Accounting 2 Notes: Debits & Credits, Normal Balances, Journal & Ledger, Trial Balance, and Debt Ratio
Debits and Credits: Core Rules and Quick Recap
Debits and credits are the basic building blocks for recording transactions. They always balance in a double-entry system.
The sign of increases and decreases depends on the type of account (asset, liability, equity, revenue, expense).
Increases and decreases: assets increase with a debit and decrease with a credit; liabilities increase with a credit and decrease with a debit.
Equity is more nuanced because it’s made up of multiple accounts; you must specify which equity account you’re talking about (owner capital, owner withdrawals, revenues, expenses).
The instructor emphasizes repeating the rules and using them to infer the other side of a transaction instead of memorizing in isolation.
The Accounting Equation and Normal Balances
Fundamental equation:
Normal balance concept: the final or “normal” balance of an account is on the side that increases that account.
For example:
Assets: increase on the left (debit) side, so the normal balance is Debit.
Liabilities: increase on the right (credit) side, so the normal balance is Credit.
Equity: depends on the specific equity account. In aggregate, the total equity balance tends to be a credit if profitable, but individual equity accounts differ.
Positive vs negative equity accounts:
Owner Capital (positive equity): increases with a Credit; decreases with a Debit.
Revenues (positive equity): increase with a Credit; decrease with a Debit.
Owner Withdrawals (negative equity): increase with a Debit; decrease with a Credit.
Expenses (negative equity): increase with a Debit; decrease with a Credit.
The instructor stresses that you must specify the exact equity account (owner capital, owner withdrawals, revenues, expenses) because they do not all behave identically.
The Normal Balances (Quick Memory Aid)
Asset accounts and expense accounts have Debit as their normal balance (increasing side).
Liability accounts and revenue accounts have Credit as their normal balance (increasing side).
For equity, use the specific account to determine its normal balance:
Owner Capital: Credit (increases with Credit).
Owner Withdrawals: Debit (increases with Debit).
Revenues: Credit (increases with Credit).
Expenses: Debit (increases with Debit).
The concept of “normal balances” helps you quickly check whether a trial balance is plausible.
Two Ways to Show Transactions: Journal Entries and T-Accounts
Journal entries (general journal): the formal, chronological record of transactions. Debits are listed first, then credits with indentation to show the credit side. Example from the description:
Transaction: Owner contributes cash to the business ($30,000).
Debit Cash $30,000; Credit Owner Capital $30,000.
T-accounts (general ledger): a visual representation of each account. Debits go on the left, credits on the right. The same transaction shown in T-accounts should balance (debits = credits).
Posting: the process of transferring journal entries to the ledger (i.e., moving the amounts from the journal to the specific accounts in the ledger).
Journal first, then ledger (J before L). The instructor emphasizes remembering this order.
Balance column accounts (ledger) show running balances after each posting, reinforcing the normal balances idea.
Worked Transaction Sequence (Chapter 2 Practice)
Transaction 1: Owner invests cash into the business.
Debit Cash $30,000 (Asset up)
Credit Owner Capital $30,000 (Equity up)
Transaction 2: Pay cash for supplies ($2,500).
Debit Supplies $2,500 (Asset up)
Credit Cash $2,500 (Asset down)
Transaction 3: Purchase equipment for cash ($26,000).
Debit Equipment $26,000 (Asset up)
Credit Cash $26,000 (Asset down)
Transaction 4: Buy supplies on credit (Accounts Payable increases).
Debit Supplies (Asset up)
Credit Accounts Payable (Liability up)
Transaction 5: Provided services for cash.
Debit Cash (Asset up)
Credit Consulting Revenue (Revenue up)
Transaction 6: Pay cash for rent (December).
Debit Rent Expense (Expense up)
Credit Cash (Asset down)
Transaction 7: Salary expense paid in cash.
Debit Salary Expense (Expense up)
Credit Cash (Asset down)
Transaction 8: Provided services on account (Accounts Receivable increases).
Debit Accounts Receivable (Asset up)
Credit Consulting Revenue (Revenue up)
Transaction 9: Receive cash from accounts receivable.
Debit Cash (Asset up)
Credit Accounts Receivable (Asset down)
Transaction 10: Partial payment of accounts payable ($900).
Debit Accounts Payable (Liability down)
Credit Cash (Asset down)
Transaction 11: Owner withdrawal of cash.
Debit Owner Withdrawals (Equity negative, but tracked as its own account)
Credit Cash (Asset down)
Notes on the amounts and accounts in the transcript:
Several amounts are explicitly stated (e.g., $30,000; $2,500; $26,000; $900; etc.).
Some descriptions are narrative without a precise amount (e.g., purchase on credit, services on account). In practice, you would capture the exact amount from source documents.
Account numbers mentioned as examples:
Cash (Asset) account number often starts with 1 (e.g., 101).
Owner Capital (Equity) account might be 301.
Accounts Payable (Liability) might start with 2, etc.
Normal Balances Revisited with Examples
If you sum up the final balances across all accounts, the total debits should equal total credits in the trial balance.
Example logic: If Cash (Asset) is an asset with a debit balance, its final balance should appear on the Debit side of the cash account, since assets are debit-heavy.
If Accounts Payable (Liability) is a liability with a credit balance, its final balance should appear on the Credit side of the accounts payable ledger.
If Owner Capital (Equity) has a credit balance (positive equity), its final balance should appear on the Credit side of the owner capital ledger.
If an expense account (e.g., Rent Expense) has a debit balance, its final balance should appear on the Debit side.
Posting from Journal to Ledger: Practical Flow
Step 1: Identify the accounts affected by a transaction in the journal.
Step 2: Record the amounts as Debits and Credits in the journal entry (debits first, credits second).
Step 3: Post each side of the journal entry to the corresponding ledger accounts (e.g., cash, accounts payable, owner capital, etc.).
Step 4: After posting, compute the running balances in each ledger account.
Step 5: Use the ledger balances to prepare a trial balance.
Trial Balance and Financial Statements
Trial Balance: a list of all accounts and their final balances at a point in time, in a specific order.
Order of the trial balance (as per chart of accounts):
Assets first, then Liabilities, then Equity (split into its specific accounts like Owner Capital and Owner Withdrawals), then Revenues, then Expenses.
Financial statements rely on these balances:
Income Statement: Revenues minus Expenses = Net Income.
Statement of Owner’s Equity: integrates ending equity from the income statement and owner contributions/withdrawals.
Balance Sheet: shows Assets, Liabilities, and Equity at a date (as of date); it is a snapshot of balances.
Important dates:
Income Statement and Statement of Cash Flows typically cover a period (e.g., for a month or year).
Balance Sheet uses a date stamp (e.g., as of December 31) because it is a snapshot at a moment in time.
Debt Ratio: Risk Illustration
Debt ratio formula:
Interpretation: A higher ratio indicates greater debt risk; more of the assets are financed by liabilities.
Quick example (illustrative): If Total Liabilities = 50 and Total Assets = 100, then , implying 50% of assets are financed by liabilities.
Chart of Accounts, Homework Tips, and Study Strategy
Chart of Accounts conventions used in the course:
Asset accounts typically start with 1 (e.g., Cash 101).
Liability accounts start with 2.
Equity accounts often use 3; revenues use 4; expenses use 6 (real-life practice may vary with more letters/numbers, but this is the textbook convention used here).
Homework/Quiz approach:
Identify account type for each given account (Asset, Liability, Equity, Revenue, Expense).
Determine how to increase or decrease each account based on its type.
Remember the normal balance side for each account to quickly determine the correct debit/credit.
Use the rule that for assets and expenses increases are on the debit side; for liabilities and revenues increases are on the credit side; for equity subaccounts, rely on their specific rules.
For decreases, apply the opposite side of the normal balance.
Purpose of normal balances: they act as a built-in check; the final balances should align with what the normal balance predicts. If a balance shows on the wrong side, it’s a red flag for an entry error.
Summary Takeaways
Debits and credits are the language of double-entry accounting and must always balance within each transaction.
The accounting equation ties together assets, liabilities, and equity; increases in assets and decreases in liabilities/equity are described with the appropriate side of the T-accounts.
Normal balances help predict where a balance should appear on the ledger and serve as a quick consistency check during the trial balance.
Journal entries capture the transaction in one place; posting transfers those effects to the ledger where running balances are tracked.
The trial balance consolidates the ledger and provides the foundation for preparing the income statement, statement of owner's equity, and balance sheet.
The debt ratio provides a quick measure of leverage and risk.
Real-world practice includes using source documents, chart of accounts conventions, and the standard order of accounts when preparing financial statements.