Debits and Credits - Part 1
A brief of history
It’s tricky to explain debit sides and credit sides without a little history. Initially debit and credit side refers to the parts on the page in a book called the ledger. And a ledger was a book that had many pages that looked something like this
Everything to the left of the centre was the debit side and everything to the right was called credit side.
Accountants would assign a page in the book to each account (eg. a page for Rent, one for bank charges etc.). Each Ledger Account had a debit side and a credit side.
So imagine that you have just made an EFT to pay your landlord. To update your ledger you’ll find the rent page and record the payment you made.
Then you would go to the bank account page and also record the same transaction there.
We obviously don’t do this anymore. But the software we use today for accounting has largely been built around this paradigm.
So this begs the question, on which side would you have put the transaction in the Rent Account? And on which side would you have put the transaction in the Bank Account?
A rule to commit to memory
To be able to answer the question of which side on the ledger we place these transactions, we need to follow the rules of accounting. Here’s the rule:
Assets increase on the debit side. Liabilities and Equity increase on the credit side.
Memorise this rule and it will help you to figure out it would be helpful.
Step by step to understand
Now let us walk through a few examples to help you understand how this works. While doing this I will highlight some questions you should be asking that will prove a useful framework for solving debit and credit questions.
Here’s our first transaction:
Owner deposits R50,000 of his own money into the business’ bank account. This is his contribution to the business.
First Question: What are the two accounts involved?
The two accounts are Bank Account and Owners Contribution Account.
Second Question: What kind of Accounts are these?
The Bank Account contains cash so it’s an Asset. And Owners Contribution is an Equity Account.
Third Question: What’s the effect on these accounts? (ie. are they increasing or decreasing)
Bank increases with R50,000. The business has R50,000 more cash than before this transaction. Since assets increases on the debit side according to accounting rules, the bank account of the business will have a debit of R50,000. Owners Contribution (an Equity account) will also increase.
The question we have to ask ourselves is whether Owners Contribution is more or less after the transaction in question. Or, another way of putting it, has the owner contributed more or has he withdrawn his contributions.
In this case the account called Owner's Contribution has increased by R50,000.
If we were doing accounting the old way, our ledger would look something like this for the bank account.
And like this for the owners contribution account.
Let’s look at another transaction for this business
The owner buys Equipment for the business to the value of R5,000. He paid via EFT from the business bank account.
Remember that, when analysing these transactions, we will answer those three questions again:
- What are the accounts affected?
- What kind of accounts are they (ie Assets, Liabilities or Equity)
- How are they affected? (increasing or decreasing)
The answer to the first question is Equipment Account and Bank Account.
To answer question two, they are both Asset accounts
How are these accounts affected? Well, we spent some of the R50,000. Since bank is an asset and assets increase on the debit side, we need to credit the bank account with R5,000 so that the account decreases.
Here’s another look at our old ledger account for the bank account. Notice the R50,000 in debit and R5,000 in credit.
As a side note. At any given time if you want to know the balance in the account you would subtract debit and credits from each other and this will give you the balance. In the case above it is Dr of 45,000.
The second part to this transaction is the effect on the equipment account. Since equipment is an asset and with this transaction we’ve increased the value of Equipment the business has, will be a debit the equipment account with R5,000.
The most important items to take away from this article is the accounting rules around debits and credits and the also the 3 question framework for dealing with transactions. Master these and you are well on your way to being able to quickly assign debts and credits to accounts.
In the next article we will go deeper on this topic as we deal with transactions that include income and expense accounts.