THE PHILOSOPHY OF DEBIT AND CREDIT
=Double-Entry Bookkeeping.=—Several systems or methods of keeping
business records have at various times been in use. The method which
at the present time is used by all businesses, excepting those of the
simplest sort, is called “double-entry bookkeeping” and is the method
which is being set forth here. It is based on the proprietorship
equation expressed in the form: Assets = Liabilities + Proprietorship.
It is possible to make a balance sheet if only asset and liability
records are kept, because proprietorship is always the difference
between them. Such a system of record-keeping would fail completely in
giving the information as to the current increases and decreases in
proprietorship and the causes of such changes. As was indicated in an
earlier chapter, such a system would have the disadvantages which the
comparative balance sheet has as a means of managing and controlling a
business enterprise. The information which is given by the profit and
loss records of the business would be entirely lacking.
Double-entry bookkeeping, accordingly, keeps a record not only of
assets and liabilities, but also of proprietorship and its constantly
changing value. The advantages of such a system were discussed when the
need for the information furnished by the profit and loss statement was
pointed out (see page 39). Not only does double-entry bookkeeping give
this full and complete information, but it ties this information into a
system whose mathematical accuracy and correctness can be proved. It is
an invention or device whose purpose is definitely to give the desired
information and to demonstrate the mathematical correctness of that
information.
As already stated, the system of double-entry bookkeeping is based on
the proprietorship equation. An equation is an expressed equality. The
ledger kept by double-entry bookkeeping always maintains this equality.
The sum total of the entries on the left side of all the accounts must
equal the sum total of the entries on the right side of the accounts.
The way in which the ledger becomes an expanded or detailed balance
sheet was explained fully in the previous chapter. There it was shown
that the sum of the net balances of all asset accounts, as carried in
the ledger as left-side balances, at all times equals the sum of the
net balances of the liability and the proprietorship accounts carried
in the ledger as right-side balances.
It is evident that, if in place of the net balances of each group of
accounts, the gross left- and right-side totals are substituted, the
equation would still be maintained, inasmuch as the net balance in each
instance is secured by subtracting the same amount, namely, the lesser
total, from both sides of the account.
Under double entry, therefore, the equality of the left side of the
ledger, that is, the total of the left-side amounts of all of the
accounts, is constantly maintained with the right side of the ledger,
that is, the total of the right-side amounts of all the accounts. The
vertical division of the ledger separating an account into its left and
right sides, may with little stretch of the imagination be considered
an equality sign, which thus makes one big equation out of all the
accounts in the ledger. Under double-entry bookkeeping, therefore, the
principles of entry in the ledger are based on no logic or philosophy
other than that which attaches to the fundamental proprietorship
equation of the balance sheet. Double entry is an invention, a device,
and its use requires adherence to the principles of entry necessary to
maintain its equation. What these principles are will now be explained.
=The Business Transaction Defined.=—Reference has constantly been
made to business transactions. It may be well to show the idea at the
bottom of such transactions. We may define a business transaction as an
exchange of values. It may be between persons, as when a sale is made,
or it may be between accounts within the business itself, as when a
transfer is made between accounts, i.e., when an item is taken from one
account and transferred to another for the sake of more clearly showing
its nature. Some authors further analyze transactions as _complete_
when the bargain is fully consummated between the parties, as when
delivery is made and the money is paid in cash; or _incomplete_ as
where something still remains to be done by either or both parties to
the transaction. In this latter case, claims or rights of action at law
arise to protect the parties until the transaction is consummated. But,
since from the accounting standpoint a claim or right is one kind of
property or asset, there is little need of this finer analysis.
=Analyzing the Transaction as to Its Accounting Record.=—When a
transaction occurs in a business, it must first be classified before
proper record can be made of it under the account title which groups
transactions of a like nature. Its elements must be analyzed, its
effect on assets and liabilities, or on expenses and income, must
be determined. Has the transaction increased or decreased assets
or liabilities, or has it increased or decreased proprietorship,
or has it resulted in simply a transfer between accounts—these are
the first questions to be determined. The basis of all fundamental
classifications is the effect of the transaction upon the balance
sheet and profit and loss statements. They are the goal towards which
all records look, but the principle which determines the subdivisions
in the main classes of accounts and the titles to be given to the
accounts which are to be carried in the records, is the amount and
kind of information desired by the management throughout the fiscal
period. After the transaction has been properly classified, it is
merely a matter of recording it according to the standards or forms of
good accounting, which is merely a device for abbreviating the work of
recording, i.e., the transaction is translated into correct accounting
language.
=The Use of Debit and Credit.=—To show the side of the account affected
by a transaction, the words “debit” and “credit” are used, indicating
left and right respectively. The use of these words had its origin
with transactions between persons and the accounts kept with them.
The person owing was charged or debited, while the person to whom the
business owed a debt was credited. Through use the terms have come
to have the meaning stated first above, though still retaining their
original connotation when applied to persons.
=Fundamental Principle of Debit and Credit.=—As stated in Chapter V,
every transaction is recorded from two viewpoints, viz., its effect
on the assets and liabilities and its effect on the proprietorship
or net worth. Sometimes, however, the transaction may require merely
a transfer entry, i.e., a transfer of an amount from one account
to another without affecting the fundamental classes, as was shown
above when defining the transaction as an exchange of values. If it
is remembered that from long-continued custom asset accounts are
debit accounts, i.e., normally have debit or left-side balances, and
liability accounts are credit accounts; that expense accounts are
debit and income accounts are credit, the fundamental principles for
determining the debit and credit involved in every transaction become
pretty well established in one’s mind.
Starting, therefore, with the original investment, whatever form it may
have, the transaction is reducible to the fundamental equation:
Assets = Liabilities + Proprietorship
in which “liabilities” may or may not be a “zero” quantity, depending
on the nature of the investment. All transactions thereafter must
be viewed according to their effects on the three terms of the
equation above. We may summarize the effects produced by the various
transactions of the business as:
Increase or decrease of assets
” ” ” ” liabilities
” ” ” ” proprietorship
with this qualification: that some transactions result in transfers
only without affecting the totals of any of the three groups above, as
when an asset is transferred from one account to another for purposes
of more accurate classification.
=The Debit and Credit Schedule.=—Bearing in mind the customary
distinction between debit and credit, and the fact that entry of a
transaction is always made from a double viewpoint—that of cause and
effect—every transaction may have its debit and credit determined by
the following schedule:
=================================================================
_Debit_: | _Credit_:
(1) Increase of Assets | (a) Decrease of Assets
(2) Decrease of Liabilities | (b) Increase of Liabilities
(3) Decrease of Proprietorship | (c) Increase of Proprietorship
=Debit and Credit Determination Illustrated.=—Examples illustrating
the various classes of transactions and the manner of determining
their debit and credit will now be given. The student should strive
to understand the double point of view necessary in determining debit
and credit. It is perhaps well to call attention to the fact that
the illustrations are entirely unrelated, i.e., do not constitute a
sequence of events in any business. It should also be kept in mind that
transactions are recorded always from the standpoint of the business
whose records are being kept.
1. The purchase of merchandise for cash. The result is an increase
of the asset Merchandise caused by the decrease of the asset Cash.
Accordingly, the debit and credit of the entry for the transaction are
shown by the above schedule under (1) and (a), i.e., debit Merchandise
and credit Cash. The transaction is also an illustration of the
transfer entry, in which there is no increase or decrease of total
assets, liabilities, or proprietorship.
2. The purchase of merchandise on account. This results in an increase
of assets caused by the increase of liabilities. The schedule above
shows under (1) and (b) a debit to Merchandise and a credit to the
personal account payable, indicated by the name of the creditor.
3. The receipt of cash for services performed, as when a broker
receives the amount of his commission in cash. The result here is an
increase of the asset Cash, caused by the increase of proprietorship,
as the performance of services is the chief source of the broker’s
income. The schedule shows under (1) and (c) a debit to Cash and a
credit to some temporary proprietorship account by name, as Commissions
Earned.
4. The payment of a note payable in cash. This results in a decrease of
the liability, Notes Payable, caused by the decrease of the asset Cash.
Accordingly, debit Notes Payable and credit Cash, (2) and (a).
5. The settlement of a personal account payable by giving a note
payable. The effect here is simply a cancellation of one kind of
liability with another kind; it is a transfer entry. Debit the personal
account payable; credit Notes Payable, (2) and (b).
6. The rendering of a business service to a creditor, thereby canceling
an indebtedness to him; as when a physician renders medical aid to his
creditor from whom he has purchased supplies. The effect is a decrease
in liabilities and an increase in proprietorship. Debit the personal
account payable, by name, and credit some temporary proprietorship
account, by name, as Fees or Services, (2) and (c).
7. A workman is paid his wages in cash. The result is a decrease in
proprietorship and a decrease in the asset Cash. Wages are a cost
of doing business and therefore decrease Proprietorship. They are
a service rendered to the business instead of by it—an expense as
distinguished from an income. Debit the temporary proprietorship
account, Wages, and credit Cash, (3) and (a).
8. The account of a lawyer is credited for the amount of his fee. A
decrease of proprietorship, for the service rendered the business, and
an increase in liabilities. Debit Legal Expense and credit the personal
account payable, (3) and (b).
9. Transfer the net gain shown by the Profit and Loss account to the
Surplus account. The result is a simple transfer, causing a decrease in
proprietorship as shown in the Profit and Loss account and an increase
in proprietorship as shown in the Surplus account. Debit Profit and
Loss and credit Surplus, (3) and (c).
In a similar manner, all transactions may be analyzed and their entry
in the accounts determined.
=Necessary Equilibrium of Debits and Credits.=—Before passing to
more detailed rules for debit and credit, the necessary equality of
debits and credits should again be pointed out. Starting with the
proprietorship equation expressed in this form:
Assets = Liabilities + Proprietorship,
of which the left side is represented in the accounts by debits and
the right side by credits, the equality of the debit balances and the
credit balances of the accounts in the ledger is readily seen. If, now,
for all succeeding transactions an entry is made having an equal debit
and credit, evidently the equilibrium of the total debits and credits
in the accounts is maintained and the two sides of the ledger are in
agreement. The making of an equal debit and credit for every entry is
fundamental and must be strictly observed.