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224 viewsThe Mecanics of Financial Accounting
The Mecanics of Financial Accounting
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IrvinSerranoJCopyright
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8 HARVARD|BUSINESS|SCHOOL
9-101-119
The Mechanics of Financial Accounting,
Accounting is often referred to as the language of business. When you speak the language with
accountants oF individuals familiar with its nuances, you hear such terms as debits and credits,
journal entries, accounts and financial statements. The objective of this note is to explain in simple
terms and numerical examples how this language is spoken and how itis used in communicating the
company's financial health to its various stakeholders.
‘The end goal of the accounting process is to create financial statements that are useful to external
partes in evaluating the performance ofthe business. Accountants prepare three main statements for
the company's financial report. The balance sheet, which is a snapshot of the company at a particular
point in time, reports on its assets, the company’s economic resources, liabilities, the company’s
‘economic obligations, and its stockholders equity, a residual interest of the firm's assets assigned to
its owners. The income statement reports on the company's profitsecking operations during a
given year? The statement of cash flows provides information on the company’s cash balance
fluctuations during a given year due to cash inflows and outflows resulting from various activities?
‘The creation of the financial statements is the final step in the accounting and reporting process.
This final step is preceded by the process of analyzing, classifying, and recording all the economic
transactions that occurred during the year that impacted the company. The accountant’ role is to
record and report all these transactions in a manner that is simple, relevant, and transparent for
financial users.
‘Accountants record these transactions by preparing journal entries. A journal entry is a method
for expressing the effect of a transaction on accounts in a debits-equal-credits format,
To understand how accountants record transactions, we must understand what is a taccount. A
t-account is a tool used by accountants to summarize the effets of transactions on account balances
and determine end of period balances. It i called a t-account because it looks like the letter T. The
top of the T bears the account's name, such as cash, accounts payable, retained earnings, etc. The left-
1 For more information se HBS note number 101-108, "The Balance Sheet.”
2 For more information se HBS note number 101-108, "The Income Statement”
3 For more information see HBS note number 101-107, “The Statement of Cash Flows.”
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hand side of the taccount is referred to as a debit, while the right hand side of the t-account is
referred to as a credit. For example the cash t-account would look like this:
Cash (Asset)
Debit) Credit)
According to the theory of double-entry bookkeeping, every transaction impacts at least two
accounts, with total debits equaling total credits thereby ensuring the continuous balance of the
accounting equation. (Assets = Liabilities + Stockholders’ Equity) Debits and credits simply refer to
the side of the taccount on which the transaction is recorded. A debit entry solely means the
recognition of the amount on the left-hand side of the taccount and a credit entry solely means the
recognition ofthe dollar amount ofthe transaction on the right-hand side of the t-account.
How accountants increase or decrease an account is dependent on whether the account is an asset,
liability, or stockholders’ equity account. Remember that the term asset refers to all the resources of
the firm. These include such assets as cash, accounts receivable, inventories, and, machines, etc. The
‘taccounts for all assets are treated in a similar manner. To increase an asset account we debit the
account (record entry on the left-hand side of t-account). To decrease the account we credit the
account (record entry on the right-hand side of taccount). There‘ore, if the company received cash
from a customer, part of the journal entry would be to debit the cash account, thus indicating an
increase in the cash account balance due to the collection of cash from the customer. Of course, we
‘understand that this is only part ofthe journal entry given the double entry bookkeeping requirement
that debits equal credits. The second half of the journal entry will be addressed later in the note.
The liabilities and stockholders’ equity accounts are treated in an opposite manner. Remember
that liabilities and stockholders’ equity are creditors’ and owners’ claims of the entity's resources. In
order to increase liability accounts such as accounts payable, accrued expenses, long-term debt, ot
any other lability account, we must credit the account. The same holds true for any stockholders’
equity section account such as common stock, retained earnings, or any other. Hence, to decrease a
liability or stockholders’ equity account the accountant must debit the account.
‘The next question is what happens to accounts that are not assets, liabilities, or stockholders’
equity, such as revenue and expense accounts. In particular, how does one treat the increase in the
revenue account asa result ofa sale? How does an accountant treat the incurrence of expense during
the year? In order to answer these very important questions we must review the interrelationships of
‘he balance sheet and income statement.
‘The income statement lists all the revere and expense accounts of the organization in a format
that simply subtracts expenses from revenues to arrive at the net income or loss for the period. That
amount is then added to the retained earnings balance reported as part of stockholders’ equity on the
balance sheet. Therefore, we can think of revenues as increasing the retained earnings amount and
expenses as decreasing the retained earnings amount. Therefore, revenues are credit entries because
credit entries increase the retained earnings account given that itis a stockholders’ equity account.
Expenses, on the other hand, are debit entries and capture the fact that the debit entry reduces the
retained earnings account. Dividends too, are debit entries, as they are also an account that works to
reduce the stockholders’ equity account via a reduction in retained earnings. Exhibit 1 provides a
diagram that illustrates this relationship. “The Mechanics of Financial Accounting wry
‘The following table provides a summary of a debit entry’s and credit entry’s impact on all the
various account categories: For example, to increase an asset account, the accountants will record a
debit entry. On the other hand, to decrease a revenue account accountants also record a debit entry.
F Debit Credit Credit Credit Debit
‘Assets (A) | Liabilities (1) | Stockholders” | Revenues (R) |” Expenses
Equity (SE)
T Credit Debit Debit Debit Credit
In the previous example we discussed that a cash sale made to a customer resulted in a journal
entry that included a debit to cash. The second half of the transaction, recognition of the sale
revenue, is required. It is the credit entry. Given that the company made a sale to a customer we
need to record an increase in revenues. From the table above we see that we need to credit the
amount of revenue from the sale. Of course, given that we need debits to equal credits it was clear
that the second half of the transaction had to be a credit en:ry. ‘Therefore, the journal entry that
captures a sale made for $100 cash is as follows:
(Dr) Cash 100
(Cx) Revenue $100
The generally accepted format for recording journal entries is to record the debit entry first and
the credit entry second. The credit entry is also indented to ensily identify it as a credit entry. Exhibit
2 provides numerous examples of journal entries recognition.
‘Once all the transactions have been posted to the taccounts, the accountant prepares a trial
balance by listing all the accounts and their respective balences in the order they appear on the
financial statements. The trial balance serves as a check thatthe total debit balances equal the total
credit balances, thus ensuring that the accounting equation remains balanced.
Following this verification process, the accountant prepares adjusting entries. Adjusting entries
are often referred to as quasi-transactions, given that no transaction took place prior to their
recognition. They are recorded to capture the usage of various resources during the accounting
period. For example, at the end of the period the accountant records an adjusting entry to bad debt
‘expense to capture the fact that some of the company’s credit
