Copyright Notice. Each module of the course manual may be viewed online, saved to
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for permission to use or reproduce these materials should be mailed to the author.
Module 2
I.
II.
III.
IV.
V.
Table of Contents
Instructions:
The General Ledger of Accounts
Debit and Credit Account Balances
Accounting for Prepaid Expenses
The Accounting Process
Errors, Their Discovery and Correction
Click on any of the
underlined titles in the
table of contents to be
directed to that section
of the module. Click
on the <back> symbol
to return to the table of
contents.
Video Lectures
Because seeing and hearing is sometimes better than just reading, I have prepared three video
lectures for this module. After you read through the sections below, click here to play or to
download the videos:
Debits and Credits, Part 1: http://youtu.be/kbXKZqW-ISk
Debits and Credits, Part 2: http://youtu.be/NWmgt0mDaKY
The General Journal: http://my-accountingtutor.com/Financial/Camtasia/GeneralJournal/Camtasia-GeneralJournal.html
©2012
Craig M. Pence. All rights reserved.
2
Accounting Course Manual
Module 2 Summary
I.
The General Ledger of Accounts.
A.
B.
The simple table-based accounting system that
was presented in the previous module is difficult
to use in an actual business. A table drawn on a
single sheet of paper simply cannot be used to
record thousands of transactions during the
accounting period in a hundred different
accounts. The solution? Devise an accounting
system in which the accounts are set up
individually on separate pages all bound
together to form a book. Another name for a
book is “ledger,” so the “table of accounts”
presented in the previous module now becomes
a book of individual accounts called the
general ledger.
The General Ledger replaces the
previous table of accounts
This general ledger accounting system can accommodate any number of
accounts and any number of transactions. It differs from the table-based
system described in the previous module in two important ways.
1.
Instead of a table with separate columns for each of the accounts,
the general ledger is composed of separate pages for each of the
asset accounts, the liability accounts, and the owner equity
accounts. Owner equity accounts? Yes, there will now be more
accounts used to record the owner’s equity than just a single Capital
(or Common Stock) account. These additional owner equity
accounts are called temporary accounts, and we will explain in
detail why they exist and how they are used a little later on.
2.
Each of the accounts has a debit (left) side and a credit (right)
side. Now, instead of the “plus” entries and “minus” entries that
were used with the accounts in the table-based system, debit and
credit entries will be made to the general ledger accounts. When
we say that an account has been debited, we simply mean that an
amount has been entered on the left side of the account. Likewise, if
an account is credited, the amount is entered on the right side of
the account. Whether the debit entry or the credit entry increases
the account or decreases the account depends on the account type.
With some accounts, debits are increases and credits are decreases,
but with others debits are decreases and credits are increases.
©2012 Craig M. Pence. All rights reserved.
Accounting Course Manual
3
More good news for accounting masochists!
The plus and minus entries that we used in the previous module are logical and intuitive. Debit
and credit entries take a lot of getting used to. Does this sound like another opportunity for
long hours spent studying accounting and working lots of boring practice problems? You bet it
does! 
Remember, though, not everyone is willing to go through all that it takes to learn this material,
so complications like these create a lot of job security and high pay rates for bookkeepers and
accountants (the accounting masochists who did the work and learned the material)!
II.
Debit and Credit Account Balances in the General Ledger
A.
The particular set of accounts that is maintained in the ledger is called the
company’s chart of accounts. The number of accounts in the chart of
accounts and their titles are determined by the business owner and the
accountant. They accounts they select will be those that they believe will
best meet the information needs of the investors, creditors and managers
who will use the statements to analyze the business.
B.
Each of the general ledger accounts is divided into two sides. The left side
of the account is called the debit side. The right side of the account is the
credit side.
The Account
Debit Side
Credit Side
When an account is debited, an amount is entered on the left side of the
account. When an account is credited, an amount is entered on the right
side. Whether the debit or credit increases or decreases the account
balance depends on the account type.
Luca Pacioli, the “father of accounting,” is credited with popularizing the
concept of debit and credit accounting systems in the 15th century. You can read
more about Pacioli by clicking the link below.
http://en.wikipedia.org/wiki/Luca_Pacioli.
C.
The debit and credit "rules" refer to the side of the account that is used to
record increases (positive entries) and the side that is used for decreases
(negative entries). This varies by type of account
The general rules regarding debit and credit entries to the
accounts are as follows:
©2012 Craig M. Pence. All rights reserved.
4
Accounting Course Manual
1. The left side (debit side) of the account is used to record
increases in assets, and decreases in liabilities and
owner's equity.
2. The right side (credit side) of the account is used to
record decreases in assets, and increases in liabilities
and owner's equity.
The General Rule for Debit and Credit Entries
Account Type
Debit
Credit
Asset
Liability
Owner's Equity
Assets
Increase
Decrease
Decrease
Liabilities
Debits
Credits
Debits
Credits
+
-
-
+
Decrease
Increase
Increase
Capital
(or Common Stock)
Debits
Credits
-
+
Here’s an Example! Suppose Jackson contributes $1,000 of cash to start his business. We
understand from the previous module that contributions increase assets and increase owner’s equity.
We would record this transaction by turning to the “Cash” account page in our general ledger, and
entering a debit in the account for the $1,000. We would then turn to the “Capital” account page (or
“Common Stock” if the business is a corporation) and credit the account for $1,000:
Cash
Debits
Credits
1,000
Capital
(or Common Stock)
Debits
Credits
1,000
Example, continued.
Note above that we entered the $1,000 without the dollar sign (everyone knows that the amounts
recorded in an accounting system are dollar values). Also, we did not put a plus sign in front of the
amount, since all bookkeepers and accountants know that debits to Cash and credits to Capital
represent increases.
Suppose now that Jackson provides $500 of services to a customer on account. We will need to record
revenue since the revenue has been earned, and revenues increase business assets and increase owner’s
equity. Therefore, we will now enter a debit in the Accounts Receivable account and a credit in Capital:
©2012 Craig M. Pence. All rights reserved.
Accounting Course Manual
Accounts Receivable
Debits
Credits
500
5
Capital
(or Common Stock)
Debits
Credits
500
Suppose now that Jackson receives a $50 utility bill, and also withdraws $100 of business cash for
personal use. We need to record an expense, since the expense has been incurred, and record the
obligation to pay the bill in the future. Therefore, we will need to increase Accounts Payable with a
credit and decrease owner’s equity with a debit. We also need to decrease the Cash account and decrease
owner’s equity to record the withdrawal. Our entries are as follows:
Accounts Payable
Debits
Credits
50
Cash
Debits
Credits
100
Capital
(or Common Stock)
Debits
Credits
50
Capital
(or Common Stock)
Debits
Credits
100
The account balances are now as follows. Note that the debit balances equal the credit balances. In
this example, the debit balances are asset accounts, and the credit balances are liability or owner’s
equity accounts, so assets are equal to liabilities plus owner’s equity. This must always be the case, so
preparing a trial balance, such as illustrated below, is a good way to check your work!
Account:
Cash
Accounts Receivable
Accounts Payable
Capital (or Common Stock)
Total
Debit
$900
500
$1,400
Credit
$50
1,350
$1,400
Video Lecture
These videos present the same information that is printed below. Some students are “visual learners,”
and a video lecture format works well for them. Some students learn well by reading.
After you read through the section below, click here to play or to download the videos:
Debits and Credits, Part 1: http://youtu.be/kbXKZqW-ISk
III. Income Statement and Balance Sheet Accounts.
A.
The debit and credit rules that we set out above seem simple enough at
first glance, but a complication occurs because of the use of separate
©2012 Craig M. Pence. All rights reserved.
6
Accounting Course Manual
temporary owner’s equity accounts. These are new accounts, and they
were not used in the previous module.
B.
Temporary accounts are used to record three of the four kinds of
transactions that can affect owner’s equity: revenues, expenses, and
withdrawals. The fourth transaction type, a contribution to the business
by the owner, is the only transaction that will be recorded directly in the
Capital (or Common Stock) account. Temporary accounts are also called
income statement accounts (even though withdrawals are not listed on the
income statement).
C.
Here is a summary of the temporary accounts and the debit/credit rules
that apply to them:
1.
2.
3.
C.
Revenue Accounts. Since revenues represent increases in owner
equity, increases in revenue accounts are recorded with credits and
decreases with debits.
Expense Accounts. Since expenses represent decreases in owner
equity, the expense account balances are increased with debits and
decreased with credits
Withdrawals. Owner withdrawals are recorded in the Drawing
account (corporations use a Dividends account for the
distributions they make to their stockholders). Since withdrawals
also represent decreases in owner equity, the Drawing account
balance is increased with debits and decreased with credits.
Why are temporary accounts used? Well, for one thing, they do
complicate the accounting process a good deal, which means they add a lot
of job security and create some pretty high pay rates for accountants and
bookkeepers! 
But there is another reason. By recording the revenues and expenses in
their own separate accounts, it is much easier to identify them and
determine the amount to report when preparing the income statement. If
they were simply recorded directly in the Capital account, along with
investments and withdrawals, sorting through hundreds of entries to
determine the amount to report on the income statement for Services
Revenue, Rental Revenue, Utilities Expense, Wages Expense and so on
would be next to impossible.
D.
Why are the Revenue, Expense, and Drawing accounts called temporary
accounts? Because they are only used to "store" the revenue, expense, and
withdrawal information temporarily. Think of them as “temporary
parking.” Once the income statement has been prepared at the end of the
©2012 Craig M. Pence. All rights reserved.
Accounting Course Manual
7
accounting period, it is no longer necessary to keep these balances in the
temporary accounts. At that time, we can move them out of “temporary
parking” and into the account where they will stay permanently, the
Capital account. This process is called closing, and it is the temporary
accounts that will be closed.
The Capital account, along with all the asset and liability accounts, is
never closed. These accounts maintain their balances permanently, and
they are called permanent accounts or balance sheet accounts. (You will
find a complete illustration of the closing process in Module 4.)
E.
The complete set of rules regarding Debit and Credit entries to
all the accounts are:

The left side (debit entries) of the account is used to record
increases in Assets, Expenses and the Drawing account; and
decreases in Liabilities, the Capital account, and Revenues.

The right side (credit entries) of the account is used to
record decreases in Assets, Expenses and the Drawing
account; and increases in Liabilities, Revenues, and the
Capital account.
Specific Rules for Debit and Credit Entries
Account Type
Debit
Credit
Asset
Liability
Capital
Revenue
Expense
Drawing
Increase
Decrease
Decrease
Decrease
Increase
Increase
Assets
Debits
Credits
+
-
Revenues
Debits
Credits
-
+
Liabilities
Debits Credits
-
+
Expenses
Debits Credits
+
©2012 Craig M. Pence. All rights reserved.
-
Decrease
Increase
Increase
Increase
Decrease
Decrease
Now, only
contributions
are recorded
in Capital.
Capital
Debits Credits
-
+
Drawing
Debits Credits
+
-
All other
owner’s equity
transactions are
recorded in
these temporary
accounts.
8
Accounting Course Manual
Another Example! Now that temporary accounts have been introduced, let’s return to our earlier
example and record the same transactions all over again. This time, though, we will use the temporary
accounts. When Jackson contributes the $1,000 of cash to the business, we will again debit Cash for
$1,000 and credit Capital. Contributions are the only owner equity transactions that are recorded
directly in the Capital (or Common Stock) account, so our entry is the same as it was before:
Cash
Debits
Credits
1,000
Capital
(or Common Stock)
Debits
Credits
1,000
Example, continued.
When Jackson provides $500 of services to a customer on account, we will again record an increase in
owner’s equity, but this time we will use a separate Services Revenue temporary account. Therefore, we
will debit Accounts Receivable and credit Services Revenue:
Accounts Receivable
Debits
Credits
500
Services Revenue
Debits
Credits
500
When Jackson receives the $50 utility bill we will again reduce owner’s equity, but this time we will do
so by recording a debit in the Utilities Expense account. We will then credit Accounts Payable.
We also need to decrease the Cash account with a credit, and decrease owner’s equity by debiting the
temporary Drawing account in order to record the withdrawal. Our entries are as follows:
Accounts Payable
Debits
Credits
50
Cash
Debits
Credits
100
Utilities Expense
Debits
Credits
50
Drawing
Debits
Credits
100
The account balances are now as shown on the trial balance below. Note that the debit balances still
equal the credit balances. In this example, though, the debit balances represent asset, expense, and
the drawing accounts. The credit balances are in liability, revenue, and the Capital accounts. The
owner’s equity is still $1,350, just as it was earlier, but it is now spread out over four different
accounts ($1,000 in Capital, plus $500 in Services Revenue, minus $50 in Utilities Expense, minus
$100 in Drawing = $1,350).
©2012 Craig M. Pence. All rights reserved.
Accounting Course Manual
Account:
Cash
Accounts Receivable
Accounts Payable
Capital (or Common Stock)
Drawing
Services Revenue
Utilities Expense
Total
Debit
$900
500
100
9
Credit
$50
1,000
500
50
$1,550
$1,550
Video Lecture
These videos present the same information that is printed below. Some students are “visual learners,”
and a video lecture format works well for them. Some students learn well by reading.
After you read through the section below, click here to play or to download the videos:
Debits and Credits, Part 2: http://youtu.be/NWmgt0mDaKY
F.
As basic to accounting as the accounting equation (Assets = Liabilities +
Owner's Equity), is the axiom that debits must equal credits. This will
be true since the sum of the debit balances in the general ledger accounts
(assets) must equal the sum of the credit balances (liabilities and owner's
equity). Also, since the changes in assets caused by transactions during the
period must equal the changes in liabilities and owner's equity, each
transaction, if recorded correctly according to the debit and credit rules,
will have total debits equal to total credits.
G.
Because accounts will generally not have negative balances, the normal
balance of an account is the side on which increases are recorded: debits
for assets, credits for liabilities and the Capital account, credits for
revenues, and debits for expense and the Drawing accounts. A nonnormal, negative balance in an account is shown by enclosing the balance
figure in parentheses, circling it, or by writing it in red (hence, the
expression, “being in the red”).
Assets
Debits
Credits
Liabilities
Debits Credits
Capital
Debits Credits
Normal
Balance
+
Normal
Balance
+
Normal
Balance
+
©2012 Craig M. Pence. All rights reserved.
10
Accounting Course Manual
Revenues
Debits
Credits
Normal
Balance
+
H.
Expenses
Debits Credits
Normal
Balance
+
Drawing
Debits Credits
Normal
Balance
+
Chart of Accounts Numbering System.
according to the type of account:
Assets:
Liabilities:
Capital and Drawing:
Revenues:
Expenses:
The accounts are numbered
Numbered in the 100's (or 1,000’s, etc.)
Numbered in the 200's (or 2,000’s, etc.)
Numbered in the 300's (or 3,000’s, etc.)
Numbered in the 400's (or 4,000’s, etc.)
Numbered in the 500's (or 5,000’s, etc.)
III. Accounting for Prepaid Expenses
<back>
A.
Prepaid Expenses are asset accounts that have not been discussed
previously. Recall that assets represent things the business owns that will
benefit the business in the future. Supplies, equipment, buildings and any
other assets that are used up in operating the business really do represent
“prepaid” expenses, though we do not call them by that title. However,
they are assets that are purchased and paid for in advance of being used,
and so they do represent an item that has been “prepaid” and that will
become expense later on as they are used up.
C.
The two new “prepaid expense” asset accounts introduced here are
Prepaid Rent and Prepaid Insurance. If rent is paid for the coming
year or if an insurance policy is acquired that provides a year’s coverage,
assets are being purchased that will provide benefits to the business
through the coming year. After the year has passed all the benefit these
assets provide will have been consumed, at which point the assets will
have become expenses. At the time of their purchase two asset accounts,
Prepaid Rent and Prepaid Insurance, would be debited.
<back>
IV.
The Accounting Process (The Steps of the Accounting Cycle).
A.
In order to ensure objectivity (remember the objectivity concept discussed
in Module I?), entries should be based upon the information contained in
source documents (purchase invoices, deposit receipts, etc.). These
©2012 Craig M. Pence. All rights reserved.
Accounting Course Manual
11
source documents prove that the transaction did, indeed, occur, and they
also document and verify the amounts involved.
B.
While source documents are the foundation for all the entries that are
made in the general ledger accounts, the entries in the general ledger
accounts cannot be made directly from them. There are two reasons for
this:
a.
It is inefficient to try to record entries in the ledger accounts when
working from a pile of paper receipts. Errors are likely to be made,
and a lot of time will be lost sorting through the scraps of paper.
a.
The source documents vary, and there are many, many of them.
After the transactions are recorded, they will be filed away and
later, if errors are discovered in the general ledger, it will be very
difficult to trace back to the original source document and use it to
identify the problem and make the correction.
C.
Therefore, in order to provide (1) an explanation for ledger account
entries, (2) a check for the equality of debits and credits used to record a
transaction, and (3) a "trail" from the entries in the general ledger
accounts back to the source documents; transactions should be recorded
in a general journal (this is referred to as journalizing the transaction)
before being entered the ledger accounts.
1.
A sample page from the general journal is shown below, and the
transactions from the previous example have been recorded in it.
GENERAL JOURNAL
Page ___ 1
Date
Account Title / Explanation
20XX
Jan
1 Cash
T. Jackson, Capital
First Bank Deposit Receipt , #00058251
Post.
Ref.
2 Accounts Receivable
Services Revenue
Invoice #00001
3 Utilities Expense
Accounts Payable
Com Ed Bill 008883231
4 T. Jackson, Drawing
Cash
First Bank, Check #00001
©2012 Craig M. Pence. All rights reserved.
Debit
1
Credit
0
0
0
1
5 0 0
0
0
0
5 0 0
5 0
5 0
1 0 0
1 0 0
12
Accounting Course Manual
D.
When transactions that have been entered in the general journal are
recorded in the general ledger accounts, the general journal entries are
said to have been posted to the general ledger. To provide references
between the journal and the ledger accounts, dates and posting
references are used. The page number of the general journal is used as a
reference from the ledger to the journal; the general ledger account
number is used as a reference from the journal to the ledger.
Video Lecture
This video presents additional information about the general journal.
After you read through the section below, click here to play or to download the video:
The General Journal: http://my-accountingtutor.com/Financial/Camtasia/GeneralJournal/Camtasia-GeneralJournal.html
E.
As noted in the previous module, if all the transactions were recorded and
posted according to the debit and credit rules, the sum of the debit
balances in the general ledger accounts must equal the sum of the credit
balances. To prove this equality, a trial balance is prepared following
posting.
1.
The trial balance is merely a listing of all the accounts along with
their debit and credit balances.
2.
The balances are then added to prove that the sum of the debit
balances equal the sum of the credit balances.
3.
If the trial balance does balance, then we know that no obvious
errors were made in the journalizing and posting process.
F.
The steps of the accounting cycle, as covered to date, may be
summarized as follows:
1.
During the accounting period, journalize transactions from source
documents as they occur.
2.
At end of the accounting period, post debit and credit entries from
the general journal to the general ledger accounts.
3.
Total account balances and prepare a trial balance.
4.
Prepare financial statements and present them to the users.
Following step 4, the process begins all over again in the next accounting
period, with the accountant “cycling back” to step 1. That’s why the process
is called the accounting cycle!
<back>
©2012 Craig M. Pence. All rights reserved.
Accounting Course Manual
V.
13
Errors, Their Discovery and Correction.
A.
Note that some errors, such as transpositions ($540 is accidentally
entered as $450) or slides ($1,000 is accidentally entered as $100) may
cause the trial balance to be out of balance. Other types of errors, such as
the omission of an entire entry, posting to the wrong account, etc., will not
cause the trial balance to be out of balance (though the information in the
accounts and on the statements will then be incorrect).
B.
Another of the accounting principles is introduced here, the materiality
concept. Material information is information that is important enough
to change the user's decision. If accounting reports are to be useful to its
users (investors, creditors and managers), material information must, of
course, be reported. But immaterial information is not useful, because it
is information that “doesn’t matter.” In this discussion, the concept is
applied in determining whether errors need to be corrected. If the effect is
so small as to be immaterial, an error does not have to be corrected. But
if the effect is material, then the error must be corrected.
C.
Errors should be corrected in a non-computerized accounting system by
simply lining out the error and writing in the correction. However, if the
entry has been journalized and posted, the original error should be left
intact in the accounting records, and a correcting entry should be made.
<back>
VI.
Horizontal Analysis of Financial Statements
A.
As shown in the illustration below, financial statements in the annual
report are presented for the current year and for one or more previous
years. They are usually displayed in columns, and each year's figures are
listed in a separate column for that year.
B.
Horizontal analysis of the information on the statements is so called
because the analyst works across the statements horizontally (i.e., from
side to side), calculating the changes in the balances reported and
computing the percentage increase or decrease.
C.
From these changes the analyst looks for interrelationships that reveal the
"story" behind any improvement or deterioration in the "bottom-line"
figures reported by the company. To illustrate this, consider the horizontal
analysis of the XYZ income statements in the table below. Here, the
bottom line net income has fallen dramatically (by 33%). This occurred
despite a 20% increase in revenues. A horizontal analysis reveals that the
major factor responsible for the loss of profitability was the increase in the
©2012 Craig M. Pence. All rights reserved.
14
Accounting Course Manual
wages expense during the year. It, along with the slight increase in
telephone expense, more than offset the increase in revenues and the small
savings in supplies expense. Why did this happen? Perhaps the company
needs to downsize its labor force. Or perhaps the company is expanding
and needed to hire more employees to staff the new stores it has built.
Financial analysis seldom really tells the analyst what has happened. But it
does tell the analyst what questions to ask!
Horizontal Analysis of XYZ Company
Consolidated Statements of Income
for the Years Ended December 31, 20X1 and 20X2
20X2
20X1
Services Revenue
$120,000
$100,000
+20,000
+20%
Wages Expense
(80,000)
(50,000)
+30,000
+60%
Utilities Expense
(10,000)
(10,000)
0
0%
Telephone Expense
(10,000)
(8,000)
+2,000
+25%
(4,000)
(8,000)
-4,000
-50%
16,000
24,000
-8,000
-33%
Office Supplies Expense
Net Income
-END-
©2012 Craig M. Pence. All rights reserved.
Amount
Percent