Understanding debits and credits
The cookbook is
suspended. This discussion (first half
of the chapter) is designed to be read from
start to end. Jumping in at the middle
will cause confusion.
Debits and credits XE "credits" XE "debits" are very simple. Debits go on the left, and credits go on the right. Debits and credits are not to be understood separately, because they are part of a system. They are movements between places. To comprehend the movements, you need to know the geography of the places. A bit metaphoric, perhaps, but a close analog for the confusion often associated with the “-it” words.
The accounting equation (from the owner’s viewpoint) is
Equity = Assets - Liabilities.
That is, the owners own
all the values of the assets, after
subtracting creditors claims. Putting
this same equation in balance sheet form,
Assets = Liabilities + Equity.
That is really a static equation. Accounting also uses a dynamic equation,
Income = Revenue - Expenses.
“Revenue” is a strict and
proper term for the account type that
QuickBooks calls “income”
accounts. QuickBooks is not alone in
this usage; it is common. In this
discussion only, the strict terminology will
be used. All of the rest of the book
follows the more usual terms, and calls these
“income” accounts.
The system can be
introduced by example. Here are some
transactions to start and run another
over-simplified business. To clarify
the example, all account types are named in
parentheses, behind the account
names. The owner invests a thousand
dollars in the business (that’s a lot of
money, for an imaginary company.)
DEBIT CREDIT
Cash in Bank (asset) $1000
Capital (equity) $1000
With this done, the balance sheet status is clear enough.
The business is a broker
of building cleaning services, who hires
others to clean buildings, and accepts the
risk of receiving or not receiving payment
from the building owners. However, the
first customer is running under Chapter 11,
and has to pay cash for everything. The
building is cleaned, for a fee of $200 cash.
DEBIT CREDIT
Cash in Bank (asset) $200
Cleaning Customer (revenue) $200
The actual cleaning is done by a subcontractor, who accepts credit.
DEBIT CREDIT
Purchased services (expense) $120
Accounts Payable (liability) $120
Whether the credit here
was to cash (reducing) or payables
(increasing the liability) the purchase of an
expense reduces net worth (equity.)
An Income Statement (Profit and Loss Report) can be prepared, using these transactions.
Income Statement
Revenue
Cleaning Customer $200
Total Revenue $200
Expense
Purchased Services $120
Total Expenses $120
Net Income $80
Closing the books is the
next step in this example, while it is still
simple. It is plain that the one
revenue account has a credit balance of $200,
and the one expense account has a debit
balance of $120. The first step in
closing the books is a major journal entry,
rolling all revenue and expense transactions
into an income account (the one income account.) Chapter 2 explained that revenue could be more descriptively called On-the-way-to-increase-equity, and expense would be On-the-way-to-decrease-equity.
Now they are doing that. Note that the
amount of the credit to Net Income is taken
from the income statement, and it balances
this transaction.
DEBIT CREDIT
Cleaning Customer (revenue) $200
Purchased services (expense) $120
Net Income (income) $80
All of the revenue and
expense accounts have been reduced to zero,
and the resulting net income is rolled into
the Net Income account. Following this
concept, this is the one and only “income”
account. Then the Net Income is moved
to the Capital (owner’s equity) account:
DEBIT CREDIT
Net Income (income) $80
Capital (equity) $80
The books are closed, and a Statement of Financial Position (Balance Sheet) may be prepared:
Assets Liabilities
Cash in Bank $1200 Accounts Payable $120
Total Liabilities $120
Equity
Capital $1000
Retained Earnings 80
Total Equity $1080
Total Assets $1200 Total Liabilities and Equity $1200
The Balance Sheet is in
balance, because credits equalled debits in
every transaction, and every transaction
adhered to the following rules about use of
debits and credits:
Dr Increases asset and expense accounts
Decreases liability, revenue, expense, and income accounts
Cr Increases liability, revenue, expense, and income accounts
Decreases asset and expense accounts.
These same rules can be stated in a different format:
|
Increase
|
Decrease
|
Asset
|
Dr
|
Cr
|
Expense
|
Dr
|
Cr
|
Liability
|
Cr
|
Dr
|
Equity
|
Cr
|
Dr
|
Revenue
|
Cr
|
Dr
|
Income
|
Cr
|
Dr
|
The term “revenue” will not be used again, and “income” will be used for those accounts. The proper
“income” type account is not used in QuickBooks. Note that it was used here only for one account with two
transactions.
|