In this lesson, I'm going to talk more about the three step process we use to perform accounting. Along the way, we're going to talk about various accounting principles and practices. Are you ready to begin? As a quick refresher, in our last lesson, we talked about a three step process to use to perform accounting. Step one is to analyze the transaction. Not all transactions give rise to a journal entry.

For example, if you hire someone, there's no entry to consider. If a customer gives you an order, it's just an order. Nothing has happened yet, so there's nothing to record. also considered in this step is whether you have transactions that are on account of income or capital. Step two, as soon as that you have a transaction to record, here, you need to consider two things, the accounts and the amounts to debit and credit. Step three is to post the journal entry into the General Ledger and that is to say we add or subtract the debits and credits from the existing balance in the impacted accounts.

To keep these lessons manageable, I'm going to chunk down our lessons into three stages. In stage one, we will analyze the transactions and prepare the journal entry. In stage two, we will post the entry to arrive at a trial balance using a spreadsheet. And in stage three will prepare a set of financial statements including the balance sheet, the statement of changes in equity and the income statement. I'm going to use a mini case throughout this lesson in the lessons to follow so that you can see for yourself how this works. Let's keep the story short and sweet.

Simple Simon decided to start his own business upon graduation on May 1 of this year. His business idea is to sell and install air conditioning units to help deal with the effects of global warming and inspired business model to say the least Today is June 15, and simple needs financial statements for the month of May, so that he can take them to the bank to arrange a line of credit to grow his business. Simple side provides us with a list of 11 transactions that have happened so far. We will work through each of these transactions applying the first two steps of our approach in this lesson. So our first transaction occurs on May 1 when simple incorporates a company named Simon AC limited, it opens a bank account, he puts $5,000 into the account and has issued 5000 common shares and return. Since cash has changed hands, it must be a reportable transaction.

However, what kind of transaction Do we have an income transaction or a capital transaction? That's right, we have a capital transaction. Let's see if we can figure out the debits and the credits. We received cash and we know that cash is an asset and that assets have debit balances. So To receive more cash, we'd have to debit the cash account further. Now the trickier part is where does the credit go.

Since this is not an income transaction, we need to look at either the assets the liabilities or the equity for our home for the credit. The contribution of funds by simple is an owner contribution, so this means it should be credited to an equity account. In the general ledger. The most common types of equity accounts are capital stock, retained earnings and dividends. This would be a credit to capital stock because equity is normally in a credit balance and to add equity, we would need to credit it further. The amount is $5,000.

And don't forget to document a description for the journal entry. You'll notice that we typically left justify the debit account in the journal entry and then indent the credit account. This is a standard accounting practice that stems from the adage that debits go on the left hand side credits on the right. Some of you may be exposed to T accounts, which reinforces this left right mentality between you and me. And personally speaking, I think this is a bunch of bull, because there's really no right or left to these numbers. And in the next lesson, I'll show you how to keep this all straight when we get to excel.

But if a T account helps you then by all means keep using them. But not since my first year of undergrad, have I ever used a T account in my entire career. So I'm not going to start teaching them now. Let's take a look at the second transaction I make second the company purchases a used truck for $12,000. Simon fingers it would be good for five years with no residual value expected. He pays $3,000 down with a balance of $9,000 financed with a 12% interest only vehicle loan and the interest is paid annually.

Wow, a lot going on in this transaction. So first of all, do we have an accounting transaction? Well, yes, we do is assets. We're both acquired and given up in a liability issue. When you acquire assets with lives greater than one year, you capitalize into a balance sheet as a long term asset. That is to say that the vehicle has an economic life over the next five years has value can be derived from its use in the coming years.

So had the date of acquisition, the amount we pay for the vehicle gets set up as a capital asset. This is a good opportunity to alert you to an accounting principle of historical cost, which basically says that asset should be initially recorded at the amount paid for the asset which makes sense. Now let's think about the credits. The last sentence references how the company financed the purchase of the truck $3,000 came out of cash. Cash is an asset normally a debit, but in this case, we want to decrease the asset we need to credit the cash account $3,000 that leaves us to ponder the fate of the $9,000 vehicle loan loan. The word by itself implies we owe somebody else money.

So you should be thinking liability. Because the loan is due more than 12 months from now, we would classify this as long term debt. So our third transaction occurs on May 3 when the company takes its first customer order for $6,000. The terms of the sale are half upfront as a deposit and half 30 days from the completion date. What do you think? all that has happened is we've gotten a piece of paper from a customer ordering an air conditioning unit.

We haven't delivered it. We haven't installed it, and the customer hasn't paid us anything yet. So the answer is, there is no journal entry when you receive a customer order. Our fourth transaction occurred on May 4 when the company received $3,000 from the customer and deposited in the bank. So The very next day we're getting cash to increase the cash account, we need to debit cash. The harder question is Where should the credit go?

Before I answer this, let me tell you about another principle, the matching principle. Now before any academic start getting their nose at a joint, I warn you that some pundits argue that the matching principle is dead, or at least going away. However, I think it's dead on a technicality. Or maybe they're just calling it something else. It's all theoretical in my mind, because the practical reality is that the matching principle is a simple way for you to think about matching up revenues and expenses, so you don't forget anything. So in this case, we can't recognize $3,000 of revenue as a credit, because we haven't incurred the cost of buy, deliver or install the air conditioner, nor have we actually done any of these activities yet.

So for this reason, the $3,000 needs to be parked as a credit somewhere on the balance sheet until we fulfill the customer. Order, it doesn't belong in assets. Nor does it belong in equity, we can park this money in a liability account that we can call 100 revenues. Keep in mind that if we don't fulfill our obligations to install the air conditioning unit, we will need to refund the customer this cash. So think of it as owing the customer this money until we complete the installation. Now our fifth transaction happened on May 7, where the company sends a purchase order to a supplier to buy the air conditioning unit.

The price of the unit is $2,000 with the balance due within 30 days of delivery. This kind of feels like the reverse of the customer order. And it is there's no accounting entry because we have no asset and we don't owe any money yet until we do. Our CICS Transaction happened on May 11. And the supplier delivers the air conditioning unit to the company. When the inventory arrives.

We now have an asset debit For $2,000, we didn't pay cash to the supplier at delivery, the supplier has been nice enough to finance our inventory for 30 days. Therefore we have a current liability for $2,000. payments to vendors are accumulated in our listing of accounts payable. Our seventh transaction happens on May 17. When Simple Simon and a friend of his who he has contracted, installed, the air conditioning unit had the customer's premise. Ah, now something has happened.

Something very important. We have fulfilled our obligation to the customer by installing the air conditioning unit. However, notice that no cash has changed hands. Hmm, the journal entry is a little bit trickier to figure out. As soon as you finish the job, or sell a product, you're able to invoice your customer and recognize revenue. The invoice in this case would read for products and services rendered thousand dollars less than $3,000 deposit leaving a balance outstanding up $3,000 the balance is outstanding from a customer that customer owes the company.

This smells like an asset has cash will be received at some point in the next 30 days. In the last lesson, we call this an accounts receivable. As for the credit, it would now make sense to record the sale as the air conditioning unit has been delivered and installed. This is called revenue recognition. But wait a minute, we only have $3,000 of sales recorded not $6,000. Once again, remember your matching principle.

The deposit that we had previously parked and unearned revenue can now be included in sales as we've earned it. We previously parked it as a liability with a credit balance. How do we in essence move this credit from a liability account? To the sales account, well, we debit unearned revenue and credit the sales account for $3,000. How are we done? Think about it for a moment, consider the matching principle.

We've got sales recorded for the air conditioning unit. But we do not have any costs recorded, namely, the unit itself. Six days ago, we set up inventory has an asset, but today the asset is gone, it was installed at the customer's premise. So we need to get rid of that asset by crediting inventory for $2,000. Any ideas to where the debit might go? It's got to go to some sort of expense account to match it with the sales.

When we sell inventory. We debit an account called cost of goods sold. And of course, your journal entry description. Whether you have this as a six line journal entry or three separate two line journal entries, it doesn't matter one iota Alright, transaction happens on May 25. Simple Simon withdraws 1500 dollars from the company as a dividend. So this is a little bit different of a transaction.

Since cash is moving around, we definitely have some sort of accounting entry to record. The credit to cash should be obvious. But where does the debit go? If you're stuck, try to remember to ask yourself the question is this an income transaction or capital transaction. This is a capital transaction. It has nothing to do with the operations of the business.

The owner is simply taking out some of the company's equity visa via dividend for 1500 dollars. The ninth transaction happens on the last day of the month, and simple uses a company credit card to pay for all the operating expenses and on this day he receives his credit card statement indicating that he spent $600 in operating expenses during the month. The description itself says these are operating expenses. So that should be your first clue. But what are operating expense accounts? a debit or credit?

Yes, that's right. They are a debit balance because they are in essence reducing equity. Now for the credit side of the entry, you think about the nature of a credit card statement, you just can't charge your purchases to a piece of plastic without paying it back. The company owes the credit card company $600 This is a liability. Liabilities have credit balances, so we need to credit our accounts payable to set up this liability on our balance sheet for $600. The 10th transaction happens on June 4, and the company receives an invoice from his friend for the $700 owed for helping about one the installation.

Now recognize that we're past the May 31 day reporting date. So there's another reason why we have no journal entry at all. And that is because the transaction does not relate to the reporting period. However, in this case, it does. Simon's friend helped out with the air conditioning unit installation. For matching purposes, we want to ensure that this expense gets picked up in the same period as the sale of the air conditioning unit.

But there's another reason that this expense gets picked up as well. And that has to do with what we call accrual accounting. accrual accounting is similar to the matching principle, and it says that revenues and expenses should be recorded in the period in which the activity took place, regardless of when they're invoiced. So the fact that simples friend had invoice the company on June 4 is irrelevant. He was invoicing for services that he provided in the month of May. So great, we need to include this entry in May.

But that doesn't help us with the credit side of the entry. It's not an accounts payable because the invoice hadn't been tendered by May 31 in this situation, We typically have another liability account set up for invoices received past the reporting date. And we call this account accrued liabilities. So that's our entry, debit operating expenses for $700. Credit accrued liabilities for $700. Her 11th and final transaction happens on June 15.

And the customer remits $2,500, indicating that he was not happy with the quality of the installation, and that some roofing tiles were damaged. He indicates that he's holding back $500 to cover the cost of the repair. Here's another transaction that happened after the reporting date of may 31. The receipt of $2,500 in cash is clearly a June transaction. So from a reporting purposes it can be ignored. However, there is something else going on here.

If you recall, we have a receivable for $3,000 set up for this customer, but it now appears that we may only realize $2,500 of that value. This dispute has the potential to result in bad debt expense has this name implies bad debt expense is an expense therefore provide you with the debit side of the entry. The credit side is a little trickier because there are two possibilities. The first is that we could just write off the remaining $500 balance of the accounts receivable. However, there are a lot of reasons we don't want to do that, because who knows the customer could be lying. So instead of writing off the receivable, we could set up what we call a contra account.

A contra account is an account that goes against another account. for presentation purposes, the two accounts are grouped together. In this case, there's an account called the allowance for doubtful accounts, which is a contra account against accounts receivable. It may seem odd to have an account in the asset section of the balance sheet with a credit balance in it. But the two accounts are presented together and the net amount is Always a debit. Few.

That was a close one. Now, here's the skills testing question to the lesson. There are two more journal entries that we haven't done yet, but are necessary to satisfy the matching principle and accrual accounting. Can you identify what these are? Going back to the second transaction, we set up a capital asset for $12,000. When we purchased the truck, the truck will lose value has an ages and gets used up in operations.

To match the cost of the truck against the revenues earned from it to use. We need to calculate something called depreciation. depreciation takes the cost of the asset and smears it over the economic life. In this case, five years. There's more than one way to calculate depreciation. Straight line is a very common method, which means simply taking the $12,000 dividing it by two Five years to get $2,400 per year, which works out to $200 per month.

I'll leave the other methods for you to figure out the accounting mechanics are exactly the same. But keep in mind that you're trying to select a method that systematically and rationally allocates the cost of the fixed asset to the period in which the money is made from its use in operations. depreciation is an expense, like any other operating expense, therefore, it's a debit balance. The credit side goes to another one of the Contra accounts called accumulated depreciation. The account is contra to the capital asset account. And remember that we have a $9,000 loan on the truck.

Under accrual accounting, even though you'll pay interest on a monthly basis, we need to accrue for it. The amount of interest to accrue would be $9,000 times 12% divided by 12 months. So $90 on a monthly basis, interest is an expense paid to those who lend you money. It's their return on lending you the money in the first place, the debit goes to interest expense, and the credit goes to the accrued liability account that we discussed earlier for those expenses that have not been invoiced. By my rough calculation, this lesson covers about eight chapters in your typical introductory accounting textbook, we covered a lot of ground. But as I told you, I was only going to tell you about the stuff you really needed to know about.

The next lesson, we'll further reinforce what we talked about in this lesson, as we will post these transactions to create a trial balance. So in this lesson, I showed you how to analyze transactions. Sometimes there is a journal entry sometimes there's not. We also prepared how crapload of journal entries in this lesson. The more you practice your journal entries, the better you're going to get and along the way We talked about some practical accounting principles and practices that help you determine which accounts to debit, and which ones to credit and how those various accounts get used. Finally, if you want to practice your journal entries more, I've literally got an app for that download general ledger, the innovative accounting game to your electronic device today.

Have some fun with it. And in no time at all, you'll master the debits and credits. That's all for this lesson.