“Debit and Credit” – Upon this Rock, the House of Accountancy was built!
14 Nov, by
Based on the profound thoughts, original ideas, and educated analysis of Michael Matthew Lee:
The Fundamental Questions
This paper addresses the age-old questions of
- What are debits and credits?
- How do we determine whether a transaction is a debit or credit?
“Debit and credit” as a whole is the foundation stone for bookkeeping, accounting and finance.
Most non-accountants are fearful of accounting because of the lack of understanding of debits and credits, and using them, how transactions are recorded to arrive at the financial position of an enterprise. To them, accounting becomes a mystery …..
Accountants may not know how to explain debits and credits, but through practice, we know whether a transaction is a debit or credit – we learn by heart. Like the French language, every item or thing is either a male or female, and how do they determine that? They also learn by heart.
What are debits and credits?
There are always 2 sides in any transaction, eg buy a van, pay cash; sell a product, receive cash.
The double entry system (consistent with 2 sides of a transaction) started long ago in Italy when trade and commerce was widespread. Over time, for recording purposes, the 2 sides of a transaction came to be known as debit and credit.
In those early days, ventures were short-term; parties put in their capital (cash or other assets) in a pool and after the venture when the pool of resources increased, they share out the profits.
As ventures became more complicated, the pool of resources was vested in an entity (and now the entity owns the assets (operating resources) and owes the venturers for those assets (funding resources) including any accretion (profits from the venture). The entity will need to balance the funding resources and the operating resources in a Balance Sheet, which is a sheet of paper to show the balancing of
- Equity and liabilities or funding resources, and
- Assets or operating resources (typically, fixed assets and working capital).
Diagrammatically, it is shown as follows:
Establishing 3 critical concepts
The first critical concept is that all assets, capital and liabilities are referenced to the entity ie from the entity’s point of view (The 1st concept – the entity as reference point).
Then we need to establish whether “assets’ or “equity and liabilities” should be called debits. It was determined long ago that “assets” are to be “Debits” and so “equity and liabilities” are “Credits” (The 2nd concept – asset as debit).
The idea of “Good” and “Not So Good” from entity’s point of view
As assets are owned by the entity, assets are “Good” from the entity’s point of view. Therefore, equity and liabilities are “Not So Good” (NSG) because the entity owes the shareholders (for the equity or capital and retained profits) and the banks (for the bank loans, etc).
Increases and decreases in debits and credits
As assets are debits and are good from the entity’s point of view, any increases in assets are therefore debits. However, any decreases in assets are “not so good” from the entity’s point of view and so decreases in assets are credits (NSG).
Likewise, capital and liabilities are credits and NSG from entity’s point of view. So, any increases in capital and liabilities are credits. Any decreases in capital and liabilities are good from entity’s point of view and are therefore debits. (The 3rd concept – increases and decreases)
The diagram is now enhanced as follows:
Steps in determining debit or credit in any transaction
A transaction has 2 sides or legs. Which leg is debit and which is credit must be taken from the entity’s point of view, always.
As illustrative, an entity purchases a van and pays $60,000 for it.
The 2 legs of the transaction are:
- Purchase of a van
Entity owns the van, an asset. It is good for the entity and therefore, from entity’s point of view, we debit “Van” for $60,000.
- Pays cash $60,000
Cash is an asset and so it should be a debit. But it is a decrease in cash and therefore, “not so good” from entity’s point of view. So, we credit (NSG) Cash for $60,000.
|1)||The transaction is always taken from the Entity’s point of view (The 1st concept – the entity)|
|2)||Question 1; What are the 2 legs of the transaction?|
|Question 2: For each leg, is it Asset or Equity/Liability? (The 2nd concept; asset as debit)|
|Question 3: For each leg, is it an increase or decrease? (The 3rd concept – increases and decreases)|
|3)||You can then determine whether each leg is a Debit or Credit (with reference to the diagram).|
How about revenue and expenses?
Most non-accountants cannot reconcile why sales (which is good) is a Credit, and assets (which are also good) is a Debit. This is because they consider sales from their own point of view, not from the entity’s. From the entity’s point of view, retained earnings (profits arising from yearly operations) belong to the shareholders. The entity owes the shareholders, and so retained earnings is “not so good” and therefore, a credit. But retained earnings originate from revenue (sales) and so the revenue (sales) must also be a credit, from the entity’s point of view.
Expenses, on the other hand, “reduces” revenue (sales) and therefore is “good” as the entity owes less to the shareholders. From the entity’s point of view, expenses are therefore debits.
As illustrative, an entity sells a product to a customer on credit for $1,000.
The 2 legs of the transaction are:
- Sales of product, $1,000
Sales is “not so good” from the entity’s point of view (as explained above) and so we credit sales for $1,000.
- Customer owes entity $1,000
Accounts Receivable (owings by customer to entity) is an asset and is good. It is therefore a debit. So we debit Accounts Receivable $1,000.
The complete diagram for this analysis is as follows:
While debits and credits appear basic and simple to the accountant, their explanation and determination are not. This paper provides the explanation and guidelines in treating the 2 legs of a transaction as debit or credit.
I hope it now makes good sense in rationalising what appears to be “mysterious” to non-accountants and accountants alike.
——————————-M M Lee Sept 2018—————————