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Chapter 22

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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 owners 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 (thats 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 (owners 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:

 

Increase

Decrease

Asset

Dr

Cr

Expense

Dr

Cr

Liability

Cr

Dr

Equity

Cr

Dr

Revenue

Cr

Dr

Income

Cr

Dr

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.

 

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Last modified: May 21, 2004