Debits and credits


Debits and credits
Accountancy
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Debit and credit are the two aspects of every financial transaction. Their use and implication is the fundamental concept in the double-entry bookkeeping system, in which every debit transaction must have a corresponding credit transaction(s) and vice versa.

Debits and credits are a system of notation used in bookkeeping to determine how to record any financial transaction. In financial accounting or bookkeeping, "Dr" (Debit) simply means left side of a ledger account and "Cr" (Credit) is the right side of a ledger account.[1]

To determine whether one must debit or credit a specific account we use the modern accounting equation approach which consists of five accounting elements or rules.[2] An alternative to this approach is to make use of the traditional three rules of accounting for: Real accounts, Personal accounts, and Nominal accounts to determine whether to debit or credit an account[3].

Contents

Aspects of transactions

  Increase Decrease
Asset Debit Credit
Liability Credit Debit
Income Credit Debit
Expense Debit Credit
Equity/Capital Credit Debit

Debits and credits form two opposite aspects of every financial transaction. For example, when a person deposits cash into his bank checking account, this financial transaction has two aspects: the customer's cash-in-hand (the customer's asset) decreases and the customer's checking account balance (the customer's asset) with the bank increases. The decrease in the cash-in-hand asset is the customer's credit while the increase in the asset balance in the bank checking account is the customer's debit.

The bank views it differently. In this example, the bank's vault cash (asset) increases which is a debit, and the corresponding increase in the customer's checking account balance (bank's liability) is a credit.

In summary: an increase (+) to an asset account is a debit. An increase (+) to a liability account is a credit.

Conversely, a decrease (-) to an asset account is a credit. A decrease (-) to a liability account is a debit.

Etymology

While the actual origin of the terms debit and credit is unknown, the first known recorded use of the terms is Venetian Luca Pacioli's 1494 work, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (translated: Everything About Arithmetic, Geometry and Proportion). Pacioli devoted one section of his book to documenting and describing the double-entry bookkeeping system in use during the Renaissance by Venetian merchants, traders and bankers. This system is still the fundamental system in use by modern bookkeepers.[4]

In its original Latin, Pacioli's Summa used the Latin words debere (to owe) and credere (to entrust) to describe the two sides of a closed accounting transaction. When his work was translated, the Latin words debere and credere became the English debit and credit. The abbreviations Dr (for debit) and Cr (for credit) likely derive from the original Latin.[5]

Understanding

When dealing with one's own business, one must set up a business bank account to record all cash transactions that may take place. Thus, when one says "my bank account", they are referring to the business account, not to their personal account. In addition, all accounts referred to in bookkeeping belong to the business, not to other businesses, regardless of their title. For instance, if my business expects to receive money from another person or company and the account is labeled "Receivable A", this does not imply that the account in question belongs to “Receivable A”. It is merely a recording of a current asset (a receivable) of one's own business. When assessing any transaction, the transaction is from the point of view of one's own business.

Any account can be classified as one of the five types of accounts (accounting elements). For instance, a business usually has more than one asset account. An essential asset account in any business is the bank account. Another common account be a "property" account. The same applies to liability accounts i.e. if I have borrowed money from two sources (called creditors or payables), then I must open two accounts to represent this present liability, called 'Creditor/Payable A' and 'Creditor/Payable B'. In this manner I may have multiple, different accounts. But because they are all classified as one of the five types of accounts, my entire business can be described in terms of its assets, expenses, liabilities, income and equity/capital (see extended accounting equation). Nothing more or less. This is the extent of "my" business in relation to accounts, regardless of the business' practices (the business may be a retail franchise, furniture shop, restaurant etc...). With respect to my business, each of the five accounting elements will have a monetary value, and this can be used to assess the financial position of my business at any time (my success, failure, or any other attributes that I might need to know).

Traditionally, transactions are recorded in two separate columns of numbers (known as a ledger or "T-account"): debit transactions in the left hand column and credit transactions in the right hand column. Keeping the debits and credits in separate columns allows each column to be recorded and totalled independently. Accounts within the general ledger are known colloquially as "T-accounts" due to the "T" shape that the table resembles. Each column of a ledger account lists transactions affecting that account.

Terminology

According to knol,[6] "debit" is:

  1. a written note on bank account or a other financial record of a sum of money owed or spent
  2. a sum of money taken from a bank account

According to wordnet,[7] "credit" is

  • money available for a client to borrow

Thus, in a non-accounting sense, "credit" is money that a creditor makes available to a client to borrow. However, "credit" in this sense is not an accounting term, although this word comes up regularly in business and therefore accounting. In the academic field of accounting (bookkeeping), such dictionary definitions are misguiding and the words "debit" and "credit" as used in accounting have little connection with the layman's understanding of "credit". This may seem confusing at first, but one will find when studying accounting that "debit" and "credit" are essential for the double-entry system of bookkeeping.

When recording numbers in accounting, a debit value is placed on the left side of a ledger for a debited account and a credit value is placed on the right side of a ledger for a credited account. A debit or a credit either increases or decreases the total balance in each account, depending on what kind of accounts they are.

Each transaction (say, of value £100) is recorded by a debit entry of £100 in one account and a credit entry of £100 in another account. When people say "debits must equal credits" they do not mean that the two columns of any T-account must be equal. If that were the case, every account would have a zero balance (no difference between the columns). The total debits equal the total credits when all accounts are totaled.

More than two accounts may be affected by the same transaction. A transaction for £100 can be recorded as a £100 debit in one account and as multiple credits that total £100 in other accounts.

Example

I owe creditors A and B £100 each. Thus my liability account for Creditor A has a credit balance of £100 and the same for Creditor B. I pay them off from my bank checking account, which from my point of view is an asset. I withdraw £200 from my bank account and split it to pay off the two liabilities. In my records, "Bank" is one account, "Creditor A" is another account, and "Creditor B" is a third account. The following transactions affect all three ledger accounts:

Dr: Creditor A (100)
Dr: Creditor B (100)
Cr: Bank (200)

When I write two checks totaling £200, the balance in my bank account is reduced by £200. In my records my "Bank" ledger account has an asset debit balance which is reduced by the credit for £200. Amounts in my records for the two creditors are liabilities which are reduced by the two debits totaling £200.

Therefore for this transaction, the total amount debited = 200 and the total amount credited = 200. When all three accounts are totaled, the total debits equal the total credits.

At the end of any financial period (say at the end of the quarter or the year), the total debits and the total credits for each account may be different and this difference of the two sides is called the balance. If the sum of the debit side is greater than the sum of the credit side, then the account has a "debit balance". If the sum of the credit side is greater, then the account has a "credit balance". If the two sides do equal each other (this would be a coincidence, not as a result of the laws of accounting), then we say we have a "zero balance".

Debit cards and Credit cards

Debit cards and credit cards are creative terms used by the banking industry to market and identify each card. From the cardholder's point of view, these terms are unrelated to the terms used in formal accounting. A debit card is used to make a purchase with one's own money. A credit card is used to make a purchase by borrowing money.[8]

However, from the bank's point of view, when a debit card is used to withdraw cash from a checking account, the withdrawal causes a decrease in the amount of money the bank owes to the cardholder. A decrease to the bank's liability account is a debit. Hence using a debit card causes a debit to a liability account in the bank. Likewise when a credit card is used by a cardholder to pay a merchant for something, that increases the amount the bank must credit to the merchant's checking account. This obligation is the bank's liability and an increase to a liability account is a credit. Hence using a credit card causes a credit to a liability account in the bank.

General ledgers

Definition: The general ledger is the term for the comprehensive collection of T-accounts. Before the advent of computerised accounting, manual accounting procedure used a book (known as a ledger) for each T-account. The collection of all these books was called the general ledger. Nowadays a 'ledger' can refer to a single spreadsheet on an accounting software system. The different ledgers can be saved under the same file (which will be called the 'general ledger').[citation needed]

"Day Books" or journals were used to list every single transaction that took place during the day, and the list was totalled at the end of the day. These day books did not use the double entry system because each book was either for debits or credits, not both. Negative amounts were recorded in red ink. This was simply a way of recording the transactions immediately, without taking time during the day to record transactions in their respective ledger accounts. Nowadays this is done with computer software that instantly updates each ledger account - for example, recording a cash receipt in a cash receipts journal and as a debit in a cash ledger account with a corresponding credit in the ledger account for which the cash was received. Not every single transaction need be entered into a T-account. Usually only the sum of transactions for the day is entered, so that each entry in the account has a different date.[citation needed]

The Five Accounting Elements

There are five fundamental elements[9] within accounting. These elements are as follows: Assets, Liabilities, Equity, Income and Expenses. The five accounting elements are all affected in either a positive or negative way. It is important to note that a credit transaction does not always dictate a positive value or increase in a transaction and similarly, a debit does not always indicate a negative value or decrease in a transaction. An asset account is often referred to as a "debit account" due to the account's standard increasing attribute on the debit side. The reasoning for an asset account being called a "debit account" is due to the fact that businesses usually purchase assets to be used in normal business activities; for example, the purchase of a "delivery vehicle". When an asset has been acquired in a business the transaction will affect the debit side of that asset account illustrated below:

Asset
Debits (dr) Credits (cr)
X  

Where "X" in the debit column denotes the increasing effect of a transaction on the asset account balance (total debits less total credits), because a debit to an asset account is an increase. The asset account above has been added to by a debit value X, i.e. the balance has increased by £X. Likewise, in the liability account below, the X in the credit column denotes the increasing effect on the liability account balance (total credits less total debits), because a credit to a liability account is an increase.

All "mini-ledgers" in this section show standard increasing attributes for the five elements of accounting.

Liability
Debits (dr) Credits (cr)
  X
Income
Debits (dr) Credits (cr)
  X
Expenses
Debits (dr) Credits (cr)
X  
Equity
Debits (dr) Credits (cr)
  X


Summary table of standard increasing and decreasing attributes for the five accounting elements:

ACCOUNT TYPE DEBIT CREDIT
Asset +
Liability +
Income +
Expense +
Equity +

Principle

Each transaction that the business makes consists of debits and credits. For every transaction the total debits must be equal to the total credits and therefore balance.

For Every Transaction: The Value of Debits = The Value of Credits

The basic accounting equation is as follows:

Assets = Equity + Liabilities
(A = E + L)

The extended accounting equation is as follows:

Assets + Expenses = Equity/Capital + Liabilities + Income
(A + Ex = E + L + I)

Both sides of these equations must be equal (balance).

When a transaction takes place, traditionally the transaction would be recorded in a ledger or "T" account. A "T" account represents any account that is opened e.g. "Bank" that can be effected with either a debit or credit transaction.

In accounting it is acceptable to draw-up a ledger account in the following manner for representation purposes:

Bank  
Debits (dr) Credits (cr)
   
   
   
   

Accounts pertaining to the five accounting elements

Accounts are created/opened when the need arises for whatever purpose or situation the entity may have. For example if your business is an airline company they will have to purchase airplanes, therefore even if an account is not listed below, a bookkeeper or accountant can create an account for a specific item, such as an asset account for airplanes. In order to understand how to classify an account into one of the five elements, a good understanding of the definitions of these accounts is required. Below are examples of some of the more common accounts that pertain to the five accounting elements:

Asset accounts

  • Cash, Bank, Receivables, Inventory, Land, Buildings (Plant), Furniture, Equipment, Vehicles, Machinery etc...

Liability accounts

  • Payables, debts, bank overdrafts, deposits owed to depositors, trust accounts, accrued expenses, etc...

Equity accounts

  • Capital, Drawings, Accumulated funds etc...

Income accounts

  • Services rendered, Sales, Interest income, Membership fees, Rent income etc...

Expense accounts

  • Telephone, Water, Electricity, Repairs, Salaries, Wages, Depreciation, Bad debts, Stationery, Entertainment, Honorarium, Rent, Fuel etc...

Example

Quick Services business purchases a computer for ₤500 for the receptionist, on credit, from ABC Computers. Recognize the following transaction for Quick Services in a ledger account (T-account):

Equipment (Asset)  
(dr) (cr)
500  
   
   
   

As the transaction is made on credit, the payable "ABC Computers" has not yet been paid. As a result, a liability is created within the entity’s records. Therefore, to balance the accounting equation the corresponding liability account is credited:

Payable ABC Computers (Liability)
(dr) (cr)
  500
   
   
   

The above example can be written in journal form:

Equipment 500

ABC Computers (Payable) 500

Note the indentation of "ABC Computers" to indicate that this is the credit transaction. It is accepted accounting practice to indent credit transactions recorded within a journal.

In the accounting equation form:

A = E + L
500 = 0 + 500 (The accounting equation is therefore balanced)

Further Examples

  1. A business pays rent with cash: you increase rent (expense) by recording a debit transaction, and decrease cash (asset) by recording a credit transaction.
  2. A business receives cash for a sale: you increase cash (asset) by recording a debit transaction, and increase sales (revenue) by recording a credit transaction.
  3. A business buys equipment with cash: You increase equipment (asset) by recording a debit transaction, and decrease cash (asset) by recording a credit transaction.
  4. A business borrows with a cash loan: You increase cash (asset) by recording a debit transaction, and increase loan (liability) by recording a credit transaction.
  5. A business pays salaries with cash: you increase salary (expenses) by recording a debit transaction, and decrease cash (asset) by recording a credit transaction.
  6. The totals show the net effect on the accounting equation and the double-entry principle where, the transactions are balanced.
Account Debit (dr) Credit (cr)
1. Rent 100
Bank 100
2. Bank 50
Sales 50
3. Equipment 5200
Bank 5200
4. Bank 11000
Loan 11000
5. Salary 5000
Bank 5000
6. Total (dr) 21350
Total (cr) 21350

"T" Accounts

The process of using debits and credits creates a ledger format that resembles the letter "T".[10] The term "T-account" is accounting jargon for a "ledger account" and is often used when discussing bookkeeping.[11] The reason that a ledger account is often referred to as a "T" account is due to the way the account is physically drawn on paper (representing a "T"). The left side (column) of the "T" for Debit (dr) transactions and the right side (column) of the "T" for Credit (cr) transactions.

Debits (dr) Credits (cr)
   
   
   
   
   

Contra account

All accounts have corresponding contra accounts depending on what transaction has taken place i.e. when a vehicle is purchased using cash, the asset account "Vehicles" is debited as the vehicle account increases, and simultaneously the asset account "Bank" is credited due to the payment of the vehicle using cash. Some balance sheet items have corresponding contra accounts, with negative balances, that offset them. Examples are accumulated depreciation against equipment, and allowance for bad debts against long-term notes receivable.

Real, personal, and nominal accounts

Real accounts are assets. Personal accounts are liabilities and owners' equity and represent people and entities that have invested in the business. Nominal accounts are revenue, expenses, gains, and losses. Accountants close nominal accounts at the end of each accounting period.[12] This method is used in the United Kingdom, where it is simply known as the Traditional approach.[3]

Transactions are recorded by a debit to one account and a credit to another account using these three "golden rules of accounting":

  1. Real account: Debit what comes in and credit what goes out
  2. Personal account: Debit the receiver and Credit the giver
  3. Nominal account: Debit all expenses & losses and Credit all incomes & gains
Debit Credit
Real (assets) Increase Decrease
Personal (liability) Decrease Increase
Personal (owner's equity) Decrease Increase
Nominal (revenue) Decrease Increase
Nominal (expenses) Increase Decrease
Nominal (gain) Decrease Increase
Nominal (loss) Increase Decrease

See also

Emblem-money.svg Business and economics portal

References

  1. ^ "Debit Credit Rules". Accounting Explained. AccountingExplained.com. http://accountingexplained.com/financial/introduction/debit-credit-rules. Retrieved 4 August 2011. 
  2. ^ Pieters, A. Dempsey, H. N. (2009). Introduction to financial accounting (7th ed. ed.). Durban: Lexisnexis. ISBN 9780409105803. 
  3. ^ a b Accountancy: Higher Secondary First Year (First ed.). Tamil Nadu Textbooks Corporation. 2004. pp. 28–34. http://www.textbooksonline.tn.nic.in/Books/11/Std11-Acct-EM.pdf. Retrieved 12 July 2011. 
  4. ^ "Peachtree For Dummies, 2nd Ed.". http://media.wiley.com/assets/267/34/559672_BC05.pdf. Retrieved 6 Feb 2011. 
  5. ^ "Basic Accounting Concepts 2 - Debits and Credits". http://knol.google.com/k/basic-accounting-concepts-2-debits-and-credits#. Retrieved 6 Feb 2011. 
  6. ^ "Basic Accounting Concepts 2 - Debits and Credits". http://knol.google.com/k/basic-accounting-concepts-2-debits-and-credits#. Retrieved 6 Feb 2011. 
  7. ^ Wordnetweb.princeton.edu
  8. ^ "Accounting made easy 4 - Debits and Credits". http://www.youtube.com/watch?v=gaZiAiETW_Y. Retrieved 13 March 2011. .
  9. ^ Pieters, A. Dempsey, H. N. (2009). Introduction to financial accounting (7th ed. ed.). Durban: Lexisnexis. ISBN 9780409105803. 
  10. ^ Weygandt, Jerry J. (2009). Financial Accounting. John Wiley and Sons. p. 53. ISBN 9780470477151. 
  11. ^ Cusimano, David. "Accounting Abbreviations - Helping You Understand Accounting Jargon". Loughborough. http://www.inloughborough.com/report/000689/accounting%20abbreviations%20-%20helping%20you%20understand%20accounting%20jargon%20,%20explanation%20of%20t-account,%20debit%20and%20credit,%20and%20double-entry%20accounting%20system,%20what%20is%20the%20difference%20between%20bookkeeping%20and%20acc. Retrieved 18 August 2011. 
  12. ^ "Account Types or Kinds of Accounts :: Personal, Real, Nominal". http://www.futureaccountant.com/accounting-process/study-notes/financial-accounting-account-types.php. Retrieved 2011-04-08. 

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