DEBIT AND CREDIT AS APPLIED TO PROPRIETORSHIP ACCOUNTS
=Proprietorship Accounts Defined.=—Proprietorship accounts are the
accounts which record the effects, both temporary and ultimate, of
business transactions upon proprietorship. The study of the two
preceding chapters has made clear the fact that transactions which
involve the receipt of income or the payment of expenses result
respectively in an increase or decrease of proprietorship, and that
these increases or decreases are temporarily recorded in suitable
income and expense accounts until the close of the fiscal period, at
which time the accounts are summarized to determine the net effect of
all transactions upon proprietorship or the capital invested in the
business. Therefore, the proprietorship accounts are of two general
kinds: temporary and vested. Temporary proprietorship accounts make
temporary and immediate record of the results of the agencies or forces
at work within the business to produce a profit. They set forth the
efforts to increase the net worth of the business. They record the
costs of the effort and its yield in earnings, the record being made
under appropriate titles to show the kind of cost and the source of the
yield. Vested proprietorship accounts record the ultimate or summarized
results of business transactions. They therefore record the original
investment and its subsequent net increases and decreases.
=Fundamental Consideration of Proprietorship Debits and
Credits.=—Income and expenses comprise the temporary proprietorship
items which, after being summarized, show their ultimate effect upon
vested proprietorship. In other words, they are proprietorship items
set up temporarily to furnish detailed information for aiding in
efficient management and control and are later transferred to the
ultimate or vested proprietorship records. Since, from the mathematical
necessity of the proprietorship equation, proprietorship items normally
have credit balances, it is evident that all income, or earnings,
must be placed on the credit side of their appropriate accounts. Cost
of management and all expenses of operation are deductions from that
income and must therefore be recorded on the left or debit side of
appropriately named accounts.
=Income Debits and Credits.=—With regard to their debits and credits,
income accounts follow this rule:
INCOME (under appropriate titles)
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_Debit_: | _Credit_:
(1) For all deductions from the | (a) For the yield.
yield shown contra. |
Income accounts normally have entries only on the credit side. They are
debited, however, for the purpose of deducting from the yield shown
on the credit side, (1) because of overstatement of the amount of the
yield in the first place; (2) because of error in the original placing
of the item of income, which is now transferred to its proper account;
and (3) for the purpose of summarizing when it becomes necessary
to transfer all income and expense items to one summary account.
The entries made for the purposes of transfer and summarization are
sometimes called “adjusting” and “closing” entries.
=Expense Debits and Credits.=—With regard to their debit and credit,
expense accounts follow this rule:
EXPENSE (under appropriate titles)
================================================================
_Debit_: | _Credit_:
(1) For the cost. | (a) For all deductions from the cost,
| shown contra.
Expense accounts normally have entries only on the debit side. Their
credits are for purposes similar to the debits to income accounts as
stated just above.
Examples of temporary proprietorship items can be found in Chapters V,
VI, and VII, where the profit and loss summary is treated.
=Vested Proprietorship Debits and Credits.=—Two accounts should be kept
on the ledger with the proprietor, a capital and a personal account,
i.e., “John Doe, Capital” and “John Doe, Personal.” The capital account
records the original investment or the amount of capital now in the
business as shown by the last financial statement. The personal account
shows all direct changes made in the capital during the fiscal period
either through withdrawal or the additional investment of funds or
properties. The capital account, therefore, shows no change until the
close of the fiscal period, when the increase or decrease in net worth
is transferred to it.
An exception to this is sometimes made when there is evident intention
to withdraw during the period some of the invested capital, in which
case such withdrawal is shown in the capital account as a debit or
subtraction item. Also, if there is evident intention to increase the
investment during the fiscal period, record of it is sometimes made in
the capital account. Practice in this regard is not uniform.
The ordinary transactions with the proprietor, such as more or less
regular withdrawals of cash or goods and other similar transactions,
are recorded in his personal account. This is his current account as
distinguished from his more permanent capital account. Both of these
accounts may be termed vested proprietorship accounts. Their debit and
credit schedule appears as follows:
(NAME OF ACCOUNT)
========================================================
_Debit_: | _Credit_:
(1) For amounts or values | (a) For amounts or values
withdrawn. | invested.
The capital account usually shows only one item throughout the
period until its close; the personal account shows both debits and
credits, made according to the above schedule. The personal account
ordinarily shows transactions of the following kind: on the debit
side, withdrawals in funds or goods, the payment or assumption by the
business of the personal debts of the proprietor, and his retention of
any funds or properties belonging to the business, such as collections
from customers; on the credit side, the investment in the business of
any funds or properties, the retention by the business of any funds or
properties belonging to the proprietor, as where the business collects
and retains a debt due him personally, and the payment or assumption by
him personally of any debts of the business.
=Further Consideration of Expense Items.=—In explaining the debits
to fixed asset accounts it was pointed out that all costs necessary
to place the asset in position for use by the business constituted a
part of the value of the asset and should be recorded in the asset
account. Similarly, it was explained that in the Merchandise account
there was included as a part of the value of the merchandise all the
costs incident to putting the merchandise in position for sale by the
business. Costs of this kind are classed as incoming costs and are
almost without exception treated as additions to the value of the
asset. The costs incurred from this point on, in the course of business
operations, are classed as expenses or proprietorship decreases.
It might sometimes appear that all these operating costs—the kind
shown in the profit and loss statement—also add to the value of the
assets of the business. Such is not the case. In a mercantile concern,
business is conducted for the purpose of selling merchandise. Profit
arises through the purchase of merchandise at one price and its sale
at a price sufficiently higher to pay for all operating expenses and
leave a margin. The cost of merchandise to the customer reimburses
the proprietor for his original outlay in merchandise and for a fair
portion of the operating expenses incident to the maintenance of the
store. The customer is willing to pay this additional amount because
it is cheaper for him to pay the merchant a margin over the cost of
the merchandise sufficient to induce the merchant to conduct a market
for merchandise, than to undergo the necessary expenditures—of time,
expense, and inconvenience—entailed in making the purchase from the
original vendor.
The economic organization of business is based on this hypothesis. In
the management of a business there is a very large element of risk.
The sale price of commodities at a given time is not always determined
on the basis of the original cost of the commodity plus the costs of
maintaining a store for its sale. Competition sometimes enters in to
drive the price down below this amount. While every merchant _expects_
in the long run to receive from the sale of his merchandise not only
what he himself has paid for it but also the cost of conducting his
store and a fair margin of profit, for a given period and for a given
item of merchandise he may not be so fortunate.
In recording business transactions, therefore, prudence demands that
the costs of operating the business be not recorded as increases in
the value of the merchandise dealt in, but rather that they be set
up separately and charged against the income received from the sale
of the merchandise before the increase (or decrease) in the value
of the assets is determined and made a part of the asset record. As
merchandise is converted into cash the amount received is recorded as
an increase in the asset cash. This cash includes the original cost of
the merchandise plus some of the costs of operating the business. These
are costs which must be incurred and they add value to the business as
indicated by the willingness of the customer to pay the merchant for
them. Because the added value is problematical at the time the costs
are incurred, they are recorded as expenditures which must be made good
out of the sale of the merchandise at a sufficiently enhanced price
to cover them, i.e., they are _expenses_ which are to be treated as
deductions from sales income.
The net difference between the income and the cost of securing the
income, as indicated by the expense accounts, will represent the value
added to the assets of the business, and will therefore be reflected
tangibly in an increase in the value of the assets by that amount. This
increase will usually be reflected either in the cash holdings or in
claims against customers.
It may not be out of place at this point to call attention to the
fact that, as the bookkeeping record is usually handled, the only
relationship between asset increases, liability decreases, and
expenses (proprietorship decreases) arises from the fact that all of
them are debits and are so placed because of the mathematics of the
fundamental equation on which double entry rests. Assets, liabilities,
and proprietorship are three distinct and separate groups of accounts
related only by the logic of the proprietorship equation. As the
subject of accounting is developed the student will see the increasing
importance of drawing sharply the lines of division among these groups
and he will see also the difficulty at times of maintaining this
distinction.