🔹 Debits & Credits
📌 Debits are always on the left, and credits are always on the right. (debit/credit)
Here's a simplified method to understand how debits and credits affect the five types of accounts:
- Assets always increase with debits and decrease with credits: (+/-)
- Liabilities always decrease with debits and increase with credits: (-/+)
- Equity always decreases with debits and increase with credits: (-/+)
- Revenues always decrease with debits and increase with credits: (-/+)
- Expenses always increase with debits and decrease with credits: (+/-)
Visualizing this horizontally is usually easier for students to memorize. See below! Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
Memorization Trick #1 (A = L + E)
Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Look at A = L + E and notice that, when comparing each side of the = sign, it flips.
- Assets works like (+/-)
- L + E both work like (-/+)
- This flip across the equal sign of A = L + E is a great visual memory aid!
Therefore, remember that Assets always behave oppositely to Liabilities and Equity. Since Assets work on a (+/-) basis, then Liabilities and Equity will be (-/+).
Memorization Trick #2 (Revenues vs. Expenses)
Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Revenues and Equity, both operating on a (-/+) basis, share a logical connection.
- Generating revenue increases a company's value, which is reflected in its equity.
- Therefore, if increasing revenue boosts equity, it makes sense that they both function similarly, utilizing a (-/+) mechanism.
- To summarize, memorize this: revenue (-/+) and equity (-/+) always work the same when it comes to debits and credits!
Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- There’s a reason that expenses and equity work opposite of eachother.
- Expenses are our “costs.” Doesn’t it make sense that costs reduce a company's equity, or “value”?
- Therefore, since incurring expenses decreases equity, it's logical that they operate inversely — Expenses being (+/-) and Equity being (-/+).
- Remember this key point: expenses (+/-) and equity (-/+) work oppositely when it comes to debits and credits.
Memorization Trick #3 (Assets & Expenses)
Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Expenses and Assets, both following a (+/-) pattern, are intrinsically linked.
- For instance, expenses will often orginate from our assets —particularly when these assets are consumed or utilized.
- Let's consider some examples to illustrate this relationship:
- A building (an asset) depreciates over time, turning into a depreciation expense.
- Inventory (an asset) transforms into the Cost of Goods Sold (an expense) once sold.
- Prepaid Rent (an asset) turns into Rent Expense as the lease term elapses.
- Prepaid Insurance (an asset) becomes Insurance Expense as our coverage expires.
- Accounts Receivable (an asset) morphs into Bad Debt Expense when a customer defaults on payment.
- Many other examples exist!
- Assets can be thought of as 'pending' expenses that will be utilized or 'expensed' eventually.
- Conversely, sometimes, expenses can best be viewed as assets that have been consumed. This cyclical relationship suggests that they're essentially the same thing at different stages.
- Given this, it logically follows that assets and expenses operate identically regarding debits and credits, adhering to the (+/-) pattern.
- To summarize, memorize this: Assets (+/-) and Expenses (+/-) always work the same when it comes to debits and credits!
- This is not true! Whether a debit or credit increases or decreases an account depends on the type of account.
- Again, this is false! Debits and credits are used to record all types of transactions, not just receiving or giving things away.
- This is a very common misunderstanding! While these terms share names with common banking tools, their usage in accounting is completely different.
These misconceptions can seriously hinder your understanding of accounting. Unlearn them now!
🔹 All of the Accounts Within Each of the Five Types (A = L + E; Revenues, Expenses)
Examples of Asset Accounts (+/-)
- Current Assets
- Cash
- Petty Cash
- Marketable Securities
- Supplies
- Inventory
- Accounts Receivable
- ANYTHING “Receivable”
- Prepaid Insurance
- Prepaid Rent
- Prepaid Supplies
- Prepaid Advertising
- ANYTHING “Prepaid”
📌 These are assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.
- Long Term Assets
- Buildings
- Equipment
- Land
- Land Improvements
- Machines
- Cars & Trucks
- Accumulated Depreciation (Contra Asset)
- Intangible Assets
- Goodwill
- Copyrights
- Trademarks
- Patents
📌 These are assets that a business uses in its operations and that have a useful life of more than one year. Note: Long-Term Assets may also be known as Fixed Assets or Plant Assets.
📌 These are non-physical assets that have value due to the special rights or privileges they grant to a company. They're usually long-term assets, as the company utilizes them over several years.
If you can identify an account as an asset, you can be confident that debits and credits will always operate on a (+/-) basis in these accounts.
Understanding debits and credits this way is essential. Don't be the student who relies on countless flashcards for each individual asset— since all assets follow the same (+/-) rule!
Rather than memorizing the debit and credit behavior for each specific asset, simplify your learning:
- Recognize when a transaction affects an asset (things we OWN)
- Assess the transaction and decide whether the asset needs to increase or decrease.
- Grasp that all assets invariably follow a (+/-) pattern. To increase an asset, debit it. To decrease an asset, credit it.
- Memorize this one rule and save your mental space for more complex topics!
Examples of Liability Accounts (-/+)
- Current Liabilities
- Accounts Payable
- Notes Payable
- Salaries Payable
- Wages Payable
- Interest Payable
- Income Taxes Payable
- ANYTHING “Payable”
- Unearned Revenue
- Long Term Liabilities
- Long-term Notes Payable
- Bonds Payable
- Lease Obligations
- Pension Liabilities
- Recognize when a transaction affects a liability (things we OWE).
- Assess the transaction and decide whether the liability needs to increase or decrease.
- Grasp that all liabilities invariably follow a (-/+) pattern. To increase a liability, credit it. To decrease a liabilty, debit it.
- Memorize this one rule and save your mental space for more complex topics!
📌 These are obligations that a company must pay within the next year or operating cycle.
📌 These are obligations due beyond the next year or operating cycle.
If you can identify an account as a liability, you can be confident that debits and credits will always operate on a (-/+) basis in these accounts.
Understanding debits and credits this way is essential. Don't be the student who relies on countless flashcards for each individual liability — since all liabilities follow the same (-/+) rule!
Rather than memorizing the debit and credit behavior for each specific liability, simplify your learning:
Examples of Equity Accounts (-/+)
📌 Equity shows what owners would theoretically "own" outright if all debts were paid, showing the true value of a company to its owners.
- Common Stock
- Additional Paid-in Capital (APIC)
- Retained Earnings
- Dividends (Contra Equity)
- Treasury Stock (Contra Equity)
Remember, all Equity accounts follow the same rules in relation to debits and credits.
If you can identify an account as a equity, you can be confident that debits and credits will always operate on a (-/+) basis in these accounts. Understanding debits and credits this way is essential. Don't be the student who relies on countless flashcards for each individual equity account — since all equity accounts follow the same (-/+) rule! Rather than memorizing the debit and credit behavior for each specific equity, simplify your learning:
- Recognize when a transaction affects an equity account (our company’s “VALUE”, “OWNERSHIP” or “NET WORTH”).
- Assess the transaction and decide whether the equity needs to increase or decrease.
- Grasp that all equity accounts invariably follow a (-/+) pattern. To increase an equity account, credit it. To decrease an equity account, debit it.
- Memorize this one rule and save your mental space for more complex topics!
Examples of Revenue Accounts (-/+)
- Fees Earned or Service Revenue
- Sales of Inventory
- Rent Earned
- Interest Earned
- ANYTHING “Earned”
- Commission Revenue
- Advertising Revenue
- Subscription Revenue
- Consulting Revenue
- Gain on Sale of Assets
- (many other examples exist!)
If you can identify an account as a revenue, you can be confident that debits and credits will always operate on a (-/+) basis in these accounts. Understanding debits and credits this way is essential. Don't be the student who relies on countless flashcards for each individual revenue account — since all revenue accounts follow the same (-/+) rule! Rather than memorizing the debit and credit behavior for each specific equity, simplify your learning:
- Recognize when a transaction affects a revenue account (what we “EARN”, or when we “DO WORK”).
- Assess the transaction and decide whether the revenue needs to increase or decrease.
- Grasp that all revenue accounts invariably follow a (-/+) pattern. To increase a revenue, credit it. To decrease a revenue, debit it.
- Memorize this one rule and save your mental space for more complex topics!
- Example #1: When we provide services on credit, the customer pays later, but the revenue is recognized as soon as the services are delivered, as per the revenue recognition principle.
- Example #2: If we receive cash in advance for services we will provide later, this is recorded as Unearned Revenue — a prime example that receiving cash doesn’t always equate to generating revenue!
- Example #3: What if we receive cash immediately upon providing services — is this reveune? Yes, this is considered revenue.
- Nevertheless, it's important to understand that revenue is attributed to the services rendered, not the cash received. The cash received does not trigger the revenue; it is the completion of the services that does.
- Refer back to example #1, where revenue is generated without any cash received yet. It's revenue because the services are delivered!
- This can be confusing, but it's a vital distinction to grasp. For determining revenue under accrual accounting, the key factor isn't whether we've received cash, but rather if we've completed the work. Understanding this is best achieved through practicing problems!
Examples of Expense Accounts (+/-)
📌 Expenses record costs incurred in the normal operations of the business to generate revenues.
- Cost of Goods Sold
- Rent Expense
- Supplies Expense
- Insurance Expense
- Advertising Expense
- Wages Expense
- Salaries Expense
- Utilities Expense
- Interest Expense
- Bad Debts Expense
- Repair Expense
- Depreciation Expense
- Amortization Expense
- ANYTHING Expense
- (many other examples exist!)
Understanding debits and credits this way is essential. Don't be the student who relies on countless flashcards for each individual expense account — since all expense accounts follow the same (+/-) rule!
Rather than memorizing the debit and credit behavior for each specific expense, simplify your learning:
- Recognize when a transaction affects an expense account (the “COSTS” involved in generating revenue)
- Assess the transaction and decide whether the expense needs to increase or decrease.
- Grasp that all expense accounts invariably follow a (+/-) pattern. To increase an expense, debit it. To decrease an expense, credit it.
- Memorize this one rule and save your mental space for more complex topics!
- Understanding the timing of expense recognition is crucial for interpreting its impact on financial statements. This is where the matching principle comes in handy: expenses are recognized when the resources or services are used to generate revenue, not necessarily when cash is paid.
- Let's consider an example. If we purchase supplies by paying cash, we're essentially trading one asset (cash) for another (supplies). At this point, no expense is recognized. Why not? Because we haven't used these supplies yet.
- The expense hits our books only when we actually use the supplies in our operations. The act of buying the supplies doesn't equate to an expense—it's the usage that counts!
Confused? Check out more examples below.
- Paying cash for a building (an asset) is NOT an expense.
- However, as it depreciates over time, we will recognize depreciation expense!
- Paying cash for inventory (an asset) is NOT an expense.
- However, we will record Cost of Goods Sold (an expense) once it’s sold!
- Paying cash for Prepaid Rent (an asset) is NOT an expense.
- However, we will record Rent Expense later as the lease term elapses.
- Paying cash for Prepaid Insurance (an asset) is NOT an expense.
- However, we will record Insurance Expense later as our coverage expires or is used.
- Consider the one-word definition of expenses: "costs." Can costs occur without involving any cash payment? Absolutely!
- One example that illustrates this well is depreciation expense. Depreciation refers to the gradual decrease in value over time of long-term assets such as buildings and equipment.
- Let's paint a scenario: You've owned a building for a year, and your accountant estimates that its value has decreased by $10,000. This depreciation is undoubtedly an expense or "cost."
- However, did you have to make any cash payment to anyone for this decline in value? Certainly not! There's no need to write a check to anyone.
- Depreciation is a cost that simply “occurs” as time passes, completely independent of any cash payment!
- Amortization: Similar to depreciation, amortization represents the gradual reduction in value of intangible assets (e.g., patents, copyrights) over time.
- Therefore, Amortization is an expense recorded without any cash payment associated with it, a topic we’ll elaborate further in Chapter 8.
- Accrued Expenses: Suppose a company has incurred employee salaries and wages for the current month but hasn't yet paid them.
- Even without a cash outflow, the company recognizes the expense by accruing the salaries and wages payable, a topic we’ll elaborate further in Chapter 3.
- Bad Debts: If a company has provided goods or services to a customer on credit and later determines that the customer is unable to pay, it records a bad debt expense.
- This expense is recognized despite no cash payment being received from the customer, a topic we’ll elaborate further in Chapter 7.
- Of course! However, it's vital to understand that expense is attributed to the cost incurred, not the cash paid.
- The cash paid does not trigger the expense; it is the incurring of costs or usage of resources that does.
- For example, if we pay cash for utilities consumed, we would immediately record a debit to Utilities Expense as the same time we paid cash — since the Utilities have already been used, so the cost has been incurred!
Remember: expenses aren't about cash payments but about resource consumption. This understanding will be particularly useful in Chapter 3, where we delve into adjusting journal entries. So keep practicing!
🔹 Normal Balances
📌 A normal balance is the side (debit or credit) that increases the value of a specific type of account. It's considered the "expected" balance of an account.
- Knowing the normal balance for different types of accounts is crucial to correctly recording and reading financial transactions. It's also your first line of defense when it comes to identifying potential errors in your accounting records.
- For instance, spotting an abnormal ending balance on a trial balance, one that doesn't align with the expected normal balance, can be a clear sign of an error somewhere that needs to be fixed.
Cash, an asset account, works like (+/-) when it comes to debits and credits. → Therefore, the normal balance of cash = DEBIT
Accounts Payable, a liabilty account, works like (-/+) when it comes to debits and credits. → Therefore, the normal balance of A/P = CREDIT
- Assets (+/-)
- Since all assets increase with a debit, all assets have a normal debit balance.
- Liabilities (-/+)
- Since all liabilities increase with a credit, all liabilities have a normal credit balance.
- Equity (-/+)
- Since all equity accounts increase with a credit, all equity accounts have a normal credit balance.
- Revenue (-/+)
- Since all revenues increase with a credit, all revenue accounts have a normal credit balance.
- Expenses (+/-)
- Since all expenses increase with a debit, all expenses have a normal debit balance.
In other words — the key to understanding balances, once again, is to memorize the Five Types of Accounts. Once you grasp how debits and credits work for each account type, answering exam questions about normal balances is a piece of cake.
🔹 Contra Accounts
📌 In the world of debits and credits, contra accounts behave in the exact opposite way to their corresponding accounts. This is because contra accounts effectively reduce the balance of the account type they are associated with.
- Take for instance Accumulated Depreciation, a contra asset account.
- While assets typically operate with a (+/-), Accumulated Depreciation, being a contra asset, flips this around and operates on a (-/+) basis.
- Accumulated Depreciation exists to track the annual depreciation of our long-term assets, reflecting the diminishing value of these assets over time.
- The increasing value of the Accumulated Depreciation account directly corresponds to the decreasing value of our assets, showcasing the inverse relationship vital to understanding contra accounts.
- Dividends serve as another example.
- As a contra equity account, they reverse the typical (-/+) pattern of equity accounts, instead operating on a (+/-) basis.
- They represent a distribution of earnings to shareholders, which reduces the company's retained earnings, an element of equity.
- Therefore, as dividends increase, equity decreases, embodying the contra nature of this account and illustrating the crucial inverse relationship characteristic of contra accounts.
- We'll be delving into various other contra asset account examples in upcoming chapters, so understanding this concept now will be beneficial.