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.
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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:
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- Assets increase on the debit side and Liabilities and Equity increase on the credit side.
- 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.
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Dream daddy: a dad dating simulator 0 11. 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.
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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:
So 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? Ssd health check 1 5.
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.
Debit and Credit Definitions
Business transactions are events that have a monetary impact on the financial statements of an organization. When accounting for these transactions, we record numbers in two accounts, where the debit column is on the left and the credit column is on the right.
- A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is positioned to the left in an accounting entry.
- A credit is an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is positioned to the right in an accounting entry.
Debit and Credit Usage
Whenever an accounting transaction is created, at least two accounts are always impacted, with a debit entry being recorded against one account and a credit entry being recorded against the other account. There is no upper limit to the number of accounts involved in a transaction - but the minimum is no less than two accounts. The totals of the debits and credits for any transaction must always equal each other, so that an accounting transaction is always said to be 'in balance.' If a transaction were not in balance, then it would not be possible to create financial statements. Thus, the use of debits and credits in a two-column transaction recording format is the most essential of all controls over accounting accuracy.
There can be considerable confusion about the inherent meaning of a debit or a credit. For example, if you debit a cash account, then this means that the amount of cash on hand increases. However, if you debit an accounts payable account, this means that the amount of accounts payable liability decreases. These differences arise because debits and credits have different impacts across several broad types of accounts, which are:
- Asset accounts. A debit increases the balance and a credit decreases the balance.
- Liability accounts. A debit decreases the balance and a credit increases the balance.
- Equity accounts. A debit decreases the balance and a credit increases the balance.
The reason for this seeming reversal of the use of debits and credits is caused by the underlying accounting equation upon which the entire structure of accounting transactions are built, which is:
Assets = Liabilities + Equity
Thus, in a sense, you can only have assets if you have paid for them with liabilities or equity, so you must have one in order to have the other. Consequently, if you create a transaction with a debit and a credit, you are usually increasing an asset while also increasing a liability or equity account (or vice versa). There are some exceptions, such as increasing one asset account while decreasing another asset account. If you are more concerned with accounts that appear on the income statement, then these additional rules apply:
- Revenue accounts. A debit decreases the balance and a credit increases the balance.
- Expense accounts. A debit increases the balance and a credit decreases the balance.
- Gain accounts. A debit decreases the balance and a credit increases the balance.
- Loss accounts. A debit increases the balance and a credit decreases the balance.
If you are really confused by these issues, then just remember that debits always go in the left column, and credits always go in the right column. There are no exceptions.
Debit and Credit Rules
The rules governing the use of debits and credits are as follows:
- All accounts that normally contain a debit balance will increase in amount when a debit (left column) is added to them, and reduced when a credit (right column) is added to them. The types of accounts to which this rule applies are expenses, assets, and dividends.
- All accounts that normally contain a credit balance will increase in amount when a credit (right column) is added to them, and reduced when a debit (left column) is added to them. The types of accounts to which this rule applies are liabilities, revenues, and equity.
- The total amount of debits must equal the total amount of credits in a transaction. Otherwise, an accounting transaction is said to be unbalanced, and will not be accepted by the accounting software.
Debits and Credits in Common Accounting Transactions
The following bullet points note the use of debits and credits in the more common business transactions:
- Sale for cash: Debit the cash account | Credit the revenue account
- Sale on credit: Debit the accounts receivable account | Credit the revenue account
- Receive cash in payment of an account receivable: Debit the cash account | Credit the accounts receivable account
- Purchase supplies from supplier for cash: Debit the supplies expense account | Credit the cash account Sketchode 2 2 0 1.
- Purchase supplies from supplier on credit: Debit the supplies expense account | Credit the accounts payable account
- Purchase inventory from supplier for cash: Debit the inventory account | Credit the cash account
- Purchase inventory from supplier on credit: Debit the inventory account | Credit the accounts payable account
- Pay employees: Debit the wages expense and payroll tax accounts | Credit the cash account
- Take out a loan: Debit cash account | Credit loans payable account
- Repay a loan: Debit loans payable account | Credit cash account
Examples of Debits and Credits
Arnold Corporation sells a product to a customer for $1,000 in cash. This results in revenue of $1,000 and cash of $1,000. Arnold must record an increase of the cash (asset) account with a debit, and an increase of the revenue account with a credit. The entry is:
Debit | Credit |
Cash | 1,000 |
Revenue | 1,000 |
Arnold Corporation also buys a machine for $15,000 on credit. This results in an addition to the Machinery fixed assets account with a debit, and an increase in the accounts payable (liability) account with a credit. The entry is:
Debit | Credit |
Machinery - Fixed Assets | 15,000 |
Accounts Payable | 15,000 |
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Other Debit and Credit Issues
A debit is commonly abbreviated as dr. in an accounting transaction, while a credit is abbreviated as cr. in the transaction.
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Debits and credits are not used in a single entry system. In this system, only a single notation is made of a transaction; it is usually an entry in a check book or cash journal, indicating the receipt or expenditure of cash. A single entry system is only designed to produce an income statement.
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