a way that should
generate reports to satisfy the needs of everyone interested in accounting information.

We can broadly divide the users of accounting information into two groups – internal users and
external users. Internal users include managers and owners of the business whereas external
users include investors, creditors of funds, suppliers of goods, government agencies, general
public, customers and employees.

Internal users
Internal users use a mix of management and financial accounting information. Some internal
users of accounting information and their needs are briefly discussed below:

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1. Management

Management uses accounting information for evaluating and analyzing organization’s financial
performance and position, to take important decisions and appropriate actions to improve the
business performance in terms of profitability, financial position and cash flows. One of the
major roles of management is to set rules and procedures to achieve organizational goals. For
this purpose, management uses information generated by financial as well as managerial
accounting system of the organization.

2. Owners

Owners invest capital to start and run business with the primary objective to earn profit. They
need accurate financial information to know what they have earned or lost during a particular
period of time. On the basis of this information they decide their future course of actions such as
expansion or contraction of business.

In small businesses (like sole proprietorship and partnership) owners themselves perform the
function of management.

External users
External users normally use only financial accounting information. Some external users of
accounting information and their needs are briefly discussed below:

1. Investors

In corporate form of business, the ownership is often separated from the management. Normally
investors provide capital and management runs the business.

The accounting information is used by both actual and potential investors. Actual investors use
this information to know how their funds are used by the management and what is the expected
performance of business in future in terms of profitability and growth. On the basis of this
information, they decide whether to increase or decrease investment in corporation in future.
Potential investors use accounting information to decide whether or not a particular corporation
is suitable for their investment needs.

2. Lenders

Lenders are individuals or financial institutions that normally lend money to businesses and earn
interest income on it. They need accounting information to assess the financial performance and
position and to have a reasonable assurance that the business to whom they are going to lend
money would be able to return the principal amount as well as pay interest there on.

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3. Suppliers

Suppliers are business individuals or organizations that normally sell merchandise or raw
materials to other businesses on credit. They use accounting information to have an idea about
the future creditworthiness of the business and to decide whether or not to continue providing
goods on credit.

4. Government agencies

Government agencies use financial information of businesses for the purpose of imposing taxes
and regulations.

5. General public

General public also uses accounting information of business organizations. For example,
accounting information is:

 a source of education for students of accounting and finance.

 a source of valuable data for those researching on organizational impacts on individuals
and economy as a whole.

 a source of information for the people looking for job opportunities.

 a source of information about the future of a particular enterprise.

6. Customers

Accounting information provides important information to customers about current position of a

business organization and to make a judgment about its future. Customers can be divided into
three groups – manufactures or producers at various stages of production, wholesalers and
retailers and end users or final consumers.

Manufacturers or producers at every stage of processing need assurance that the organization in
question will continue providing inputs such as raw materials, parts, components and support etc.
The wholesalers and retailers must be assured of consistent supply of products. The end users or
final consumers are interested in continuous availability of products and related accessories.
Because of these reasons, the accounting information is of significant importance for all three
types of customers.

7. Employees

Employees who do not have a hand in core management of the business are considered external
users of accounting information. They are interested in financial information because their
present and future is tied up with the success or failure of the business. The success and

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profitability of business ensures job security, better remuneration, job promotion and retirement
benefits.

Accounting equation
Accounting equation describes that the total value of assets of a business is always equal to its
liabilities plus owner’s equity. This equation is the foundation of modern double entry system of
accounting being used by small proprietors to large multinational corporations. Other names used
for accounting equation are balance sheet equation and fundamental or basic accounting
equation.

Definition and explanation

We know that every business owns some properties known as assets. The claims to the assets
owned by a business entity are primarily divided into two types – the claims of creditors and the
claims of owner. In accounting, the claims of creditors are referred to as liabilities and the
claims of owner are referred to as owner’s equity.

Accounting equation is simply an expression of the relationship among assets, liabilities and
owner’s equity in a business. The general form of this equation is given below:

Assets = Liabilities + Owner’s Equity

Notice that the left hand side (also known as assets side) of the equation shows the resources
owned by the business and the right hand side (also known as equity side) shows the sources of
funds used to acquire the resources. All assets owned by a business are acquired with the funds
supplied either by creditors or by owner. In other words, we can say that the value of assets in a
business is always equal to the sum of the value of liabilities and owner’s equity. The total dollar
amounts of two sides of accounting equation are always equal because they represent two
different views of the same thing.

In accounting equation, the liabilities are normally placed before owner’s equity because
the rights of creditors are always given a priority over the rights of owners. Because of this
preference, the liabilities are sometime transposed to the left side which results in the following
form of accounting equation:

Assets – Liabilities = Owner’s Equity

If dollar amounts of any two of the three elements are known, we can solve the equation to find
the third one. For example, if a business has total assets amounting to $200,000 and total
liabilities amounting to $60,000, the owners’ equity must be equal to $140,000 as computed
below:

Assets – Liabilities = Owner’s Equity

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$200,000 – $60,000 = $140,000

Example 1:

Using the concept of accounting equation, compute missing figures from the following:

1. Assets = $50,000, Liabilities = $20,000, Owner’s equity = ?

2. Assets = ?, Liabilities = $10,000, Owner’s equity = $15,000

3. Assets = $60,000, Liabilities = ?, Owner’s equity = $40,000

4. Assets = ?, Liabilities + Owner’s equity = $150,000

Solution

1. Owner’s equity = Assets – Liabilities

= $50,000 – $20,000
= $30,000
2. Assets = Liabilities + Owner’s equity
= $10,000 + $15,000
= $$25,000

3. Liabilities = Assets – Owner’s equity

= $60,000 – $40,000
= $20,000

4. The basic accounting equation is: Assets = Liabilities + Owner’s equity. If liabilities plus
owner’s equity is equal to $150,000, the assets must also be equal to $150,000.

Accounting equation and business transactions

Every business transaction impacts accounting equation in terms of dollar amounts but the
equation as a whole always remains in balance. Any increase in one side is balanced either by a
corresponding decrease in the same side or by a corresponding increase in the other side and any
decrease is balanced either by a corresponding increase in the same side or by a corresponding
decrease in the other side. For better explanation, consider the impact of twelve transactions
included in the following example:

Example 2:

Mr. John started a T-shirts business to be known as “John T-shirts”. He performed following
transactions during the first month of operations:

1. Mr. John invested a capital of $15,000 into his business.

2. He purchased a building for $5,000 cash for business use.

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3. He purchased furniture for $1,500 cash for business use.

4. He purchased T-shirts from a manufacturer for $3,000 cash.

5. He sold T- shirts for $1,000 cash, the cost of those T-shirts were $700.

6. He purchased T-shirts for $2,000 on credit.

7. He sold T-shirts for $800 on credit, the cost of those shirts were $550.

8. He paid $1,000 cash to his payables.

9. He collected $800 cash from his receivables.

10. The shirts costing $100 were stolen by someone.

11. Mr. John paid $150 cash for telephone bill.

12. He borrowed money amounting to $5,000 from City Bank for business purpose.

Required: Explain how each of the above transactions impacts the accounting equation of
John T-shirts.

Solution

Transaction 1: The investment of capital by John is the first transaction of John T-shirts which
creates very initial accounting equation of the business. At this point, the cash is the only asset
of business and owner has the sole claim to this asset. Therefore, the equation would look like
the following:

Equation element(s) impacted as a result of transaction 1: “Assets” & “Owner’s equity”.

Transaction 2: The second transaction is the purchase of building which brings two changes.
First, it reduces cash by $5,000 and second, the building valuing $5,000 comes into the business.
In other words cash amounting to $5,000 is converted into building. The impact of this
transaction on accounting equation is shown below:

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Equation element(s) impacted as a result of transaction 2: “Assets”

Transaction 3: The impact of this transaction is similar to that of transaction number 2. Cash
goes out of and furniture comes in to the business. On asset side, The reduction of $1,500 in cash
is balanced by the addition of furniture with a value of $1,500.

Equation element(s) impacted as a result of transaction 3: “Assets”

Transaction 4: The impact of this transaction is similar to transactions 2 and 3. One asset (i.e,
cash) goes out and another asset (i.e., inventory) comes in. The cash would decrease by $3,000
and at the same time the inventory valuing $3,000 would be recorded on the asset side.

Equation element(s) impacted as a result of transaction 4: “Assets”

Transaction 5: In this transaction, shirts costing $700 are sold for $1,000 cash. It increases cash
by $1,000 and reduces inventory by $700. The difference of $300 is the profit of the business
that would be added to the capital. The whole impact of this transaction on accounting equation
is shown below:

Equation element(s) impacted as a result of transaction 5: “Assets” & “Owner’s equity”

Transaction 6: In this transaction, T-shirts costing $2,000 are purchased on credit. It increases
inventory on asset side and creates a liability of $2,000 known as accounts payable (abbreviated
as A/C P.A) on the equity side of the equation. Since it is a credit transaction, it has no impact on
cash.

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Equation element(s) impacted as a result of transaction 6: “Assets” & “liabilities”

Transaction 7: In this transaction, the business sells T-shirts costing $550 for $800 on credit. It
reduces inventory by $550 and creates a new asset known as accounts receivable (abbreviated as
A/C R.A) valuing $800. The difference of $250 is profit of the business and would be added to
capital under the head owner’s equity.

Equation element(s) impacted as a result of transaction 7: “Assets” & “Owner’s equity”

Transaction 8: In this transaction, business pays cash amounting to $1,000 for a previous credit
purchase. It will reduce cash and accounts payable liability both with $1,000.

Equation element(s) impacted as a result of transaction 8: “Assets” & “Liabilities”

Transaction 9: In this transaction, the business collects cash amounting to $800 for a previous
credit sale. On asset side, it increases cash by $800 and reduces accounts receivable by the same
amount.

Equation element(s) impacted as a result of transaction 9: “Assets”

Transaction 10: The loss of shirts by theft reduces inventory on asset side and capital on equity
side both by $100. All expenses and losses reduce owner’s equity or capital.

Equation element(s) impacted as a result of transaction 10: “Assets” & “Owner’s equity”

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Transaction 11: The payment of telephone and electricity bills are business expenses that reduce
cash on asset side and capital on equity side both by $150.

Equation element(s) impacted as a result of transaction 11: “Assets” & “Owner’s equity”

Transaction 12: The loan is a liability because the John T-shirts will have to repay it to the City
Bank. This transaction increases cash by $5,000 on asset side and creates a “bank loan” liability
of $5,000 on equity side.

Equation element(s) impacted as a result of transaction 12: “Assets” & “Liabilities”

In above example, we have observed the impact of twelve different transactions on accounting
equation. Notice that each transaction changes the dollar value of at least one of the basic
elements of equation (i.e., assets, liabilities and owner’s equity) but the equation as a whole does
not lose its balance.

Double entry system of accounting

A brief history

The first book on double entry system was written by an Italian mathematician Fra Luca Pacioli
and his close friend Leonardo da Vinci. The book was entitled as “Summa de arithmetica,
geometria, proportioni et proportionalita” and was first published in Venice in 1494. Pacioli and
da Vinci did not claim to be the inventors of double entry system but they explored how
the concepts could be used in a more efficient and organized way.

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Pacioli wrote the text and da Vinci drew the practical illustrations to support and explain the text
in the book. The book was divided into various sections and the one that talked about double
entry system was entitled as “Particularis de computis et scripturis”. It was further divided
into many small chapters describing double entry, journals, trial balance, balance sheet, income
statement and many tools and techniques subsequently adopted by many accountants and traders.

Before pacioli’s contribution, some form of double entry system was already in practice. No one
knows exactly when and how it was invented. However, it was pacioli’s book that introduced the
system in Europe and other trading countries of the world. As the acknowledgement of his work,
Pacioli is known as the “father of accounting” by modern accounting professionals.

Definition and explanation

The double entry system of accounting or bookkeeping is based on the fact that each business
transaction essentially brings two financial changes in business. These changes are recorded as
debits or credits in two or more different accounts using certain rules known as ‘rules of debit
and credit’. In double entry system, every debit entry must have a corresponding credit entry
and every credit entry must have a corresponding debit entry. It is the basic principle of double
entry system and there is no exception to it. For example if a business purchases furniture for
$500 cash, the value of total furniture is increased by $500 and at the same time the cash
amounting to $500 is decreased. If the business is using double entry system of accounting, it
must debit the furniture account by $500 and credit the cash account by $500. See the rules of
debit and credit.

The double entry system of accounting can be broadly divided into the following three stages:

1. Original records (journal or subdivision of journal)

2. Classification (ledger accounts)

3. Summary (final accounts)

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1. Original records (journal and subdivision of journal):

The transactions are first recorded in a book called journal which is further divided into various
subsidiary books such as cash journal, purchases journal and sales journal etc. The number of
subsidiary books to be maintained by a business depends on its nature and size.

2. Classification (ledger accounts):

In the second stage, all transactions relating to the same person or thing are collected and stored
in one statement called account. The book in which these classified accounts are kept is known
as ledger.

3. Summary (profit and loss account and balance sheet):

After certain periods, the ledger accounts are balanced and a statement called trial balance is
prepared which is further used for calculating profit or loss and determining the financial
position of the business.

Advantages/merits
The major advantages of employing a double entry system of accounting are given below:

1. Under double entry system of accounting, the two aspects of each transaction are
recorded (i.e., for every debit there must be a credit and vice versa). It creates an
equilibrium within the records which helps in detecting errors, omissions and frauds.
2. Under this system, a trial balance can be prepared to check arithmetical accuracy of all
accounting entries. The trial balance can be further used for finding out operating results
by preparing income statement and determining the financial position of the business by
preparing a balance sheet.

3. Double entry system is the most advanced and useful form of maintaining accounting
records and is extensively used by companies worldwide. Without this system, a
company would not be able to compare its financial statements with that of other
companies.

4. Double entry system is highly systematic that follows certain rules and principles so it is
easy to find information about a particular transaction or account quickly when needed by
owners, management, accountants or other employees.

5. Almost all accounting standards and laws in the world require the use of double entry
system of accounting. If a company fails to comply with this requirement, the auditors
will not accept the financial statements of that company.

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6. The financial reports and results generated by double entry system is reliable to great
extent for decision making purpose.

Disadvantages/demerits
The double entry system is complex enough to require skilled and qualified employees to handle
the whole process of maintaining accounting records. Therefore, its employment may be costly
and time consuming for small businesses.

The advantages of double entry system far outweigh its disadvantages. Double entry system has,
therefore, become the standard and in many cases a requirement for maintaining accounting
records of medium and large size businesses. Most of the manual as well as
computerized accounting systems are based on it.

Account and its format

An account may be defined as a record to keep track of increases and decreases in financial
statement items such as revenue, expenses, cash, machinery, accounts payable and loan etc. A
separate account is maintained for each financial statement item. Normally, a firm or company
maintains many accounts which are collectively known as ledger. The information about number
and titles of accounts maintained by an entity is usually available in its chart of accounts.

Format of account
The simplest form of account has three parts:

1. the account title or account name,

2. a left side to record debit entries,

3. a right side to record credit entries.

The format of account is given below:

The account format shown above is known as T-account because it resembles the English letter
“T”. The left side of the account is known as debit side and is abbreviated as Dr. The right side is
known as credit side and is abbreviated as Cr. When an amount is written on the debit side, the

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account is said to be debited and when an amount is written on the credit side, the account is said
to be credited. The debit and credit entries in an account are made according to certain rules of
double entry known as rules of debit and credit.

Example

In cash account illustrated below, all cash receipts are entered on debit side and all cash
disbursements are entered on credit side. See rules of debit and credit.

Balancing the account

The balance of an account is the difference between the total of debit entries and the total of
credit entries in the account. If the total of debit entries exceeds the total of credit entries, the
account has a debit balance; if the total of credit entries exceeds the total of debit entries, the
account has a credit balance. In cash account illustrated above, the total of debit entries is
$41,400 and the total of credit entries is $33,100. The total of debit entries exceeds the total of
credit entries. The cash account therefore has a debit balance of $8,300 ($41,400 – $33,100).
This balance has been written on the debit side below the line drawn following the last entry in
the account. It represents the amount of cash that the business should have in hand at the date of
balance i.e., January 31. If a balance sheet is prepared on January 31, the cash in the amount of
$8,300 would be shown in the assets section.

Some more formats of account

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(1). Account format with date, description and amount column on both sides.

The format given above is a more professional form of T-account. In this format, the balance is
put on the lighter side of the account. In our illustration, the credit side is lighter. The debit
balance of $8,300 has therefore been put on the credit side of the account.

(2). Running balance account format:

The T-account is used in situations where account balance is required periodically i.e., weekly,
monthly or biannually etc. Running balance account is helpful in situations where account
balance is needed after each entry.

The account formats used in this article are easy to understand and are used in most of the
educational materials. If you are using accounting software, it might use a slightly different

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format. Regardless of the format used, the basic concept of recording entries and finding account
balance is the same.

Chart of accounts
Chart of accounts is simply a list of account names that a company uses in its general ledger for
recording various business transactions. It provides guidance to book-keepers, accountants or
other relevant persons in using specific account names while entering transactions in journal and
posting them to ledger.

Structure or template
There is no common structure or template of chart of accounts available for the use of all types
of businesses. Each company prepares its own chart of accounts depending on its individual
requirements. The structure of a chart of accounts is normally as complex as the business
structure of the company. For example, the type and number of accounts needed by a large
corporation would significantly differ from those needed by a small retailer. Similarly many
accounts that are essential in manufacturing businesses are not used by merchandising
companies.

The type and number of accounts used in a chart of accounts depends on a number of factors
such as the nature and volume of business carried on by the company, the need of internal
management for making important business decisions and the need of external parties who use
financial statements of the company for various purposes.

The account names are listed in the chart of accounts in the same order in which they appear in
company’s financial statements. Usually, the balance sheet accounts (i.e., assets, liabilities and
owner’s equity) are listed first and income statement accounts (i.e., revenue and expense) are
listed later.

Numbering accounts in a chart of accounts

Each account in the chart of accounts is assigned a unique number for indexing and
identification. Normally each account number consists of two or more digits that tell something
about the account. For example, a number starting with “1” might tell us that the account is an
asset account and a number starting with “2” might tell us that the account is a liability account.
Normally, appropriate gaps are provided between numbers (i.e., some numbers are left
unassigned) that makes it easy to add more accounts in future without disturbing other accounts.

The organizations operating in many territories with a lot of departments usually have account
numbers consisting of five or more digits. The account numbers of a company with different
departments and operations might have digits to reflect the department or operation to which the
accounts relate. Similarly, a company operating in different territories or regions might include a

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digit in its account numbers to identify the territory or region to which a particular account
relates. For example, the account numbers of Procter and Gamble (a multinational consumer
goods company) consist of more than 30 digits to reflect different departments, operations and
territories or regions.

Example

Following is an example chart of accounts of a merchandising company:

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In above chart of accounts, three-digit account numbers have been used. The first digit shows the
major classification of accounts, the second digit shows the sub-classification of accounts and the
third digit identifies the specific account name.

For example, for assets:

 1 > The account is an “asset account”.

 11 >> The account is a “current asset account”.

 110 >>> The account is “cash account”.

and for liabilities:

 2 > The account is a “liability account”.

 21 >> The account is a “current liability account”.

 210 >>> The account is “accounts payable account”.

In above example of chart of accounts, notice that there are gaps between some account
numbers. These gaps provide flexibility for adding more accounts if needed in future.

Classification of accounts
In accounting, the accounts are classified using one of two approaches – modern approach
or traditional approach. We shall describe modern approach first because this approach
of classification of accounts is used in almost every advanced country. The use of traditional
approach is very limited.

Modern approach
According to modern approach, the accounts are classified as asset accounts, liability accounts,
capital or owner’s equity accounts, withdrawal accounts, revenue/income accounts and expense
accounts.

1. Asset accounts:

Assets are things or items of value owned by a business and are usually divided into tangible or
intangible. Tangible assets are physical items such as building, machinery, inventories,
receivables, cash, prepaid expenses and advance payments to other parties. Intangible assets
normally include non-physical items and rights. Examples of intangible assets include goodwill,
trademarks, copyrights, patent rights and brand recognition etc.

A separate account for each tangible and intangible asset is maintained by the business to record
any increase or decrease in that account.

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2. Liability accounts:

Liabilities are obligations or debts payable to outsiders or creditors. The title of a liability
account usually ends with the word “payable”. Examples include accounts payable, bills payable,
wages payable, interest payable, rent payable and loan payable etc. Besides these, any revenue
received in advance is also a liability of the business and is known as unearned revenue. For
example, a marketing firm may receive marketing fee from its client for the forthcoming quarter
in advance. Such unearned revenue would be recorded as a liability as long as the related
marketing services against it are not provided to the client who has made the advance payment.

3. Capital or owner’s equity accounts:

Capital is the owner’s claim against the assets of the business and is equal to total assets less all
liabilities to external parties. The balance in capital account increases with the introduction of
new capital and profits earned by the business and decreases as a result of withdrawals and losses
sustained by the business.

In sole proprietorship, a single capital account titled as owner’s capital account or simply capital
account is used. In partnership or firm, each partner has a separate capital account like John’s
capital account, Peter’s capital account etc. In corporate form of business there are many owners
known as stockholders or shareholders and the title capital stock account is used to record any
change in the capital.

4. Withdrawal accounts:

Withdrawals are cash or assets taken by a business owner for his personal use. In sole
proprietorship and partnership, an account titled as drawings account is used to account for all
withdrawals. In corporate form of business withdrawals are more systematic and usually termed
as distributions to stockholders. The account used for recording such distributions is known as
dividend account.

5. Revenue or income accounts:

Revenue is the inflow of cash as a result of primary activities such as provision of services
or sale of goods. The term income usually refers to the net profit of the business derived by
deducting all expenses from revenue generated during a particular period of time.
However, in accounting and finance, the term is also used to denote all inflows of cash resulted
by those activities that are not primary revenue generating activities of the business. For
example, a merchandising company may have some investment in an oil company. Any dividend
received from oil company would be termed as dividend income rather than dividend revenue.
Other examples of income include interest income, rent income and commission income etc. The
businesses usually maintain separate accounts for revenues and all incomes earned by them.

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6. Expense accounts:

Any resource expended or service consumed to generate revenue is known as expense. Examples
of expenses include salaries expense, rent expense, wages expense, supplies expense, electricity
expense, telephone expense, depreciation expense and miscellaneous expense.

Traditional approach
According to traditional approach, the accounts are classified into four types – personal
accounts, real accounts, nominal accounts, and valuation accounts. A brief explanation of each is
given below:

1. Personal accounts:

The accounts related to real persons and organizations are classified as personal accounts.
Examples of personal accounts include John’s account, Peter’s account, Procter and
Gamble’s account, Vibrant Marketing Agency’s account and City bank’s account etc. The
business keeps a separate account for each individual and organization for the purpose of
ascertaining the balance due from or due to them.

2. Real accounts:

Real accounts are accounts related to assets or properties (both tangible and intangible) owned by
a business enterprise. A separate account for each asset is maintained to account for increases and
decreases in that asset. Examples of real accounts include cash account, inventory account,
investment account, plant account, building account, goodwill account, patent account, copyright
account etc.

3. Nominal accounts:

The accounts related to incomes, gains, expenses and losses are classified as nominal accounts.
These accounts normally serve the purpose of accumulating data needed for preparing income
statement or profit and loss account of the business for a particular period. Examples of nominal
accounts include sales account, purchases account, wages account, salaries account, interest
account, rent account, gain on sale of fixed assets account and loss on sale of fixed assets
account etc.

4. Valuation account:

Valuation account (also known as contra account) is an account used to report the carrying value
of an asset or liability in the balance sheet. A popular example of valuation account is the
accumulated depreciation account. Companies maintaining fixed assets in the books of accounts
at their original cost also maintain an accumulated depreciation account for each fixed asset.

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In balance sheet, the balance in the accumulated depreciation account is deducted from the
original cost of the asset to report it at its book value or carrying value. Another example of
valuation account is allowance for doubtful accounts. In balance sheet, the balance in allowance
for doubtful accounts is deducted from the total receivables to report them at their net realizable
value or carrying value.

Example
From the following transactions identify the accounts involved and classify them according to
modern and traditional approaches of classification of accounts:

1. Mr. John started business with cash $25,000

2. Purchased goods for cash $5,000

3. Sold goods for cash $7,500

4. Purchased goods for cash $2,500

5. Sold goods to Sam on account $3,000

6. Purchased furniture for $1,000

7. Purchased machinery for $5,000

8. Paid wages $200

9. Mr. John withdrew $100 from business to pay his personal expenses.

Solution:

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Business transaction
Definition and explanation

In accounting, the business transaction (also known as financial transaction) is an event that
must be measurable in terms of money and that essentially impacts the financial position of the
business. For example, you run a merchandising business and you sell some goods to a
customer for $500 cash; it is an event that you can measure in terms of money and that impacts
the financial position of your business so it is a transaction. Similarly, you pay $400 cash to your
salesman as his pay. This event is also a transaction because it has a monetary value of $400 and
it has a financial impact on your business. Only those events that can be measured in monetary
terms are included in accounting records of the business.

There may be numerous events related to a business to which we cannot reliably assign a dollar
value. Such conditions or events cannot be called business or financial transactions. For example,
the CEO of a company delivers a motivational lecture to the employees. Undoubtedly, this event
may be of great benefit for the company’s business but we cannot assign a monetary value to it
so it is not a business transaction and therefore cannot become a part of accounting records.

Each transaction is recorded by making a journal entry by a bookkeeper or accountant. Since

each transaction impacts financial position of the business, the bookkeeper or accountant must

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make sure that it has been authorized by a responsible person and is properly supported by one or
more source documents before recording it the journal. A source document is a document that
provides basic information needed to record a transaction in the journal. Usual examples of
source documents include sales invoices, purchase invoices, cash receipts, payment vouchers,
statement of accounts, bills of exchange, promissory notes and any other document containing
the basic transaction details which can be presented as a proof of valid transaction.

Characteristics of a business transaction

From above discussion, we can point out the following five important characteristics of a
valid business transaction that every bookkeeper or accountant must take care of before
entering the transaction in the journal.

1. It is a monetary event.
2. It affects financial position of the business.

3. It belongs to business not to the owner or any other person managing the business.

4. It is initiated by an authorized person.

5. It is supported by a source document.

Types of business transactions

In accounting, the transactions may be classified as:

1. cash transactions and credit transactions

2. internal transactions and external transactions

(1) Cash and credit transactions

A transaction in which cash is paid or received immediately at the time when transaction occurs
is known as cash transaction. For example, you sell some goods to Mr. John for $50 and Mr.
John immediately pays $50 cash for the goods purchased. It is a cash transaction because
you have immediately received cash for the goods sold to your customer. Similarly, you buy
furniture for your business for $750. You immediately pay $750 cash to the supplier and get the
possession of furniture. It is also a cash transaction.

In today’s modern business world, cash transactions are not limited to the use of currency notes
or coins for making or receiving payments, all transactions made using debit or credit cards
issued by financial institutions are also categorized as cash transactions.

In a credit transaction, the cash does not change the hands immediately at the time when
transaction occurs. In other words, the cash is received or paid at a future date. For example, you

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buy some merchandise from your vendor for $1,000. Upon your request, your vendor agrees to
receive the payment of $1,000 for goods sold to you next week. You take the possession of the
goods and transport them to your store. It is a credit transaction because you have not made the
payment in cash immediately at the time of purchase of goods. Similarly, you sell some goods to
Mr. Sam for $150. Mr. Sam requests you to receive the payment of $150 next month. You agree.
Mr. Sam takes the goods to his home for use. This is also a credit transaction because you have
not received the payment in cash at the time of sale of goods to Mr. Sam.

In today’s business world goods are mostly purchased and sold on credit.

(2) Internal and external transactions

Internal transactions (also known as non-exchange transactions) are those transactions in

which no external parties are involved. These transactions do not involve in the exchange of
values between two parties but the event constituting the transaction is measurable in monetary
terms and impacts the financial position of the business. Examples of such transactions include
recording depreciation of fixed assets and realizing the loss of assets caused by fire etc.

External transactions (also known as exchange transactions) are transactions in which a

business exchanges value with external parties. Normally, all transactions other than internal
transactions are external transactions. These are the usual transactions that a business performs
on daily basis. Examples of external transactions include purchase of goods from suppliers, sale
of goods to customers, purchase of fixed assets for business use, payment of rent to owner,
payment of gas, electricity or water bills, payment of salary to employees etc. Normally, a large
portion of transactions performed by any business consists of external transactions.

Rules of debit and credit

A ledger account (also known as T-account) consists of two sides – a left hand side and a right
hand side. The left hand side is commonly referred to as debit side and the right hand side is
commonly referred to as credit side. In practice, the term debit is denoted by “Dr” and the term
credit is denoted by “Cr”.

In the rest of the discussion we shall use the terms debit and credit rather than left and right.

When a financial transaction occurs it affects at least two accounts. For example, purchase of
machinery for cash is a financial transaction that increases machinery and decreases cash
because machinery comes in and cash goes out of business. The increase in machinery and
decrease in cash must be recorded in the machinery account and the cash account respectively.
As stated earlier, every ledger account has a debit and a credit side. Now the question is that on
which side the increase or decrease in an account is to be recorded. The answer lies in the
learning of normal balances of accounts and the rules of debit and credit.

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Normal balance of accounts

The understanding of normal balance of accounts helps understand the rules of debit and credit
easily. If the normal balance of an account is debit, we shall record any increase in that
account on the debit side and any decrease on the credit side. If, on the other hand, the
normal balance of an account is credit, we shall record any increase in that account on the
credit side and any decrease on the debit side.

Rules of debit and credit

(1). Asset accounts:

Normal balance: Debit

Rule: An increase is recorded on the debit side and a decrease is recorded on the credit side of all
asset accounts.

(2). Expense accounts:

Normal balance: Debit

Rule: An increase is recorded on the debit side and a decrease is recorded on the credit side of all
expense accounts.

(3). Liability accounts:

Normal balance: Credit

Rule: An increase is recorded on the credit side and a decrease is recorded on the debit side of all
liability accounts.

(4). Revenue/Income accounts:

Normal balance: Credit

Rule: An increase is recorded on the credit side and a decrease is recorded on the debit side of all
revenue accounts.

(5). Capital/Equity accounts:

Normal balance: Credit

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Rule: An increase is recorded on the credit side and a decrease is recorded on the debit side of all
equity accounts.

(6) Contra accounts:

Normal balance: Opposite to the normal account.

An example: Accounts receivable is an asset account that normally has a debit balance.
The allowance for doubtful accounts is a contra account to the accounts receivable and normally
has a credit (opposite) balance.

Rule: If the normal balance of the contra account is debit, the increase will be recorded on the
debit side and the decrease will be recorded on the credit side. If the normal balance of the contra
account is credit, the increase is recorded on the credit side and the decrease is recorded on the
debit side.

A summary of the whole discussion about rules of debit and credit is given below:

Example:
The following transactions are related to Small Traders:

1. Started business with cash $95,000.

2. Purchased furniture for cash $8,000.

3. Purchased goods for cash $40,000.

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4. Purchased goods on credit from Big Traders $57,000.

5. Sold goods for cash $5,000.

6. Purchased equipment for business $4,000.

7. Sold goods on credit to John Retailers $15,000.

8. Paid salary to employees $1,200

Required: Identify the accounts involved in above transactions and state the nature of each
account. Also mention how increases or decreases in accounts resulting from above transactions
should be recorded.

Solution:

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