Understanding Debits & Credits

❑Understanding Debits and Credits - Perhaps you have heard or seen this expression before:

•"Debits must equal Credits" which means the following:

✓The sum of all Debit entries made to a General Ledger must equal the sum of all Credit entries made to that General Ledger.

✓The rules for Debits & Credits (as outlined below) are Rules.

✓Just remember them - don't question them until you understand them - and once you do, you won't.

•This may be the most difficult concept for you to understand when first getting involved with a General Ledger Accounting System - manual or automated.

✓The REASON people find this confusing is because initially, it is.

✓And this is because the phase "Debits and Credits" is actually used to describe two very different things!

•General Ledger Account Types - There are five Primary Account Types used to describer the type of Account to which a Financial Transaction is recorded in a General Ledger System:

1.Asset Accounts 1000 - 1999 - Debit - An Asset Account identifies items that have an actual cash value or can reasonably be converted to cash.

2.Liability Accounts 2000 - 2999 - Credit - A Liability Account identifies a portion of what the Company owes, or in some other manner is obligated to pay to others.

3.Equity Accounts 3000 - 3999 - Credit - The Equity Accounts identify the net value of the business (Company).

4.Sales Accounts 4000 - 4999 - Credit - These Sales Accounts identify the Revenue (Income) from Sales, Interest earned from savings, and any other miscellaneous Income.

5.Expense Accounts 5000 - 9999 - Debit - These Expense Accounts identify the Purchases made to sustain the business, produce product, complete an installation, and/or provide services.

❑Review:

•First, some review (see the "Types of Account Divisions" section in the Accounting Terminology chapter for additional information) using the recommended - not mandatory - Account Numbering scheme (i.e., the Numbering Range for each Primary Account Division) which, in the example below, is 1000 - 9999:

1.Asset Accounts 1000 - 1999 - Debit - An Asset Account identifies items that have an actual cash value or can reasonably be converted to cash.

2.Liability Accounts 2000 - 2999 - Credit - A Liability Account identifies a portion of what the Company owes, or in some other manner is obligated to pay to others.

3.Equity Accounts 3000 - 3999 - Credit - The Equity Accounts identify the net value of the business (Company).

4.Sales Accounts 4000 - 4999 - Credit - These Sales Accounts identify the Revenue (Income) from Sales, Interest earned from savings, and any other miscellaneous Income.

5.Expense Accounts 5000 - 9999 - Debit - These Expense Accounts identify the Purchases made to sustain the business, produce product, complete an installation, and/or provide services.

❖All of these five Primary Account Division classifications, and the Secondary sub-classifications which are also provided, should be further characterized by using General Ledger Account Groups as additional sub-group classifications.

✓Although General Ledger Account Numbering scheme (see the "Choosing the Account Numbering scheme" discussion immediately below) may contain up to 8 digits; plus 4 additional digits coming after a decimal point (e.g., 12345678.1234), the list above presents a typical - and our recommended - Account Numbering scheme (the recommended Numbering Range) for each of the five Primary Account Divisions:

•Choosing the Account Numbering scheme - The Account Numbering scheme and the Numbering Range for each Primary Account Division that will be used for designing your Company's Chart of Accounts (i.e., General Ledger Accounts):

✓Although a Numbering Range of 1000 to 9999 is recommended, a much more complex numbering scheme may be utilized, if necessary.

▪Up to 9,999,999 main General Ledger Accounts, each with up to 9,999 subordinate Accounts may be created (e.g., 12345678.1234).

▪This power and capacity must be used wisely, as the longer and more complex the number scheme used for defining General Ledger Accounts is, the more complicated the management and reporting becomes for this (or any) General Ledger System.

▪Remember: With Power comes Responsibility

✓So, unless you have a compelling reason to be more complicated and complex when designing your Numbering Range, stick with our recommendation (i.e., a Numbering Range of 1000 to 9999).

❑The two definitions for Debits and Credits are stated simply (and we hope, and clearly) below.

➢Note: We did not make these rules, so don't be angry with us... (a smile is required here, please...)

1.An Account Type's Classification: (a noun) - The words Debit and Credit are used to classify each Type of Transaction as defined in the list of Account Divisions:

✓Each Financial Transaction entered for any Account Division's Account (i.e., Asset, Liability, Equity, Revenue and Expense, or any of its sub-classifications) is designated as being either a Debit Account, or a Credit Account.

▪Almost everyone has heard that "Debits must equal Credits" and that means:

a)The sum of all Transaction Amounts posted to any Account Division's Account(s) that are classified as Debit Accounts in your Company's General Ledger, must equal the sum of all the Transaction Amounts posted to any Account Division's Account(s) that are classified as Credit Accounts in your Company's General Ledger; and/or

b)The sum of all Transaction Amounts posted to any Account Division's Account(s) that are classified as Debit Accounts in your Company's General Ledger must be equal when one Debit Account is Debited (added to) and one or more of another Debit Account is Credited (subtracted from); and/or

c)The sum of all Transaction Amounts posted to any Account Division's Account(s) that are classified as Credit Accounts in your Company's General Ledger must be equal when one Credit Account is Credited (added to) and one or more of another Credit Account is Debited (subtracted from).

✓Therefore, referencing the list of the Types of Transaction Account Divisions shown above, you now know that when you sum the values in each of the Debit Accounts (Asset and Expense Accounts) and compare it to the sum of the values in each of the Credit Accounts (Liability, Equity and Revenue Accounts), the total for the Debit Accounts should be the same as the totals for the Credit Accounts - and if not, your Company's General Ledger will be considered "out-of-balance".

▪Fortunately for you, the MKMS General Ledger System tracks this "in-balance" issue automatically and assures that the Debits and Credits do equal each other at all times.

▪In fact, baring a database error (illegal shutdown, PC crash, etc.), the MKMS General Ledger System does not accept an out-of-balance transaction, thus preventing it from ever occurring.

1.An Action (a verb) - The Posting of a Financial Transaction to an Account: - The words Debit and Credit may also represent the action of posting a Financial Transaction to any Account as noted in a), b), and c) immediately above.

✓Is the transaction adding to an account's balance, or subtracting from it?

1)When adding to any Account's Balance, that transaction's Action Name (Debit or Credit) is the same as the Account Type's Classification (see #1. An Account Type's Classification above).

2)When subtracting from the Account's Balance, the transaction's Action Name (Debit or Credit) is the opposite of the Account Type's Classification (see #1. An Account Type's Classification above).

✓Wasn't that fun? Not really - but with the following transaction descriptions added, this should clarify the issue:

1)When adding to any Account's Balance, that transaction's Action Name (Debit or Credit) is the same as the Account Type's Classification (see #1. An Account Type's Classification above).

a)Adding to a Debit Account Type's Balance is referred to as Debiting the Account (the action of adding to the account's balance takes on the name of the Account Type's Classification).

b)Adding to a Credit Account Type's Balance is referred to as Crediting the Account (the action of adding to the account's balance takes on the name of the Account Type's Classification).

2)When subtracting from the Account's Balance, the transaction's Action Name (Debit or Credit) is the opposite of the Account Type's Classification (see #1. An Account Type's Classification above).

a)Subtracting from a Debit Account Type's Balance is referred to as Crediting that Account (the action of subtracting from the account's balance takes on the opposite name of the Account Type's Classification).

b)Subtracting from a Credit Account Type's Balance is referred to as Debiting that Account (the action of subtracting from the account's balance takes on the opposite name of the Account Type's Classification).

•Continuing with the discussion of the "Debits must equal Credits" rule, the sum of all Debit entries must equal the sum of all Credit entries.

✓This means that you can never make one entry into a General Ledger System, you will always make a minimum of two (a Debit entry and a Credit entry of the same value) when creating a Financial Transaction.

▪Sometimes the transaction may require multiple Credit and/or Debit entries - which is fine - as long as all of the Credit entries add up to the same Value and all of the Debit entries.

✓By following this "Debits must equal Credits" methodology, the General Ledger automatically stays "in-balance".

▪This process is what is known as "Double Entry Bookkeeping" (see the related Double Entry Bookkeeping chapter for more information as to why this method is used).