Debit and Credit, are key parts of any accounting entry. These are the fundamental “effect” of each financial transaction. For maintaining correct accounting records, you must have full knowledge of what is Debit and what is Credit.
In the double entry system of book keeping, you have two columns for entering your transactions. It is a basic understanding that an entry to the left side column is Debit and an entry to the right side column is Credit. Debit & Credit are shortly mentioned as Dr. and Cr. respectively. Any kind of transaction has two effects. So for every debit there is a corresponding credit of equal amount. In order to understand debit and credit entries, it is important to understand what are the different account types and rules for debit and credit in each account type apart from a clear idea on five accounting elements.
Debit and Credit Rules for 3 Different Account Types
There are three “Account Types”. All accounts have been classified into either of Real, Personal or Nominal accounts. The rules for entering transactions into these groups of accounts are as follows:
Debit what comes in and credit what goes out – Real Accounts
Real accounts constitute all assets like Building, Land, Road, Machinery, Plants, Constructions, Furniture and other Equipments. When they are purchased you debit the respective account with the amount. When it is sold or removed, you credit the account with its value.
Debit the receiver and Credit the giver – Personal Accounts
Personal accounts constitute the accounts of an owner, partners, shareholders (Capital and Drawings Account), customers and suppliers (Debtor or Creditor) etc. When a payment is made to somebody, you debit the receiver of that payment and credit Cash or Bank as money is paid from cash or by means of cheque. When money or cheques are received, you credit the person who is paying you and you debit the cash or bank.
Debit all expenses and losses – Nominal Accounts
Credit all incomes and gains. Nominal accounts constitute all expenses and income accounts and also profit or loss. You debit the expenditure account whenever some expenditure is incurred and credit the income account whenever income is received. Income accounts include interest received, rent received, and profit or surplus, etc.
Understanding Five Accounting Elements
Modern accounting equation principle consists of five accounting elements. They are Assets, Liabilities, Income or Revenue, Expense, and Equity or Capital.
All financial transactions are classified according to their nature of the transaction and grouped into the above five groups of accounts. Let us have a basic concept of these elements to properly understand the accounting rule of debit and credit.
- Assets: Assets have debit balance. They constitute company’s movable and immovable property and goods. They include items of Cash balance and Bank balance also in addition to vehicles, buildings, furniture and bills receivable and interest receivable etc. All these items add to the asset of business. When some asset is sold, it is posted on the credit side of the account.
- Liabilities: Liabilities have a credit balance. They indicate the amount payable by the company to creditors such as bills payable, loans, overdraft, etc.
- Equity/ Capital: Capital refers to the paid-up capital of the company. This constitutes the company’s fund invested in business. It is a liability because it has been taken from the owner / shareholders of the company. It will always have a credit balance.
- Income/ Revenue: This group of accounts shows the income received by the company by way of sale of goods or services or by any other form of interest received, profit on the sale of assets, commission etc.
- Expenses: Expense includes all expenditure items incurred such as rent, cartage, electricity, postage, travel, stationery, bank charges, salary, wages etc.
Example Explaining Credits and Debits
Each credit and debit entry requires a correct perception of the nature of a transaction. To make the picture clear, let us have an example and see how the transaction has an effect on each of the above 5 accounting elements by following the rules of “Real, Personal and Nominal” account as discussed above.
|Effect on Capital||Effect on Assets||Effect on Expenses||Effect on Income||Effect on Liabilities|
|A and B start a computer business. A invests cash of $60000 and B invests $30000||90000||90000 (Cash)|
|They pay rent by cash for office as $1000||1000 (Cash)||1000|
|They purchase furniture of $500 by cash||500||500 (cash)|
|They procure 10 computers worth $800 each on credit from Mr. C||8000||8000|
|But they sell extra 3 computers out of 10 for $900 each on cash||2700 (Cash)||2400 (Comp.)||300 (Profit)|
|They pay electricity bill $200 by borrowing from Mr. D||200||200|
Once you clearly understand the effects, this is how the balance sheet would look like, which you can understand better after reading about balance sheet and types of accounts (Ignoring Depreciation):
|Liabilities||Amount ($)||Assets||Amount ($)|
|Profit / (Loss) (Income-expense)||-900||Cash||91200|