Debits and credits - Part 2

In the previous article we covered the basics of solving debit and credit questions. Let’s take it one step further by working through transactions that involve income and expenses.

Before we go on, let’s review the two components of the previous article. In order to solve any debit and credit question you need to remember the following:

  1. Assets increase on the debit side and Liabilities and Equity increase on the credit side.
  2. The 3 question framework:
    • What are the accounts involved?
    • What kind of accounts are they? (Assets, Liabilities or Equity?)
    • How are they affected? (Increase or decrease?)

On to our first example:

Income and Expenses

Paid monthly Rent to Landlord via EFT.

Let’s run this transaction through the 3 question framework.

Q1. What are the accounts involved?

Bank Account and Rent Paid Account. Bank because the amount of cash in our account is affected, and the amount we spent on Rent is also affected.

Q2. What kind of accounts are they?

Bank is the easy one; it is an Asset.

Rent Paid? What kind of account is this? Let’s see. It’s not an Asset; we don’t have something that has value in itself, it can’t be sold for cash, nor is it cash itself.

It’s not a Liability; we aren’t increasing the amount of cash owed to people outside of the business like banks, suppliers or SARS.

By way of elimination it must then be Equity. Like we explained previously: Equity is a combination of money and/or assets that the owner invests into the business, as well as the profits of the business’ activities.

A Brief Look at Business Activities: Profits or Losses

All businesses do something to make a profit. Profit is what you have left when you take the money you made in a certain venture and subtract the money you spent to make it. Eg. If you made R10,000 in selling shoes and it cost you R6,500 to make those sales, it means you’ve made a profit of R3,500.

Here are a few more examples of business activities:

A bakery buys in flour, sugar, butter and other ingredients and sells cakes and breads.

A property company has properties and spends money on Repairs & Maintenance, rates, security etc. and in return they receive a Rent Income.

A plumber has tools, then buys in parts and supplies and uses his expertise to make an income from charging customers to repair and install baths, toilets and showers.

Nominal Accounts

If we accept that Rent Paid is an Equity Account we can go on to answer the third question.

Q3. How are these accounts affected?

Bank decreases because we now have less cash than before. So we credit Bank.

:: Take care as we move along here; there is a common error to avoid ::

The wrong approach

Rent Paid belongs to Equity. Equity increases on the credit side. Therefore Rent Paid is credited. But it would be incorrect to simply say Rent Paid is Equity.

The right approach

Rent Paid falls into the category of Equity because forms part of calculating profit or losses made by the business.

Think of Profit & Loss as a single ledger account but instead of having a debit and a credit side only, both the debit and credit sides have their own sub-debit and credit sides.

(This is, in fact, why accounts like Sales, Interest, Income, Bank Charges, Accounting Fees, Postage Expenses etc are referred to as Nominal Accounts. ie Not a real account.)

Think of it as something like this:

profit and lossSo all expenses will have debit balances and all income will have credit balances. This makes sense since sales and other income increases profits while expenses decrease it.

Expenses increase on the debit side and income on the credit side.

Now it’s time to work through a few examples.

 

Example 1

Received interest on bank deposit of R50.

Q.1 What are the 2 accounts involved?

Bank and Interest Received.

Q.2 What type of accounts are these?

Bank is an Asset and Interest is an income (Equity).

Q.3 How are they affected?

Bank is increasing. This means a Dr of R50 in the bank account. Income (Equity) is increasing. This means a Cr of R50 to the Interest Account (Equity).

 

Example 2

Paid R500 cash for materials used in the manufacturing process

Q.1 What are the 2 accounts involved?

Bank and Cost of Sales.

Q.2 What type of accounts are these?

Bank is an Asset and Cost of Sales is Equity.

Q.3 How are they affected?

Bank is decreasing. This means a Cr of R500 in the Bank Account.

Cost of Sales (Equity) is increasing. This means a Dr of R500 to the Cost of Sales Account (Equity).

 

Example 3

Sold goods for on credit to customer, R1,200. The customer will pay us in 30 Days.

Q.1 What are the 2 accounts involved?

Sales and Debtors.

Q.2 What type of accounts are these?

Debtors is an Asset and Sales is an income (Equity).

Q.3 How are they affected?

Debtors is increasing because we are owed more money than before. This means a Dr of R50 in the bank account. Income (Equity) is increasing. This means a Cr of R50 to the income account (Equity).

Conclusion

Understanding that Expenses and Income Accounts are part of Equity is key in being able to deal with debit and credit problems.

Again, keep going over the examples in this article and the previous one to make sure that you understand the concepts being taught.

In the next article we will add a little more complexity to what has been done so far by looking at VAT and how we do accounting with transactions involving VAT.