Now let us understand two most used terms in Financial Statements. These are the most misunderstood accounting terms. If I ask you to give the understanding or definition of Debit and Credit everyone will have their own definition. Debit and Credit by itself has got no meaning.
For example in a game of chess before the last pawn is moved, the player says checkmate. The term checkmate by itself has got no meaning. However in context of the game of chess it has meaning.
Similarly in football they have on-side, off-side, D-box, penalty shoot-out, Golden Goal. These terms by itself they have no meaning. However in relation to football it has meaning.
In the same manner Debit and Credit by itself has got no meaning. Only in context to accounting and the double entry system of book-keeping it has got some meaning. Every financial transaction will have an impact on two accounting heads simultaneously. That is what double entry is all about. Double Entry means something is entered twice.
So every financial transaction will have an impact on two accounting heads simultaneously. ‘Debit’ and ‘Credit’ denotes two opposite effects of one transaction on two accounting heads.
We have just understood that – Every Financial transaction has to be Expense or Income or Liability or Asset.
Among these two must be Debit and two must be Credit. Now the question is. Which is debit? And which is credit?
Expenses are it Debit or Credit? What about Incomes? Is it Debit or Credit? What about Liabilities and Assets? Which is debit and which is Credit?
Expenses are Debit. Incomes are Credit. Liabilities are Credit. Assets are Debit. However you do not need to learn this as a law. Let us try and use our common sense. If Expenses and Asset are Debit and if Income and Liabilities are Credit there has to be some similarity between them. What is the similarity?
The similarity between Expense and Assets is money goes out of the business. Similarly the similarity between Income and Liabilities is that money comes in to the business. Expenses, money is going out of the business. Assets you may say we have got land and machinery. But to purchase the land and machinery money goes out of the business. That is the reason it is important to see from a business perspective and not from an owner’s perspective. From the business perspective if the money is going out of the business either it becomes and Expenses or creates an Asset. Money is coming in to the business. If it is by selling the product or service it is called Income. If money comes in to the business because of borrowing then it becomes a Liability.