UNDERSTANDING DEBIT & CREDIT

Average reading time – 6 minutes

Outcome – You will never get confused with the terms Debit & Credit after reading this article. Wanna bet?

The two most widely used terms in finance and accounting are also the most misunderstood. Whenever I ask participants in my seminar to define Debit and Credit everyone will come up with their own definition. Even most of the definitions by Prof. Google are confusing.

Now I would request you to keep aside all your understanding about Debit and Credit. Just forget it for a moment because Debit and Credit by itself has got no meaning. Yes, you read it right, Debit and Credit by itself has no meaning.

For example in a game of chess before the last pawn is moved, the player says checkmate. The term checkmate by itself has got no meaning. However in the context of the game of chess it has a meaning.

Similarly in football (soccer) they have on-side, off-side, D-box, penalty shoot-out, golden goal. These terms by itself they have no meaning. However in relation to football it has some meaning.

In the same manner, Debit and Credit by itself has got no meaning. Only in the context of Double Entry System of Bookkeeping they have a meaning.

The term Double Entry says something is entered twice.

Double Entry system of bookkeeping means, every financial transaction will have an impact on two accounting heads simultaneously.

‘Debit’ and ‘Credit’ denotes two opposite effects of one transaction on two accounting heads.

For example, when you purchase a printer for your business worth $200 using money from the business bank account, it becomes a financial transaction. This one financial transaction impacts two accounting heads – Bank Balance and Office Equipment.

Your business ‘Bank Balance’ got less by $200 and the ‘Office Equipment’ increased by $200 in the form of a printer.

Another example, you purchase a flight ticket to attend a business conference for $1500. Again it is one financial transaction that will affect two accounting heads – Bank Balance and Travel Expense.

Note: Account head is like a name of a place or book. As we know lots of transactions take place in a business, it becomes confusing if they are not segregated accordingly. So names are given to the business transactions according to the nature of a transaction. These names, allocated to business transactions are called Account Heads.

In my previous articles on ‘Understanding Balance Sheet’ and ‘Understanding Profit & Loss Statement’ I had mentioned there are only four types of financial transactions that can happen in any business:

1.      Money comes-in

2.      Money goes out

3.      Money supposed to come-in

4.      Money supposed to go out

(You can read them later by clicking the above highlighted links.)

I had also mentioned every financial transaction has to be an Expense or Income, or a Liability or Asset. They are the main headings on ‘Profit & Loss Statement’ and ‘Balance Sheet’.

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Among these, two must be Debit and two must be Credit.

Now the question is. Which is debit? And which is credit?

Are Expenses Debit or Credit?

What about Incomes? Is it Debit or Credit?

What about Liabilities and Assets? Which is debit and which is Credit?

Expenses are Debit.

Incomes are Credit.

Assets are Debit, and

Liabilities are Credit.

However, you do not need to learn this as a law. For me business finance is a common sense subject so let us try and use our common sense to understand it.

If Expenses and Asset are Debit and if Income and Liabilities are Credit there has to be some similarity between them. The question is – what is the similarity?

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The similarity between Expense and Assets is ‘money goes out’ of the business. Conversely, the similarity between Income and Liabilities is ‘money comes-in’ to the business.

Debit, money is going out of the business. For Assets, you may say we have got building, machinery, office furniture’s and so on. To purchase them money first goes out of the business. That is the reason it is important to read financial reports from a business perspective and not from an owner’s perspective. From the business perspective if the money is going out either it becomes an Expense or creates an Asset.

Credit, money is coming-in to the business. If it is by selling the product or service, it is called Income. If money comes-in to the business because of borrowing then it becomes a Liability.

All you have to remember is when ‘money goes out’ of the business it is Debited and if ‘money comes-in’ to the business it is Credited.

Note: Debtor (Dr) in short is called Debit and Creditor (Cr) in short is called Credit.

If you would like to learn how financial statements are prepared then click this link to watch our recent webinar.

In my next article, I will explain the difference between Profit & Money.

Meanwhile, if you meet your accountant or banker or any financial expert – ask them how they were taught about Debit & Credit 😉

Yours Non-accountant,

Chinmay Ananda