Retained earnings 303 Interest expense 509

Currency translation reserve 304 Income tax expense 510

Dividends 305 Loss on sale of assets 511

Special ledgers are used to record the details of accounts in the general ledger.
For example, the trade receivables ledger has the accounts of the individual
receivable accounts of customers. The balance of the trade receivables account in the
general ledger should be equal to the sum of the individual receivable accounts.
Special ledgers are often kept for trade payables, property, plant and equipment, and
inventories.

COMMONLY USED ACCOUNTS

Let’s now see some commonly used accounts. Assets are what a
business owns. Land, buildings, equipment, trade receivables, bills receivable, cash,
prepaid expense, unbilled revenue and interest receivable are examples of asset
accounts. Liabilities are what a business owes. Salaries payable, warranty payable,
trade payables, bills payable, bonds payable, tax payable, unearned revenue, and
interest payable are examples of liability accounts. Equity is the owners’ claim on the
business. Share capital, retained earnings, sales revenue, interest income, cost of
goods sold, advertisement expense, interest expense, drawings, and dividends are
examples of equity accounts.
The accounting system builds an organization’s memory. An organization
remembers what is recorded in its accounts. There will be no trace of what is not
recorded. Writer and Nobel laureate, Garcia Gabriel Marquez says, “What matters in
life is not what happens to you but what you remember and how you remember it.”
The accounting system determines what activities an organization ‘remembers’ and
‘how’ it remembers them.
The number of accounts and specific account titles used by an enterprise depend
on the nature and complexity of the enterprise’s business. For example, an
automobile company will keep detailed accounts for its plant and equipment, whereas
a bank will need meticulous information about its various deposits, investments and
loans, and its cash kept in various forms. Again, a small bakery that sells for cash can
possibly manage with a few accounts, while a large multinational company will have
thousands of accounts.
In deciding on the level of detail in the accounts, a firm should also consider
relevant legal requirements. For example, the Companies Act requires disclosure of
directors’ remuneration; the Income Tax Act disallows many kinds of entertainment
expenses. It is necessary to keep separate accounts for such items.
Recognition is the process of recording 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.
TEST YOUR UNDERSTANDING 3.1
Classifying Accounts

State whether the following are asset, liability or equity accounts:

(a) Directors’ fees
 (b) Cost of materials consumed
(c) Gain on sale of investments
(d) Provision for leave wages
(e) Security deposit with Customs
(f) Work-in-progress
ONE-MINUTE QUIZ 3.1
Account

Which of the following statements about account is correct? There may be more than one correct answer.
(a) An account records all increases and decreases in an item.
(b) The trade payables account describes credit purchases and payments to suppliers of goods and services.
(c) The Companies Act has a model chart of accounts.
(d) An accountant records important increases and decreases in an item.
DISCUSSION
Should revenues and expenses relating to an enterprise’s core and peripheral activities QUESTION 3.1
be collected in separate accounts?
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THE DOUBLE-ENTRY SYSTEM

In Chapter 2, we analyzed the effect of transactions on the

accounting equation. Recall that each transaction affects two columns. For example,
receiving cash from customers for past invoices increases cash and decreases trade
receivables. Thus, we record each transaction in two accounts so that the accounting
equation, Assets = Liabilities + Equity, is always in balance. This balancing is as
important 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 (needless to add, safely).
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”).18

The T Account
The common form of an account has three parts:

1. Title describing the asset, liability or equity account.

2. Debit side, or left side.
3. Credit side, or right side.

This form of account is called a T account because it looks like the letter T, as
shown below.
Title of Account
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 an account and to credit an account is to enter an amount on the
right side of an account. Note that in accounting debit and credit do not have any
value connotations such as bad and good. They are simply the accountant’s terms for
left and right – and nothing more.
The T account explained In the illustration in Chapter 2, Softomation received and
paid cash. We record these transactions in the cash account below, with receipts on
the left or debit side and payments on the right or credit side:
Cash

Date Explanation Amount Date Explanation Amount

20XX 20XX
March 1 Owner’s investment 50,000 March 3 Cash purchase of computer 58,000
2 Loan from Manish 20,000 12 Payment to suppliers 2,000
9 Cash sales 12,000 26 Salaries 4,000
23 Refund for supplies returned 1,900 26 Office rent 1,200
30 Drawings 3,500
Total 83,900 Total 68,700
31 Balance 15,200

The debit and credit totals, or footings in accounting jargon, are an intermediate
step in determining the cash at the end of the month. The difference between the total
debits and the total credits 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 has a debit balance of `15,200 (`83,900 – `68,700). It represents
the cash available on March 31. You would have observed that the cash account has
the same information as that in the cash column in Exhibit 2.1.

Standard Form of Account

The T account is a convenient way to record transactions. In practice, accountants
use the standard form, given in Exhibit 3.2. The standard form shows the balance
after every transaction and is, therefore, more useful and efficient than the T account.
Your bank statement is an everyday example of the standard form.
EXHIBIT 3.2
Standard Form of Account
The standard form is more efficient than the T form. The bank statement follows the standard form.
Cash
Date Explanation Post. Ref. Debit Credit Balance
20XX
March 1 Owner’s investment 50,000 50,000
2 Loan from Manish 20,000 70,000
 3 Cash purchase of computer 58,000 12,000
9 Cash sales 12,000 24,000
12 Payment to suppliers 2,000 22,000
23 Refund for supplies returned 1,900 23,900
26 Salaries 4,000 19,900
26 Office rent 1,200 18,700
30 Drawings 3,500 15,200

Here is a common question that comes up in the early stages of an

accounting course: 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’s 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 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 3.1 describes
the recording procedure in terms of the accounting equation:

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 2, you know the following 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, expenses, drawings, and dividends. Thus, we credit revenues to increase
them; we debit expenses, drawings, and dividends to increase them. Figure 3.2
summarizes the rules for debit and credit.