What’s the logic behind Debits and Credits?

This one’s easy: for every action there is an equal and opposite reaction. Pure physics; a fundamental law of the universe.

Now, how do you remember that assets are increased by debits? This one is also pretty logical and easy. Imagine a balance sheet, with the left hand side listing the assets. On the right hand side are the liabilities and equity. We know that the total of all the assets, on the left, equals the total of all the credits on the right.

Debits and Credits. Debit is on the left hand side of that statement. Assets are on the left hand side of the balance sheet. Ah! Debits increase assets!

Credits… the credit is on the right hand side, and on the right hand side of the statement. Thus Credits increase liabilities. Example: we take out a loan. We debit cash ( the loan increases our cash, an asset) and we credit liabilities, because we now owe a loan ( increase in liabilities) Brilliant!

Now, let’s do a tough one…. income and expenses. First, remember we said that equity was on the right hand side of the balance sheet. It represents the amount invested in the business, plus the earnings of the business. Think of it this way: how did we get the assets? By borrowing money to buy them or by investment, or by retained earnings. Those loans, investments or retained earnings are credits. More Brilliance!

Income increases equity, which is a credit. So revenues are recorded as credits. Debit cash (increase an asset), credit revenues (increase equity) . Logically, expenses are the opposite of income, so they are debits. Debit expense and credit cash (decrease it). Kind of mind blowing, isn’t it!

Work through this and at some point the light will go on and you will realize that Pacciola, the 15th century Italian monk who invented double entry accounting was one of the world’s great genius’s. Such a simple system, but so incredibly powerful. The entire world depends upon this simple, brilliant construct.

April 27, 2017

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