The Balance Sheet, Debits and

Credits, and Double-Entry

Accounting: Practice Problems

The Balance Sheet:

A company will use a Balance Sheet to summarize its financial position at a

given point in time. It summarizes a company's assets, liabilities, and
owners' equity. The balance sheet is derived using the accounting equation.
The balance sheet is also commonly referred to as the statement of financial
position.

Debits and Credits:

Every accounting transaction must be either a credit or debit. Quite simply,

either you are crediting money or debiting money to the overall balance. In
bookkeeping texts, you will see debits abbreviated as "Dr." and credits
abbreviated as "Cr."

"T " Accounting:

When representing the debits and credits equation, accountants and

bookkeepers commonly use the "T" accounting method. In this
representation, you draw a big capital letter "T" on a paper, and on one side
of the T you place your debits; on the other side of the T, you place your
credits; and on the top of the T, you usually name the item you are debiting
or crediting, as shown:
 Accounts Payable
--------------------------------

|
Debits | Credits
|
|
|

Double-entry Accounting:

There are two methods accountants use to show credits and debits for
financial transactions. They can use the single-entry, or one-column
method, or the more widely used double-entry, or two-column, method to
show debits and credits. When using double-entry accounting, debits must
always equal credits:

Debits = Credits

This is yet another extremely important accounting equation to remember.

Because debits must always equal credits, it is common practice to use
double- entry accounting to prevent errors. In double-entry
accounting, every financial transaction must have two journal entries,
or affect two different accounts: the debit transaction and the credit
transaction. The theory behind this is that for every transaction, you are
taking money away from one account and adding it to another account. For
example, if your company purchases $800 in business supplies, you would
be inclined to think of taking $800 cash out of the checking account, and you
would be right. However, in double-entry accounting, you also need to add
this amount to inventory, as shown:

$800.00 subtracted (credited) in Cash

$800.00 added (debited) in Inventory

This accounts for where the cash went. The cash did not just disappear into
thin air; it turned into business supplies, thus this change is reflected
correctly in double-entry accounting. It is equally important to note that with
the equation Debits = Credits,the left side must always contain debits, and
the right side must contain only credits. Order and consistency when
representing debits and credits are paramount.

We need to clarify one more very confusing point when dealing with double-
entry accounting, and debits and credits specifically. You need to disregard
your traditional understanding of how credits work in your everyday
life. In your normal checking account, credits usually refer to money
increasing in your account, and debits usually refer to decreasing the money
in your account. If you add money to your checking account, your checking
account is credited and your bank account increases. This point of view
differs from that in the accounting world because you are viewing your
checking account through your own personal perspective, not the bank's
perspective. In the accounting world, financial transactions are looked at as
if from the bank's point of view.
Therefore, if a financial transaction causes a company's checking account to
be credited, its balance decreases. Additionally, crediting an account such
as accounts payable will ultimately increase the balance of a company. This
leads to much confusion when referring to credits and debits. When
discussing credits and debits, we need to be absolutely certain we
understand what we are doing to what side of the accounting equation.

We can clarify our understanding of what is going on with credits and debits
by returning to the Debits = Credits equation. Debits must always be on the
left side or left column, and credits must always be on the right side or right
column. Whether a debit or credit can either increase or decrease an overall
account balance is determined by the account type that is receiving the
credit or debit transaction. For example, if you are adding numbers to
the debit side of your retained earnings account, you are decreasing the
account value. But if you are adding numbers to the debit side of
your cash account, you are increasing the account value. The following chart
better summarizes with plus and negative signs what happens to your
overall account balance when you add numbers to the respective credit/debit
accounts:
The summary below illustrates how debits and credits are being recorded in
the fundamental accounting equation A = L + OE:

- If you are increasing your assets, you are adding debits to the assets side (left
side) .

- If you are decreasing your assets, you are adding credits to the assets side
(left side) of the equation.

- If you are increasing your liabilities and owners' equity, then you are
adding credits to the right side of the accounting equation.

- If you are decreasing your liabilities and owners' equity, then you are
adding debits to the right side of the accounting equation.

If you have a good understanding of how credits and debits work in the
accounting equation, you may wonder what exactly is the difference
between liabilities and owners' equity? Since both handle debits and credits
pretty much the same way, why isn't the right side of the equation just
liabilities? This is a great question, and it has a simple answer. Liabilities,
such as bank loans or buying merchandise on credit, must be paid off by a
set due date, whereas owners' equity, or capital, has no reason to ever to
be paid off. For this reason, owners' equity is not a true liability and cannot
be treated as such.
Problem 1:

Judy decided to start her own gift basket business. Here is a summary of
transactions she made for the month of September:

 Sept. 1: Judy invested $10,000 to start her

new business.
 Sept. 2: Judy paid $900 in cash for gift
basket supplies to make gift baskets.
 Sept. 3: Judy paid $800 rent for the month of
September for her storefront.
 Sept. 4: Judy bought $400 worth of office
equipment (desk, chairs).
 Sept 28: Judy sold $2,200 in gift baskets and
gift basket accessories.
 Sept. 29: Judy bought $1,500 worth of straw
and birchwood to make gift baskets on credit
payable in 90 days.
 Sept. 30: Judy took inventory at the end of
the month and found she had $1,800 worth
of gift basket supplies remaining.

Question: Using the above transactions, how would you set up a simple
diagram of a balanced accounting equation for each transaction for
Judy's gift basket business?
Answer: A simple balanced equation for the gift basket business may
look like this:

As you can see, if you add up all the assets and compare it to the sum of
liabilities and owners' equity, they are equal (12,300 = 12,300).

Problem 2:

Solve for each of the missing variables in these equations:

Owners'
Assets = Liabilities +
Equity

1. $28,000 ??? $20,000

 2. ??? 9,200 80,000

3. 86,000 ??? 86,000

4. 45,000 22,000 ???

5. 39,000 9,000 ???

6.

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Answer: The answer for each of these problems can be found by using
simple algebra and solve for x or in this case ???. We know that Assets =
Liabilities + Owners Equity, so for each of these we just solve for x:

Owners'
Assets = Liabilities +
Equity

1. $28,000 8,000 $20,000

 2. 89,200 9,200 80,000

3. 86,000 0 86,000

4. 45,000 22,000 23,000

5. 39,000 9,000 30,000

6. 33,500 6,500 27,000

Problem 3:

Determine the effect on owners' equity (increased, decreased, stayed the

same) for each of the following transactions that occurred in the month of
September for the Orion Computer Repair Company:

 Sept. 1: Orion Computer Repair Company

invested $10,000 in cash to start the
company.
 Sept. 15: OCRC pays $1,800 in cash for rent.
 Sept. 30: OCRC receives $12,300 in
computer repair sales.

Answer:

 The first item is a direct increase in owners' equity

(capital).
  The second item is an expense (cash expense), so that
is a decrease in owners' equity.
 The third item is a cash increase from computer sales
(revenue); this is an increase in owners' equity.

Problem 4:

For each of the following statements, show by account where the debits
and credits would go:

Sept. 1: Orion Computer Repair Company invested

$10,000 in cash to start the company.

Answer: This is tricky because you may be inclined to think that we

would credit a cash account (under assets). However, as we have
studied earlier, asset increases are shown as a debit. This is a very
important rule to remember. The balanced, double-entry method of showing
credits and debits would be as follows:
 Sept. 5: OCRC pays $1,800 in cash for computer
spare parts.

Answer: Paying $1,800 in cash for computer parts is a cash expense that
directly affects inventory. Essentially, we are just dealing with the left side of
the equation (assets) and we are changing the form of an asset from cash to
inventory (spare parts), as shown:

Sept. 17: OCRC receives $12,300 in computer

repair sales.

Answer: The important part to remember about this statement is that it

affects both sides of the accounting equation. You are debiting cash
(because you are increasing cash) and you are crediting
revenue (owners' equity) on the other side of the equation because you are
increasing capital. You should understand more clearly now how credits and
debits work on each side of the equation.
 Sept. 25: OCRC buys $2,500 in computer spare
parts on credit.

Answer: Since OCRC is purchasing computer spare parts on credit (a

liability), you are increasing both liabilities and inventory (assets) on both
sides of the accounting equation:

Sept. 30: OCRC pays the above $2,500 bill.

Answer: This is fairly easy to solve. We need to debit the Accounts Payable
account the money that we were credited ($2,500), and we need to then
credit the amount in cash to pay off the bill. Both sides of the equation are
affected, as shown:

Important Note: Please make sure you fully understand how debits and credits
work and how they increase and decrease the different parts of the accounting
equation. These concepts are the hardest to understand for newcomers to
accounting. The best way to solidify your understanding of debits and credits is to
memorize the following diagram and study these practice problems above.