Debits and credits
Encyclopedia
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) means left side of a ledger account and "Cr" (Credit) is the right side of a ledger account.
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. 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.
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.
'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.
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.
(a receivable) of one's own business. Therefore, when assessing any transaction, the transaction is from the point of view of one's own business.
All accounts must first be classified as one of the five types of accounts (accounting elements). To determine how to classify an account into one of the five elements, the definitions of the five account types must be fully understood i.e. the definition of an asset
according to IFRS is as follows: An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity . To understand this definition we can break it down into its constituent parts with an example:
A business will most often have more than one asset account. An essential asset account in any business is the businesses bank account (see: "Accounts pertaining to the five accounting elements" below for more examples) 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. However all these accounts are all classified as one of the five types of accounts, therefore my entire business can be described in terms of its assets, expenses, liabilities, income and equity/capital (see extended accounting equation
). 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.
In a non-accounting sense, according to knol
, a "debit" is:
In a non-accounting sense, according to wordnet
, "credit" is
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 "debit" and "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 ledger account must be equal. If that were the case, every account would have a zero balance (no difference between the columns) which is often not the case. The rule that total debits equal the total credits applies when all accounts are totalled.
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:
When I write two cheques totalling £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 totalling £200.
Therefore for this transaction, the total amount debited = 200 and the total amount credited = 200. When all three accounts are totalled, 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".
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 checking (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 when the check clears. 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.
"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 daybooks did not use the double entry system because each book was for either debits or credits. 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.
, 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:
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.
Summary table of standard increasing and decreasing attributes for the five accounting elements:
For Every Transaction: The Value of Debits = The Value of Credits
The basic accounting equation
is as follows:
The extended accounting equation
is as follows:
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:
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:
The above example can be written in journal
form:
The journal entry "ABC Computers" must be indented to indicate that this is the credit transaction (not accurately shown here due to restrictions). 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)
Transactions are recorded by a debit to one account and a credit to another account using these three "golden rules of accounting":
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
. Their use and implication is the fundamental concept in the double-entry bookkeeping system
Double-entry bookkeeping system
A double-entry bookkeeping system is a set of rules for recording financial information in a financial accounting system in which every transaction or event changes at least two different nominal ledger accounts....
, 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
Bookkeeping
Bookkeeping is the recording of financial transactions. Transactions include sales, purchases, income, receipts and payments by an individual or organization. Bookkeeping is usually performed by a bookkeeper. Bookkeeping should not be confused with accounting. The accounting process is usually...
, "Dr" (Debit) means left side of a ledger account and "Cr" (Credit) is the right side of a ledger account.
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. 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.
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
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
. 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 PacioliLuca Pacioli
Fra Luca Bartolomeo de Pacioli was an Italian mathematician, Franciscan friar, collaborator with Leonardo da Vinci, and seminal contributor to the field now known as accounting...
'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
Renaissance
The Renaissance was a cultural movement that spanned roughly the 14th to the 17th century, beginning in Italy in the Late Middle Ages and later spreading to the rest of Europe. The term is also used more loosely to refer to the historical era, but since the changes of the Renaissance were not...
by Venetian merchants, traders and bankers. This system is still the fundamental system in use by modern bookkeepers.
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.
Understanding
When dealing with one's own business, one must set up various accounts to record all transactions that may take place. When the owner of a business refers to their 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 assetCurrent asset
In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months...
(a receivable) of one's own business. Therefore, when assessing any transaction, the transaction is from the point of view of one's own business.
All accounts must first be classified as one of the five types of accounts (accounting elements). To determine how to classify an account into one of the five elements, the definitions of the five account types must be fully understood i.e. the definition of an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
according to IFRS is as follows: An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity . To understand this definition we can break it down into its constituent parts with an example:
- Example: Classify what type of account the business "Bank account" is.
- The bank account of a business is "a resource controlled by the entity" as it belongs to the business. "As a result of past events" such as the opening of the business. "From which future economic benefits are expected to flow to the entity" - a business such as a grocery store can expect to make money due to the sale of their goods. This basic analogy can be applied to any asset account.
- All accounts have their own definitions (which is discussed in other articles see: assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
, liabilityLiabilityA liability can mean something that is a hindrance or puts an individual or group at a disadvantage, or something that someone is responsible for, or something that increases the chance of something occurring ....
, equityEquityEquity is the name given to the set of legal principles, in jurisdictions following the English common law tradition, that supplement strict rules of law where their application would operate harshly...
, incomeIncomeIncome is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
and expenseExpenseIn common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
) that must be fully understood in order to classify an account correctly.
A business will most often have more than one asset account. An essential asset account in any business is the businesses bank account (see: "Accounts pertaining to the five accounting elements" below for more examples) 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. However all these accounts are all classified as one of the five types of accounts, therefore my entire business can be described in terms of its assets, expenses, liabilities, income and equity/capital (see extended accounting equation
Accounting equation
The basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.In a corporation, capital represents the stockholders' equity.-In practice:...
). 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
The words debit and credit are both used differently depending on whether they are used in an accounting sense, or non-accounting sense.In a non-accounting sense, according to knol
Knol
Knol is a Google project that aims to include user-written articles on a range of topics. The project was led by Udi Manber of Google, announced December 13, 2007, and was opened in beta to the public on July 23, 2008 with a few hundred articles mostly in the health and medical field.Knol has no...
, a "debit" is:
- a written note on bank account or a other financial record of a sum of money owed or spent, or
- a sum of money taken from a bank account.
In a non-accounting sense, according to wordnet
WordNet
WordNet is a lexical database for the English language. It groups English words into sets of synonyms called synsets, provides short, general definitions, and records the various semantic relations between these synonym sets...
, "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 "debit" and "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 ledger account must be equal. If that were the case, every account would have a zero balance (no difference between the columns) which is often not the case. The rule that total debits equal the total credits applies when all accounts are totalled.
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 cheques totalling £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 totalling £200.
Therefore for this transaction, the total amount debited = 200 and the total amount credited = 200. When all three accounts are totalled, 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.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 checking (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 when the check clears. 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 (so called because there was a preprinted vertical line in the middle of each ledger page and a horizontal line at the top of each ledger page, like a large letter T). 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 spread sheet on an accounting software system. The different ledgers can be saved under the same file (which will be called the 'general ledger')."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 daybooks did not use the double entry system because each book was for either debits or credits. 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.
The Five Accounting Elements
There are five fundamental elements within accounting. These elements are as follows: Assets, Liabilities, EquityEquity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
, Income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
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
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
and similarly, a debit does not always indicate a negative value or decrease in a transaction. An asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered 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
Accounting equation
The basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.In a corporation, capital represents the stockholders' equity.-In practice:...
is as follows:
- Assets = Equity + Liabilities
The extended accounting equation
Accounting equation
The basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.In a corporation, capital represents the stockholders' equity.-In practice:...
is as follows:
- Assets + Expenses = Equity/Capital + Liabilities + Income
Both sides of these equations must be equal (balance).
When a transaction takes place, traditionally the transaction would be recorded in a ledger
Ledger
A ledger is the principal book or computer file for recording and totaling monetary transactions by account, with debits and credits in separate columns and a beginning balance and ending balance for each account. The ledger is a permanent summary of all amounts entered in supporting journals which...
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, Trademarks and patents, Goodwill etc...
Liability accounts
- Payables, debts, bank overdrafts, deposits owed to depositors, trust accounts, accrued expenses, 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
Journal
__FORCETOC__A journal has several related meanings:* a daily record of events or business; a private journal is usually referred to as a diary....
form:
| dr | cr | |
|---|---|---|
| Equipment | 500 | |
| ABC Computers (Payable) | 500 |
The journal entry "ABC Computers" must be indented to indicate that this is the credit transaction (not accurately shown here due to restrictions). It is accepted accounting practice to indent
Indent
Indent has several meanings:*In computing, indent is a computer program that formats C programming language files with a particular indent style...
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
- A business pays rentRentingRenting is an agreement where a payment is made for the temporary use of a good, service or property owned by another. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from landowners...
with cash: you increase rent (expense) by recording a debit transaction, and decrease cash (asset) by recording a credit transaction. - 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.
- A business buys equipment with cash: You increase equipment (asset) by recording a debit transaction, and decrease cash (asset) by recording a credit transaction.
- A business borrows with a cash loanLoanA loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
: You increase cash (asset) by recording a debit transaction, and increase loan (liability) by recording a credit transaction. - A business pays salaries with cash: you increase salarySalaryA salary is a form of periodic payment from an employer to an employee, which may be specified in an employment contract. It is contrasted with piece wages, where each job, hour or other unit is paid separately, rather than on a periodic basis....
(expenses) by recording a debit transaction, and decrease cash (asset) by recording a credit transaction. - 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". The term "T-account" is accounting jargon for a "ledger account" and is often used when discussing bookkeeping. 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. This method is used in the United Kingdom, where it is simply known as the Traditional approach.Transactions are recorded by a debit to one account and a credit to another account using these three "golden rules of accounting":
- Real account: Debit what comes in and credit what goes out
- Personal account: Debit the receiver and Credit the giver
- 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 |
External links
- Debits and Credits
- YouTube Presentation - A valuable explanation in an audio/visual format