Alright,” Said Steve’s new friend. “Let’s answer ‘what are debits and credits’ question.”
Debit comes from a Latin word which means “that which is owing”. Credit also comes from Latin meaning “to trust or believe”. In the past, around the 15th century or so, you would keep a record showing who you owed money to and who owed you money.
People would write down who they owed money to on the left side of the page and naturally, the right side of the page was used to record money that you were to receive.
It was this convention that evolved into our modern system of accounting.
Today, we record the money we pay to others, as debits, on the right. Likewise, any money that we get is recorded, as a credit, on the right.
But we have also taken the system further. We have created an accounting rule that says: For every transaction, the value of the debits must equal the value of the credits.
It is the use of these debits and credits that give the double entry system is ability to record both sides of a transaction.
Here is your first question. Let’s say you paid your cell phone bill, would that be recorded as a debit or a credit?
It would be a debit. Why? Because debits are used to record the money we pay to others. But, that is only half of the answer.
Remember, what we just said about the accounting rule; debits equal credits, for every transaction. That means that there is another side.
Since we already have a debit, we need a credit. In this case, we paid cash for the bill, so cash gets credited.
We now have a complete transaction. Cash gets exchanged for a cell phone bill.
While this might at first seem odd, it is the use of debits and credits gives the double entry system built-in checks and balances. This is because the total of the debit values recorded must equal the total of the credit values recorded. Unlike the single entry system of accounting, which does not use debits and credits, errors are evident right way. This double-entry system is self-balancing.
“Okay,” said Steve. “So every time my business has a transaction I need to record it as both a debit and a credit.”
“That is correct,” His friend said. “There is always at least one debit and on credit to the accounts that are effected by the transaction.”
Steve’s reaction, of course, was “huh’?
Accounts are records of resources, claims to resources, or other events that keep track of any changes.
Basically, you can think of accounts as buckets. You can fill them up and you can take stuff out.
Take cash for example. As you receive cash you throw money into the bucket. When you spent cash you have to reach in and take money out. You can always know how much is in the bucket simply by counting what is inside.
Every transaction results in things moving from one bucket and moved to another, into buckets, or out of buckets. You might have one account for cash, one for your vehicle, or one for your house. Your cell phone bill might be another. Businesses have buckets, accounts, for everything.
In the cash of your cell phone bill, when you pay it, you are taking the money out of one bucket, your cash bucket, and placing it in your cell phone expense bucket.
If you buy a house, you are taking money out of your cash bucket and putting a house into your ‘home’ bucket. Of course people don’t unusually buy a home with cash. Instead, along with putting a house into your ‘home’ bucket you would place an IOU into your ‘Mortgage’ bucket. Then every time you make a payment, you take money out of your cash bucket and you would take that same amount out of the IOU in your ‘Mortgage’ account.
“That seems easy enough,” said Steve. “But how do I know which buckets to use for each transaction?”
“Before I can answer that,” said his friend. “We will need to talk about the categories that accounts fall into. That will be what we discuss tomorrow over lunch.”