Accounting can be defined as the recording, summarizing, analyzing, classifying, presenting, and reporting of financial information.
Financial information is mainly obtained when business transactions take place.
Once financial information about business transactions is obtained, it is entered into the accounting system, mainly the general ledgers of a business.
At the end of every period, this data is presented and reported to the stakeholders of the business in the form of Financial Statements of a business.
The main entry point to the accounting system of a business, for any business transaction, is the business’ General Ledgers.
General ledgers record every business transaction that can reliably be measured. General ledgers are categorized by the type of transaction that is being recorded.
For example, if the company has incurred an expense, the transaction is recorded at the expense of the general ledger. These are also known as accounts. These accounts can also be extended to group transactions of a similar nature.
The general ledger has two sides on which transactions are recorded. The left side of a general ledger is known as the Debit (Dr.) side, while the right side of a general ledger is known as the Credit (Cr.) side. When a business transaction occurs, it must be recorded in two ledgers.
One of the ledgers must have a Debit entry and another ledger must have a Credit entry for the same transaction. This is due to the double-entry concept of accounting.
In this article, we will discuss the role of debit and credit in accounting on how they help the business to record its daily accounting transactions.
Double Entry Concept
The double entry concept is the basis of accounting. The double entry concept states that every business transaction must be recorded in at least 2 accounts in the accounting system of a business.
Furthermore, it states that the amounts of the Debits and Credits must be equal at all times when recording a business transaction.
For example, if a business incurs an expense of $500 and pays it in cash. The business must record both the expense of the business that has increased by $500 and the cash of the business that has decreased by $500.
The expense is recorded in the related expense account, while cash is recorded in the business’s cash account.
Here is now the debit and credit of this transaction look like,
Debit (Dr) Expenses Account $500
Credit (Cr) Cash Account $500
Separate Entity Concept
Another concept that is crucial in accounting is the separate entity concept. The separate entity concept states that the business and its owner are two separate entities.
Any business transaction is independent of the owner and the owner is seen as a foreign entity. This concept identifies the business owner as an outsider to the business.
Therefore, any business transactions with the owner of the business must also be recorded as if the transaction took place with a third party.
For example, a business receives an investment of $10,000 from the owner of a business.
This transaction must be recorded in the books of the business as if the business took place with a foreign entity while also keeping the double entry concept into consideration.
Thus, this transaction must again be recorded in two accounts. The first effect of this transaction is taken to the cash account, where the cash has increased by $10,000 and the second effect is taken to the capital account, which keeps track of the owner’s capital in a business.
Here is what the double entry of this transaction will look like,
Debit Cash Account $1,000
Credit Equity Account $1,000
Fundamental Elements of Accounting
There are 5 fundamental elements of accounting. All business transactions have two effects on the accounting system according to the double-entry concept.
The two entries, Debit and Credit can be categorized into one of the five fundamental accounting elements.
Therefore, to understand the rule of Debit and Credit in accounting, it is necessary to understand the fundamental elements of accounting. These are:
Assets are resources controlled by a business that enables the business to benefit from them in the future. For example, a car bought by the business is considered an asset of the business.
Similarly, the inventory of a business is its asset because the inventory will bring future benefits to the business when they are sold.
Other examples of assets include but are not limited to, fixed assets, cash in bank accounts, physical cash in the business, investments made in other companies or instruments, etc.
In the rule of debit and credit, an increase of assets is recording on the debit side and the decrease of assets is recording on the credit side.
Liabilities are the opposite of assets. Liabilities are obligations of the business that the business has to pay to a third party in the future due to legal or contractual obligations that result in benefits outflowing from the business.
The simplest example of liabilities is a bank loan. If a business takes a bank loan, it will have to pay the loan back to the bank in the future, which will result in cash outflow from the business.
In the rule of debit and credit, an increase of liabilities is recording on the credit side and the decrease of liabilities is recording on the debit side.
Equity is a concept that is realized due to the separate entity concept. Equity is similar to a liability for the business, except liabilities are payable to third parties while equity is payable to the owner of the business.
Technically, equity is defined as the residual value of a business after reducing its liabilities from its assets. This means that if a business is liquidated, any assets that are left after paying all the liabilities of a business are the owner’s right in the business.
Anything that an owner invests into the business is their capital and anything they take out is known as drawings.
In the rule of debit and credit, an increase of equity or capital is recording on the credit side and the decrease of equity or capital is recording on the debit side.
Income is defined as an increase in the benefits of a business. Therefore, any inflow of benefits to a business is considered as the income of the business. The main source of income for any business is the revenues it generates from daily activities.
However, there might be other sources of income as well such as interest income, dividends from investments, profits on sales of assets, etc.
In the rule of debit and credit, an increase of income is recording on the credit side and the decrease of income is recording on the debit side.
Expense is defined as the decrease in benefits of a business. Therefore, any outflow of benefits from a business is considered an expense for the business.
All businesses have a wide variety of expenses. For example, businesses may have purchases or production expenses, utility expenses, rent expenses, repair and maintenance expenses, etc.
In the rule of debit and credit, an increase of expenses is recording on the debit side and the decrease of expenses is recording on the credit side.
Rule of Debit and Credit in Accounting
As mentioned above, all business transactions can be categorized into one of the five fundamental accounting elements.
This means any business transaction will either affect the assets, liabilities, equity, income, or expense accounts of a company.
Therefore, the rules of Debit and Credit are associated with these 5 fundamental elements of accounting.
All general ledger accounts in a business will be of the 5 fundamental elements type.
Whether the account is debited or credited depends on the type of the account and whether it is increasing or decreasing. The rule of Debit and Credit for these accounts can be remembered using the acronym DEAD CLIC.
The above acronym can be used to determine whether an account should be debited or credited. However, this rule only applies when there is an increase in these accounts.
This means an increase in expenses, assets, and drawings of a business should always be debited in their respective accounts.
While an increase in the liabilities, income, and capital of a business must always be credited to their respective accounts.
In contrast, when there is a decrease in these accounts, then the Debit and Credit rule for the above acronym gets reversed.
A decrease in expenses, assets, and drawings is always credited in their respective accounts. While a decrease in liabilities, income, and capital gets debited in their respective accounts.
A business, ABC Biz, has the following business transactions for a period, with the respective double entries:
1) The owner invested $10,000 in the ABC Biz.
Since the owner of the business invested cash into the business, there will be two effects of the business transaction on the business.
The first effect will be the cash of the business increasing by $10,000, which is an asset of the business. The second effect is that the business has to pay the owner back $10,000.
In simpler terms, the owner’s capital has increased by $10,000. Since there is an increase in assets and capital of the business, the double-entry is as follows:
Debit Cash $10,000
Credit Capital $10,000
2) ABC Biz borrowed $5,000 cash from a local bank.
The business took a loan from the bank. The cash of the business has increased by $5,000 while the liability of the business has also increased by $5,000. This is because the business is now obligated to pay the bank $5,000. The double entry is as follows:
Debit Cash $5,000
Credit Loan (Liability) $5,000
3) ABC Biz bought goods for $1,000 in cash.
Goods bought for business are the expense of the business. There is an increase in expenses for the business. While cash has been paid, it is a decrease in cash, an asset. The double entry can be done as follows:
Debit Purchase (Expense) $1,000
Credit Cash $1,000
4) ABC Biz sold the goods for $1,200 in cash.
In this business transaction, the cash of the business has increased by $1,200. This cash has increased due to income of $1,200 from sales, thus, this is an increase in income as well. The double entry is as below:
Debit Cash $1,200
Credit Sales (Income) $1,200
5) The owner withdrew $200 cash from the business.
Since the owner withdrew $200 from the business, it means the business’ cash has decreased by $200. Furthermore, the drawing of the business has increased. The drawings can also be viewed as a decrease in the owner’s capital. The double entry is as follows:
Debit Drawing $200
Credit Cash $200
6) The business paid the $1,000 loan amount back to the bank in cash.
Since the business has paid $1,000 to the bank, the cash of the business has decreased by $1,000. Furthermore, the liability of the business has also decreased by $1,000. The double entry is as follows:
Debit Loan (Liability) $1,000
Credit Cash $1,000
The modern account system is based on two major concepts. The first concept is the Double Entry concept which gives rise to the double-entry bookkeeping system that is prevalent in accounting.
Business transactions are recorded in general ledger accounts using either a Debit or Credit double entry.
The second concept is the Separate Entity concept which gives rise to the concept of Equity. Equity is one of the five fundamental elements of the accounting system.
Once a business transaction can be associated with the two corresponding accounts, using the base element of the account, the business can determine whether the account should be debited or credited.