Debit and credit

The term “debit and credit” is generally as­so­ci­at­ed with money, business, and commerce. You will also find the two words in your personal finances: Do you have a “debit” bank account? Do you have ad­di­tion­al money available in it? As a business owner, you need to re­con­sid­er: You come across debit and credit as the core concept of proper, “double-entry” book­keep­ing. But the two words have a more formal meaning here – “credit” is by no means the same thing as “having” something. What exactly is debit and credit? These terms are explained below.

The words debit and credit are taken from accounts, or more precisely, from double entry accounts, as they are used in the prin­ci­ples of proper ac­count­ing. These prin­ci­ples consist of legal reg­u­la­tions and informal rules and are intended to ensure that the accounts “provide an expert third party with an overview of the business trans­ac­tions and the situation of the company within a rea­son­able period of time.” The business trans­ac­tions must be ac­count­able on both sides of the trans­ac­tion. This means that ac­count­ing records the business trans­ac­tions of an en­ter­prise in numerical values – and according to the prin­ci­ples of proper ac­count­ing, this should take place in a timely and factual manner and the trans­ac­tions must be traceable, with doc­u­men­ta­tion.

The third parties mentioned in the law are all those who might have a le­git­i­mate interest in the business trans­ac­tions of the re­spec­tive company. These include, for example, the share­hold­ers of the company, under certain cir­cum­stances (e.g. in the event of in­sol­ven­cy) also the business partners, and the state – usually rep­re­sent­ed by the tax office.

For orderly ac­count­ing i.e. financial ac­count­ing, the system of double-entry book­keep­ing is used worldwide today. His­tor­i­cal­ly, double-entry book­keep­ing was first used in northern Italy in the first half of the 15^th century – and in principle it has changed very little to this day.

The term “double-entry ac­count­ing” derives from the fact that this ac­count­ing method affects two separate accounts, as an account has two pages, a debit and credit side.

However, the concept of debit and credit also means that there are (in principle) no negative values in double-entry book­keep­ing – unlike on the account statement of your bank account, for example. Only positive amounts are posted – either left (debit) or right (credit).

The opposite sides of the two accounts are always balanced. This results from the standard form of a record: it is always valid and is “debit to credit.” A posting can also address several accounts on one side or the other. Of course, the amount on the two sides must be the same.

A second in­ter­pre­ta­tion is based on the two books of which this book­keep­ing es­sen­tial­ly consists: The journal (or register) records business trans­ac­tions in chrono­log­i­cal order. The general ledger contains the accounts to which these trans­ac­tions are recorded.

A third ex­pla­na­tion of the term “double-entry book­keep­ing” indicates that there are two ways to measure a company’s success – through:

• The balance sheet, showing whether the company’s assets have increased or decreased compared to the previous year
• The profit and loss account, which shows the profit or loss for the period, when expenses are sub­tract­ed from income/revenue

The basis of any double-entry ac­count­ing is a single account: the balance sheet. It provides an overview of the financial situation of a company: on the left are the assets, on the right: li­a­bil­i­ties and equity (which rep­re­sents the amount of money that would be returned to a company’s share­hold­ers if all of the assets were liq­ui­dat­ed and all of the company's debt was paid off). One can say: On the left is what the funds of a company are used for, and on the right is where they come from. However, the left and right sides of the balance sheet are not called debit and credit, but asset and li­a­bil­i­ties.

There are guide­lines for how to break down a balance sheet. The assets on the left are, among other things:

• In­tan­gi­ble assets – licenses, business value, goodwill
• Property, plant and equipment – land and buildings, as well as technical equipment and machinery
• Financial assets – e.g. in­vest­ments in other companies
• Current assets – raw materials, con­sum­ables and supplies, as well as work in progress and finished goods
• Re­ceiv­ables – e.g. from sales/services rendered

The li­a­bil­i­ties on the right include:

• Shares, reserves, and net income (or loss) for the year
• Pro­vi­sions for future oblig­a­tions
• Li­a­bil­i­ties – bank loans, bonds, trade payables, and other li­a­bil­i­ties

The shares, reserves and net income for the year form the company’s equity. All li­a­bil­i­ties that will have to be paid off in the fore­see­able future, or will bear interest – i.e. credits, bonds, out­stand­ing invoices, but also pro­vi­sions – are sum­ma­rized under the term debt capital.

As the balance sheet item net income (or deficit) already indicates, another important ac­count­ing principle is applied in a company’s balance sheet: time period as­sump­tion. At regular intervals (financial years), a company must “draw up a balance sheet” – i.e. an opening balance sheet at the beginning of the period and a closing balance sheet at the end. The course of the financial year in question is then de­ter­mined by comparing these two balance sheets.

All financial balances are reflected in its balance sheet. The­o­ret­i­cal­ly, you could also post all business trans­ac­tions to this one account. In practice, however, this is com­plete­ly im­prac­ti­ca­ble, and the SEC’s demand for clarity and com­pre­hen­si­bil­i­ty of ac­count­ing would not be met. Therefore, each operating account works with a chart of accounts – that is, a whole system of accounts and sub-accounts, but they are all derived from the balance sheet.

Depending on the field of activity of the in­di­vid­ual company, these charts of accounts can look very different. For the different types of companies and branches of industry, however, there are so-called charts of accounts that can be adapted in­di­vid­u­al­ly and thus make the ac­count­ing de­part­ment’s work easier.

There are two main classes of accounts, which are derived from the balance sheet as sub­ac­counts and sub­di­vid­ed as required: balance sheet accounts and profit and loss accounts.

The inventory accounts, as their name suggests, concern the raw materials, work in progress, and finished goods of a company. The asset accounts contain the tangible assets, in­ven­to­ries, cash and cash equiv­a­lents, and so on that are located on the asset side of the balance sheet. The liability accounts comprise the equity (business shares, reserves, annual surplus, etc.) as well as the borrowed capital (loans, out­stand­ing invoices, and other li­a­bil­i­ties) on the li­a­bil­i­ties side of the balance sheet.

The equity capital of a company occupies a special position: The profit and loss accounts in ac­count­ing are sub-accounts from this balance sheet area – again divided into income accounts and expense accounts. These are mainly sales revenues – but asset growth is also included. In the expense accounts, you post expenses that reduce the company’s assets – for purchases, rent, interest, as well as wages and salaries.

There are also business processes that have no influence on the success of a company – they are neutral in terms of financial per­for­mance. When posting such trans­ac­tions, no profit and loss accounts are involved, only balance sheet accounts.

For example, when a customer pays an invoice, the amount of money in the supplier’s bank account increases and the re­ceiv­ables decrease ac­cord­ing­ly. As a result, nothing changes. Other examples are the purchase of a new machine or raw material for pro­duc­tion. Depending on whether the goods are paid for im­me­di­ate­ly or later, the cash balances on the assets side of the balance sheet decrease or the li­a­bil­i­ties on the li­a­bil­i­ties side increase. However, the increase in assets due to the purchased goods com­pen­sates for this in each case. The expenses that influence the profit total for the busi­ness­es are also included in the profit and loss account here, like de­pre­ci­a­tion of the machine.

A further principle rounds off double-entry book­keep­ing: All accounts must be balanced at the end – in other words, they must show the same totals in debit and credit. This applies first of all to the balance sheet itself. It must always be prepared in such a way that the totals on both sides are the same.

However, all other ac­count­ing accounts must also be balanced. To do this, you post a balance at the end of the year that clears the two sides of an account to the next higher account, and repeat this until you finally arrive at a special balance sheet account in which all the balances are collected. The actual balance sheet is then formed from this account.

The closing of all accounts, which forms an essential part of the annual financial reporting process, ensures that all the values posted to the various ac­count­ing accounts during the financial year find their way to the balance sheet at the end of the year.

Ul­ti­mate­ly, every business trans­ac­tion changes the financial situation of a company in some way. Ac­cord­ing­ly, these events must be doc­u­ment­ed. And that is exactly what book­keep­ing is for. Typical examples of business trans­ac­tions are:

• A company purchases goods on credit
• A company sells goods to customers who pay by bank transfer
• A company transfers salaries to its employees
• A company buys a new machine, pays part of the purchase price im­me­di­ate­ly in cash and the rest later on the payment date of the invoice

The debit to credit book­keep­ing applies to all records. But which accounts post a business trans­ac­tion on the debit side and which on the credit side? Un­for­tu­nate­ly, there is no general answer to this question. Depending on the type of account, receipts and issues are posted either on the one side or on the other. The rule is:

The posting record with debits and credits provides in­for­ma­tion on which accounts are affected by a business trans­ac­tion and whether the posting is made on the debit or credit side of the re­spec­tive account. This means that the relevant amount is entered on the debit side of one account and then on the credit side of another account. An example: If a posting record is “Bank to cash: $100,” then the amount of 100 dollars is entered on the debit side of the account “Bank” and on the credit side of the account “Cash.” Both are current asset accounts, the bank increases by 100 dollars, the cash decreases ac­cord­ing­ly: 100 dollars were withdrawn from the cash reserve and paid into the bank account.

Rec­og­nized in profit or loss are income and expenses that affect the assets of a company through the income statement. Income accounts are li­a­bil­i­ties and expense accounts are assets. Typical income postings are:

• Cash at sales: $500 – goods were sold for cash
• Trade accounts re­ceiv­able: $1,500 – goods were delivered on invoice with payment terms

Expense postings are cor­re­spond­ing:

• Rent to bank: $1,200 – the monthly rent was trans­ferred
• Material con­sump­tion of in­ven­to­ries: $2,000 – raw material was used for pro­duc­tion

Postings that do not affect net income, on the other hand, only affect a company’s in­ven­to­ries and do not change its asset situation (they are also called postings that affect inventory). Typical examples of this are:

• Inventory of li­a­bil­i­ties: $1,000 – goods have been purchased and are to be paid at the end of the payment period
• Technical equipment at checkout: $5,000 and li­a­bil­i­ties $10,000 – a machine was bought and partly paid for, partly financed with a trade credit

The im­me­di­ate­ly paid purchase of the monitors can now be booked in the simplest case directly as an increase in the value of the business equipment against the reduction of the bank balance: office equipment at the bank: $5,000. (In practice, however, the gross amount paid would be divided into the net amount as an increase in the value of the office equipment and the input tax to be refunded by the tax office as a re­ceiv­able and booked ac­cord­ing­ly.)

In our simple example, no further postings are to be made in the two accounts “Bank” and “Office equipment” by the end of the financial year. Then, in a final step, you calculate the balance, i.e. the dif­fer­ence between debit and credit, and clear the accounts with it.

At the end of a financial year, you must close all balance sheet and profit and loss accounts in your ac­count­ing de­part­ment in this way. You post the balances to general ledger accounts and then to the closing balance sheet account, which serves as the basis for the statutory closing balance sheet. Always observe the golden rule of ac­count­ing: debit the receiver, credit the giver. The closing balance sheet is a statutory part of the annual financial state­ments. Your balances are trans­ferred to the next fiscal year as opening balances.

The balance sheet accounts are debited from the closing balance sheet account. To do this, you post the balance of the asset account (credit side) on the debit side of the closing balance sheet account and the balance of the liability account (debit side) on the credit side of the closing balance sheet account.

Account balancing also takes place for profit and loss accounts according to the principle of posting the balance of the opposite side of the account, that is, debit to credit. The profit and loss accounts are closed. Postings are made here in the same way as for balance sheet accounts. The balance of the profit and loss can then be posted to an equity account. Finally, the profit (or loss) for the fiscal year can be seen from this account – if necessary, taking into account further changes in equity.

The two pages of a double-entry account are called debit and credit. This ac­count­ing procedure, which is used worldwide, makes it possible to present the business trans­ac­tions and the financial situation of a company clearly and ac­cu­rate­ly. Always follow the basic rules of double-entry ac­count­ing when making entries and closing accounts:

1. Debit denotes the left and credit the right side of an account
2. Debit what comes in, credit what goes out

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