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Unlocking the secret of Debit and Credit

Updated on September 4, 2015
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Introduction

We all have heard this statement, for every debit there is a credit. And yes we see this statement at work and see it proving itself when a trial balance tallies or when both sides of balancesheet settle themselves at an equal amount. But why for every debit there is a credit? What is the mystery behind it? And at last what do the terms debit and credit mean? To answer these questions we have to understand some basic terms and concepts of accounting. So let us proceed by exploring some of the fundamental ideas on which the system of accounting is based.

What is an account?

To account something is to record it. A business entity records the data relating to:

a. Financial resources it has received or paid- by opening accounts such as assets.

b. Persons to whom it has an obligation to pay or persons from whom it has the right to receive- by opening accounts such as capital, liability and debtors.

What is a financial transaction?

Transaction is the exchange of value between two or more financial entities. It also means an agreement to exchange value.

According to Publilius Syrus- “a thing is worth whatever the buyer will pay for it”. Value of a thing is the bundle of benefits expected from it. It is the maximum amount that a buyer will pay for enjoying the benefits from a good or service. In accounting we measure the financial information in terms of money. Since money has no universal denomination, transactions are recorded in the currency of the country in which the business organization operates. Value of money is not stable; its purchasing power varies with time. But it is the best alternative we have to measure value.

As it is said above, value is the benefit expected and we know that expectation varies from person to person. So ultimately, value is subjective. It is here business plays its role. A business is nothing but a mechanism of value management. A businessman purchases row materials, goods, avail services from those persons or entities for whom these things worth less and sell them to other persons or entities to whom these things worth more. In this way he pockets the difference in value.

Financial entities

These are the participants of a financial transaction. They can be real persons or artificial persons. For example, starting a business by investing a capital of $10000 is a financial transaction, in which the participants are owner and business entity.

Relevant concepts

These are some of the most important concepts that should be understood before recording a transaction.

Entity concept: In accounting we treat business and owner as separate entities. All the transactions are recorded form the perspective of business entity. It is because of this concept we treat the capital contributed by the owner as a claim on business entity.

Going concern concept: it means the business entity will continue to operate for a foreseeable future. This concept affects our valuation of assets. Short term fluctuations in the value of the assets are to be ignored because of this concept.

Periodicity concept: The primary objective behind doing a business is to maximize the value that is invested in the business. In going concern concept we take the life of enterprise as infinite. But we are also interested in knowing how our business is performing. We cannot measure the performance of the business at the end of its life. So we have to divide its infinite life into shorter periods. Generally we take it as one year, at the end of which we prepare financial statements to ascertain the performance of the business. This concept helps us to identify revenue and capital expenditure, revenue and capital receipts, assets and liabilities of that period.

Accrual concept: This concept cannot exist without periodicity concept. This concept states that revenue and expenses are to be recognized in the period to which they relate or occur irrespective of whether there is actual cash inflow or outflow. Because of this concept we have liabilities or assets relating to expenses and incomes. For example, if an expense related to current year is not paid, at the end of the accounting year we have to recognize it in the current year as an obligation to pay. So we recognize it as an expense of this year and simultaneously recognize it as a liability by opening an account called expense outstanding.

Matching Concept: This concept depends on accrual and periodicity concept. It says the revenue of the period should be matched with the items of expenses used to generate such revenue.So if you have purchased 1000 units of a product and sold only 700 units of it, then revenue from 700 units should be matched with the expenses to acquire 700 units. This concept helps us to ascertain the profit or loss for the accounting period.

Five accounts

Asset: It is a resource controlled by a business entity, arising out of past events, from which future economic benefits are expected to flow to the enterprise.

Liability: It is an obligation of business entity, arising out of past events, the settlement of which, will result in an outflow of business resources.

Capital: It is the resources contributed by the owner in the business. It represents the claim of the owner on the business entity.

Expenses: It is further classified into two types- capital and revenue. Expenses are goods or service or any other item acquired for the day to day operations of business, benefits of which do not extend beyond one accounting period. Items of expenses are used to generate revenue. This is the benefit they provide. On the other hand capital expenses are classified as asset or addition to assets. So usually expenses mean revenue expenses.

Incomes: It is also classified into revenue and capital. Revenue incomes are the value received (usually in the form of money) by the business entity from its ordinary course of business. Revenue is earned from (a) using the items of expenses i.e. – sale of goods, rendering of services (b) use by others the economic resources of entity i.e. -interest, royalty, dividend received. Capital incomes are those which are not revenue income.

So these are the five broad categories to record the transactions. But how these accounts are derived and why there is only five basic accounts, not two or ten? These are derived from common sense. Follow this illustration: you have $10000 at your home. Instead of keeping it idle you want to invest it in a business. So you started a business. From an accounting perspective, the moment you have started the business you have given your money to an artificial person (business). So the artificial person owes this money to you and you have a claim on this money. So we have a transaction between you and the artificial person. You have transferred some value (money) and the business entity has received it. Suppose, later, you have borrowed some money, on behalf of business, from your friend to invest in the business. It is a transaction between your friend and the business entity. So how do the business entity records these transactions? To record these transactions it must have the accounts of:

a. the resources received by it and

b. the persons from whom it has received such resources


Account of the owner is called
Capital account
Account of the lender or creditor is called
Liability account
Account for the resources received is called
Asset account
Source

So you saw how and why the above three accounts are contemplated. Does it need the other two accounts? Of course it needs them. See how. We know that business is not a static entity. It puts your resources in motion. It manages the value received by it with the sole objective to increase it. So it performs various activities like purchase, sale, production, distribution, promotion etc.

In the course of business, value invested by you may increase or decrease.You know that you, the owner, bear all the risk associating with the business. Your friend who has lent his money will walk away with his money even if the business has a decrease in its resources. So if there is a decrease in value you have to suffer it. Since you take all the risks you deserve all the reward created by the business after paying to your friend his limited portion of reward (interest).

There is a need for the business to keep track of the factors that are responsible for the increase or decrease in your account, to manage the resources invested by you in an efficient way. The factors which contributes toward the decrease of your capital are called expenses and the factors which contributes towards the increase in your capital are called incomes.They represent the variation in your account. So an income increases the owing of business towards owner and an expense decreases the owing towards owner.Rather than reducing capital account for each item of expense and increasing capital account for each item of income it transfers all the income and expense accounts to a separate account called profit and loss account or statement. Then it matches the total of expense with total of income and transfer the balance to the capital accounts.

Debit and Credit:

Simply speaking debit is the left hand side of an account and credit is the right hand side of the account. These are the labels to identify the increase or decrease in an account.

Traditional vs. modern approach

There are two approaches to record a transaction.

Traditional approach: It divides the accounts into three types: Personal, Real and Nominal. Personal accounts represent real and artificial persons, real accounts represent assets and nominal accounts represents incomes and expenses. Rules for these accounts are:

Personal accounts: Debit the receiver, Credit the giver.

Real accounts: Debit what comes in, Credit what goes out.

Nominal accounts: Debit all expense and losses, Credit all incomes and gains.

There are times when traditional approach fails to explain a transaction. For example, consider the entry for bad debts. Bad debt is a nominal account as it is a loss. Debtor is a personal account. The journal entry for this transaction is: Bad debt account debited to Debtor account credited. Now try to explain this journal entry through the traditional approach. You have debited the bad debt account because it is a loss but why do you credit the debtor? According to the rules of personal account you can only credit the giver. Bad debt has occurred because the debtor hasn’t given you back the money owed by him to you and you are showing him as a giver? Traditional approach fails here.

Modern approach

The modern approach is very helpful to construct a journal entry. It doesn’t suffer from the drawbacks of Traditional approach. It has five basic accounts.

Accounts
Increase
Decrease
Asset
Debit
Credit
Liability
Credit
Debit
Capital
Credit
Debit
Income
Credit
Debit
Expenses
Debit
Credit
Source
Source

Meaning of Debit and Credit Unlocked

We know that there is no free meal for the business entity. Assets – liabilities- capital = Zero. When it receives some value, it gives some value or recognizes an obligation to give. When it gives some value, it receives some value or recognizes the right to receive. So it records: value it receives or gives and persons to whom it is obliged to give or the persons from whom it has the right to receive.


The accounting equation

Value claimed by the owner + Value claimed by the lender = Value controlled by the business entity.

Value owed by the business entity = Value controlled by the business entity

Capital + Liability = Assets

Capital + (income- expenses) + Liability = Assets

Capital + income + liability = Assets + Expenses

In modern approach Increase in the left hand side (L.H.S) of the equation is called credit and increase in the right hand side (R.H.S) of the equation is called debit. Similarly decrease in the L.H.S is called debit and decrease in the R.H.S is called credit. For every debit there is a credit because the accounting equation must not be disturbed. An increase in L.H.S either results in a decrease in L.H.S or increase in R.H.S. Similarly a decrease in L.H.S either results in an increase in L.H.S or decrease in R.H.S.

Debit = Increase in value controlled or decrease in value owed.

Credit = Increase in value owed or decrease in value controlled.

Accounts
Increase
Decrease
Assets
Increase in value controlled
Decrease in value controlled
Liability
Increase in Value owed
Decrease in value owed
Capital
Increase in value owed
Decrease in value owed
Incomes
Increase in value owed
Decrease in value owed
Expenses
Decrease in vaue owed
Increase in value owed

NOTE: Before recording a transaction always consider the relevant concepts we have discussed. Always remember:

1. All transactions are recorded from the perspective of business entity.

2. Business and owners are separate entities for accounting purpose.

Some examples

1. James started the business with $10000.

It increases the value controlled and simultaneously increases the owing of business towards owner. So cash (asset) account should be debited and capital account should be credited.

2. Business takes a loan of $1500 from Brady.

It increases the value controlled and simultaneously increases the owing towards the creditor. So cash account should be debited and liability (loan) account is to be credited.

3. Purchase of goods worth $500.

It is an expense. It decreases the value controlled by the business and simultaneously decreases the value owed towards the owner. The account of the factor which decreases the owing towards owner (purchases account) is debited and cash account is credited.

4. Sale of goods for cash $650.

It is an income. It increases the value controlled by the business and simultaneously increases the value owed towards the owner. The account of the factor which increases the owing towards owner (sales account) is credited and cash account is debited.

5. Bad debt of $200.

It is a loss. It decreases the value controlled by the business and simultaneously decreases the value owed towards the owner. The account of the factor which decreases the owing towards owner (bad debt account) is debited and debtor (asset) account is credited.

Conclusion: The concept of debit and credit is one of the most confusing topics in accounting. A sound understanding of these concepts will help you in the advanced stages of accounting. I hope this article has been helpful to you in understanding these intriguing concepts.


© 2013 Shubhasish Das

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      admasu agegnehu 22 months ago

      601659

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      Shubhasish Das 4 years ago

      m glad that you found the article easy to understand..

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      easy 4 years ago

      This is too easy