Explaining the Rule of Debit and Credit Transactions with Examples
Accounting is an integral part of any business as it helps record its financial transactions and gives information about its financial health. Today, most businesses record their financial transactions via the double-entry accounting system.
Debit and credit transactions are the two parts of this double-entry system and should be equal in value. When this takes place, the books of accounts will be in balance. Only then can a business generate accurate financial statements.
It is easier to explain the rules of debit and credit if you have an idea about the golden rules of accounting. The following sections will cover these rules in detail.
What Is the Rule of Debit and Credit in Accounting?
Accounting refers to the process of recording transactions in a systematic manner where all assets and liabilities are ascertained and summarised on a balance sheet.
There are two types of accounts on which the accounting world stands. These are debit (dr) and credit (cr) accounts.
There are some basic rules called the golden rules of accounting that make the recording of financial transactions accurate and easier to keep track of. Mentioned below are these rules:
- Debit is what comes in; credit is what goes out
This rule is applicable to any real account. If a company purchases assets like land and building, machinery, furniture and fixtures, it will be treated as a debit balance on its account. On the other hand, if the company gives out any of these items, it will be treated as a credit.
- Debit includes expenses and losses; credit includes incomes and gains
This rule is applicable to all nominal accounts, which record losses and gains. Expenses such as telephone charges, electricity bills, rent, etc., are considered debit balances. In contrast, if you earn money from selling items, rental income, interest received, etc., it will be treated as a credit in the account.
- Debit the receiver, and credit the payer
This rule is applied to personal accounts. When an organisation or individual provides anything to the business, it is treated as a debit in the account. Similarly, if the organisation gives out anything to an individual or another organisation, it is treated as a credit balance in the account.
Also Read: 11 Common Myths about Credit Score
Examples of Debit and Credit in Accounting
The examples between Debit and Credit in accounting are as follows:
- If you purchase an asset costing Rs. 20,000 on credit, you have to debit Rs. 20,000 to your fixed asset account, thereby signifying an increase. Buying an asset means that you increase your liabilities as well. To record the increase in books of accounts, you have to credit your accounts payable account by Rs. 20,000.
- Suppose you are buying Rs. 2,000 of stocks from someone with cash. When recording the transaction, you need to debit your stock account and credit your cash account since both of them are asset accounts.
Types of Accounts on Which the Golden Rule of Accounting is Based
The following are three different accounts involved in the Golden Rule of Accounting. These are:
- Real account
A real account or permanent account is a general ledger account which never closes and lasts till the end of a financial year. In general, the balances of real accounts are carried forward as the opening balances of an upcoming financial year. Examples of assets recorded in real accounts are buildings, inventory, cash, machinery, patent, etc.
This account records the transactions that involve assets or possessions. Real accounts are classified into two types. They are:
- Nominal account
The nominal accounts keep a record of financial transactions for a particular span of time, generally a year. This account opens with zero balance and closes at the end of an accounting year. A nominal account keeps the transaction regarding income, expenses, profits, losses, etc.
- Personal account
Personal accounts are the general ledger account used by a person for his/her own needs. As its name suggests, this account is much different from those used for corporate or business use. Examples of personal accounts are capital accounts, salary accounts, drawings, etc.
If you receive something, you need to make a debit on your personal account. In contrast, credit is recorded on this account when you give something.
Also Read: How to check PPF account statement
Advantages of Following the Golden Rule of Accounting
There are various benefits of the Golden Rule of Accounting system. The following are some of these advantages:
- Records transactions efficiently
Since an organisation enters into numerous transactions on a regular basis, it becomes very difficult to remember every one of them. Thus, bookkeeping or maintaining an account of all transactions on a daily basis is an ideal way to maintain an accounting system.
- Profit and loss analysis
Recording transactions in the proper way helps an organisation maintain the accrued profit and loss (P/L) account at the end of a quarter or a particular period.
- Shows a firm’s financial position
Accurate and systematic bookkeeping helps to record financial data on a regular basis. Showing accurate financials is essential for a business to attract investors.
- Management of business
Maintaining regular transactions in a proper way helps an organisation to keep track of its present nominal accounts. By doing so, they can even maintain their future income and expenses.
- Records expenses
Keeping a systematic record of transactions helps a company in analysing unnecessary expenses that occurred over a particular period. Then, the company can formulate a plan to deal with such expenses.
- Comparative analysis
Recording daily transactions systematically help an organisation to do a comparative analysis of their performance in the following year and in recent times. Companies need to analyse and compare the year-on-year financials to be able to make better corporate decisions.
Difference between Debit and Credit in Accounting
The debit side only keeps records of those accounting transactions that either increase the asset account or decrease the liability account. On the contrary, the credit side records transactions that increase a liability account or decrease an asset account.
In accounting, the debit and credit entries are placed on the left and right sides, respectively. The capital decreases in the case of debit, whereas it increases when it comes to credit. Furthermore, the income and expenses decrease and increase in the case of debit and credit sides, respectively.
For every transaction, both the debit and credit accounts need to have a corresponding entry. Another essential rule of debit and credit is that the totals of debit and credit must always be equal to each other. This double system of entries in accounting makes it easy for businesses to balance their accounts.
Being a businessperson, you should have a sound idea of how debits and credits function to keep your accounting system in order. To understand the rules of debit and credit, you can go through the above sections. Proper use of debits and credits is vital, as they are necessary for financial statements like income statements, profit and loss accounts and balance sheets etc.
Frequently Asked Questions
How are debits and credits used?
Debit and credit balances show the values coming inside and going outside of a business. Even though they are equivalent to each other, they work in a reverse way. So, whenever you make a purchase or sell something, one account increases in value while the other decreases.
How many types of accounts are present in a general ledger?
The general ledger of an organisation consists of seven kinds of accounts appearing on their financial statements that include assets, liabilities, revenue, expenses, equity and profits and losses.
What is a T-chart in accounting?
‘T-chart’ or ‘T-account’ is the graphical representation of financial recordings which utilise the double-entry accounting system. In this, records in the general ledger are represented by a two-column chart, where all entries must match. This chart looks like the letter “T”, in which the left column shows debits and the right column shows the credits.