Understanding debits and credits

The cookbook is suspended. This discussion (first half of the chapter) is designed to be read from start to end. Jumping in at the middle will cause confusion.

Debits and credits XE "credits" XE "debits" are very simple. Debits go on the left, and credits go on the right. Debits and credits are not to be understood separately, because they are part of a system. They are movements between places. To comprehend the movements, you need to know the geography of the places. A bit metaphoric, perhaps, but a close analog for the confusion often associated with the “-it” words.

The accounting equation (from the owner’s viewpoint) is

Equity = Assets - Liabilities.

That is, the owners own all the values of the assets, after subtracting creditors claims. Putting this same equation in balance sheet form,

Assets = Liabilities + Equity.

That is really a static equation. Accounting also uses a dynamic equation,

Income = Revenue - Expenses.

“Revenue” is a strict and proper term for the account type that QuickBooks calls “income” accounts. QuickBooks is not alone in this usage; it is common. In this discussion only, the strict terminology will be used. All of the rest of the book follows the more usual terms, and calls these “income” accounts.

The system can be introduced by example. Here are some transactions to start and run another over-simplified business. To clarify the example, all account types are named in parentheses, behind the account names. The owner invests a thousand dollars in the business (that’s a lot of money, for an imaginary company.)

DEBIT CREDIT

Cash in Bank (asset) $1000

Capital (equity) $1000

With this done, the balance sheet status is clear enough.

The business is a broker of building cleaning services, who hires others to clean buildings, and accepts the risk of receiving or not receiving payment from the building owners. However, the first customer is running under Chapter 11, and has to pay cash for everything. The building is cleaned, for a fee of $200 cash.

DEBIT CREDIT

Cash in Bank (asset) $200

Cleaning Customer (revenue) $200

The actual cleaning is done by a subcontractor, who accepts credit.

DEBIT CREDIT

Purchased services (expense) $120

Accounts Payable (liability) $120

Whether the credit here was to cash (reducing) or payables (increasing the liability) the purchase of an expense reduces net worth (equity.)

An Income Statement (Profit and Loss Report) can be prepared, using these transactions.

Income Statement

Revenue

Cleaning Customer $200

Total Revenue $200

Expense

Purchased Services $120

Total Expenses $120

Net Income $80

Closing the books is the next step in this example, while it is still simple. It is plain that the one revenue account has a credit balance of $200, and the one expense account has a debit balance of $120. The first step in closing the books is a major journal entry, rolling all revenue and expense transactions into an income account (the one income account.) Chapter 2 explained that revenue could be more descriptively called On-the-way-to-increase-equity, and expense would be On-the-way-to-decrease-equity. Now they are doing that. Note that the amount of the credit to Net Income is taken from the income statement, and it balances this transaction.

DEBIT CREDIT

Cleaning Customer (revenue) $200

Purchased services (expense) $120

Net Income (income) $80

All of the revenue and expense accounts have been reduced to zero, and the resulting net income is rolled into the Net Income account. Following this concept, this is the one and only “income” account. Then the Net Income is moved to the Capital (owner’s equity) account:

DEBIT CREDIT

Net Income (income) $80

Capital (equity) $80

The books are closed, and a Statement of Financial Position (Balance Sheet) may be prepared:

Assets Liabilities

Cash in Bank $1200 Accounts Payable $120

Total Liabilities $120

Equity

Capital $1000

Retained Earnings 80

Total Equity $1080

Total Assets $1200 Total Liabilities and Equity $1200

The Balance Sheet is in balance, because credits equalled debits in every transaction, and every transaction adhered to the following rules about use of debits and credits:

Dr Increases asset and expense accounts

Decreases liability, revenue, expense, and income accounts

Cr Increases liability, revenue, expense, and income accounts

Decreases asset and expense accounts.

These same rules can be stated in a different format:

The term “revenue” will not be used again, and “income” will be used for those accounts. The proper “income” type account is not used in QuickBooks. Note that it was used here only for one account with two transactions.