Debate on debit and credit:
The concept of Debit and credit are one of the important and fundamental concepts in accounting. They are very basic and simple yet they are the most confusing terms for someone who has started to learn accounting. Even many professional accountants are confused with the these terms. They simply apply the rules without proper understanding about them. The main reason for this is, wrong understanding about the meaning of debit and credit. If you are new to accounting I recommend you to start from Accountancy an Overview for Non Accountants.
Reason for the confusion:
- Misconception about the meaning of debt with debit and meaning of creditors with credit.
- In general we think that debit means “we are giving the money or reducing” and credit means “we are receiving the money or increasing”.
Take an example: When a customer receives a credit in his bank account he thinks he received money. So credit means receiving money right?. Actually it is not correct, the reason is we forget to note from whose perspective it is mentioned as credit. It is from bank’s perspective, they are giving their cash to customer’s account. So from Bank’s perspective the customer’s account is credited.
Therefore what mentioned in his passbook or statement is from bank’s perspective. As a business owner the customer has to think from his business point of view for any transaction related to his business. So the same transaction is accounted differently in his books of accounts i.e the bank account in his book is debited (increased) and his cash account will be credited (decreased).
If you have the above mentioned misconceptions with you about debit and credit. Please erase it from your memory before reading further.
Then what is Debit and what is Credit?
Debit and credit are the fundamental effects in any financial transaction which uses double entry system of book-keeping. From mathematical point of view debit means “adding positive value to an account” and credit means “subtracting value from an account or adding negative value to an account“. They are denoted as DR (Debit) and CR (Credit) in the accounting books.
If you remember the number system, whole numbers consists of positive integers and negative integers. Compare the Dr with ” + ” sign of positive integers and Cr with ” – ” sign of the negative integers. In simple language and understanding “A Debit adds a positive number and a Credit adds a negative number but without a minus sign before it”.
Double Entry Bookkeeping:
The concept of Debit and Credit is more or less like Newton’s third law of motion in double entry system. That is every debit (action) has an equivalent credit (opposite reaction) in any transaction. Whenever you record an transaction, one account is debited and another account (or group of account with similar nature) should be credited. Also the amount of the debit must equal to the (total) amount of the credit. This is called double-entry bookkeeping.
In double entry system of accounting you have two columns for entering your transactions. It is a tradition to mention the Debit (Dr) in the left side column and Credit (Cr) on the right side column. There is a reason for entering the Dr and Cr entries in different columns.
Lets say you write both increasing value (Positive) and decreasing value (Negative) of an account in the same column. While tallying the accounts you may wrongly add or subtract a value which leads to manual error. So to avoid this, entries that are intended to increase the value (Dr) and which are intended to decrease the value (Cr) of an account are mentioned in separate columns. This way of organising the data saves the accountants energy and time.
Rules for Debit and Credit:
To fully understand the rules for debit and credit , we must know about the different categories and classification of accounts. The are five categories of account. They are detailed in the below mentioned table.
Since some of the accounts are either in Debit balance or in Credit balance, the net effects of Debit (adding positive value) and Credit (adding negative value) is varies.
Why some accounts are in Debit Balance and some are in Credit Balance?
We already saw every transaction will have debit in one account and a Credit of equal value in another account. So some accounts may receive more debits than credits which leads to Debit balance in an account and vice versa for Credit balance in an account. Hence account which are having positive values are Debit Balance account and accounts which are having negative values are Credit balance accounts.
- Moreover some accounts represent liabilities of the business. So the business has to pay them in future. So they will be in Credit Balance.
- The asset accounts are always positive since they are valuable possessions and tracks of the cash.
- Expenses are viewed positive because they help the firm to run the business. Hence they are always in Debit balance.
- While Incomes are viewed negative because it should be paid to the Owner so it is a kind of liability.
|S.NO||Category of Account||Balance standing in Dr or Cr||Net Effects of Debit and Credit|
What the company owns such as Cash, Accounts Receivable, furniture, vehicles, etc,.
|Debit Balance (Positive value)||Remember Algebra Basics and Number Line.
What the company needs to repay to others such as, loans, Accounts Payable, outstanding expenses, etc,
|Credit Balance (Negative value)||
Networth or Equity/Owner’s Capital:
The owner’s fund in the business. It also a liability the company needs to pay to his owner. So it is also in Credit balance
|Credit Balance (Negative value)||
Money company is earning. It is always in credit balance this is because the net income /revenue is added to the Owner’s Equity of the company. So it is a liability the company needs to pay his owner.
|Credit Balance (Negative value)||
Money company spends.
|Debit Balance (Positive Value)||
Three main Classification of accounts:
There are three different types of accounts classified based on its nature. The golden rules of debit and credit for each type of account is mentioned in the table.
|Type of Account||Rule for Debit and Credit||Application|
Accounts that represents a person or an organisation
|Eg: Consider your business makes payment to someone by cheque. In its books you debit the someone’s account (receiver) and Credit your bank account (Giver).
Accounts which represents assets
||Eg: Lets say you buy a Machinery. Then you create a machinery account and it is debited (new Machinery comes in). Then you credit the cash account (amount goes out).
Accounts that represents all expenses and incomes as well as profit and loss.
If you fully understand the above, you will find it easier to decide which accounts need to be debited and which accounts need to be credited. Also note that the net increase or decrease of an account is also depends upon the debit balance or credit balance of the account. If you know the concepts of number line in basics mathematics you can just take an analogy of them and apply the same here.