Thursday, 22 November 2007

Debits and Credits

These two words are typical to the world of accounting and they relate to the Accounting Equation discussed yesterday: -

Assets = Liabilities + Owners’ Equity

Under what we called double entry system in accounting, each transaction must be recorded TWO times. For example, when you as an owner of an entity you contribute capital to the business by opening a bank account lets say $10,000, the following entry is made: -

Dr. Cash at bank $10,000 (Asset)
Cr. Paid-up share capital $10,000 (Owners’ Equity)

Note: Dr. represents “debit” and Cr. represents “credit”

Points to note: -
1. All assets item when recorded initially, you must follow the convention of “debiting” the account relating to that particular asset.
2. All liabilities item and Owners’ Equity item on the other hand you must “credit” the relevant accounts relating to that item when you first recognise them.

Refering the above example, if right after you have contributed the capital to the business and there are no further transactions till the end of the financial year (this is the last day of the period that you wish to set as the financial period for your business entity, 12 months is the full financial period in a year) say 31 December 2006, the Balance Sheet of your business as at 31 December 2006 will look like this: -

The above balance sheet is showing the financial position of ABC Co. Limited as at 31 December 2006 i.e. on this date, the entity has $10,000 of asset, cash at bank to be specific which is financed/represented by the $10,000 of paid-up share capital contributed by its owner. Can you see that with the figures included, the Accounting Equation has now become meaningful? Of course in this example, the entity has no liabilities.

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