Why We Need this “Debit and Credit” Thing
Imagine you just started a company and you are trying to record the following transactions that took place in the company: Last week, you invested $10,000 cash into the company. As this is not enough for your business to operate, the company took an extra $8,000 cash loan from the bank. With the money, the company bought a $5,000 machine. The company also got an insurance for $200 for the new machine. The company then bought some inventory (goods for resale) worth $400 and the seller agreed that your company does not need to pay immediately…
Wait. Is there a more systematic and elegant way of expressing these transactions – a method that provides a common language for companies to describe their transactions and also helps the businesses to summarize them? Sure there is. In accounting, we use the double-entry accounting system, where each entry involves at least one debit entry and one credit entry (hence the name “double-entry”).
The Meaning of “Debit” and “Credit”
Here are the informal meanings of the two words:
- Debit (abbreviated as “Dr”) = receive
- Credit (abbreviated as “Cr”) = take out
Side note: The abbreviations “Dr” and “Cr” comes from debere and credere, which are the Latin counterparts of debit and credit respectively.
This meaning can be generalized so as to express more complex transactions. See Part 2 of this article for more.
Using the Double-Entry Accounting System
Let’s try to express the transactions listed at the top of the article with the double-entry accounting system. Remember transactions have to be recorded from the company’s perspective, not from the owners’ or someone else’s point of view.
(1) “… you invested $10,000 cash into the company.”
Here is what happens from the company’s perspective: the company receives $10,000 in cash. The cash is taken out from the owners (aka. the shareholders). The corresponding double entry is:
|Dr. Cash (Asset)||10,000|
|Cr. Paid-in capital (Shareholders’ Equity)||10,000|
(2) “… the company took an extra $8,000 cash loan from the bank.”
From the company’s perspective, it receives another $8,000 cash. This time, the cash it receives is taken out from the bank in form of a loan. The corresponding double entry is:
|Dr. Cash (Asset)||8,000|
|Cr. Bank loan (Liability)||8,000|
(3) “… the company bought a $5,000 machine.”
From the company’s perspective, it has taken out $5,000 cash from its coffers and received a machine in return. The double entry for this transaction is:
|Dr. Plant and Machinery (Asset)||5,000|
|Cr. Cash (Asset)||5,000|
(4) “… got an insurance for $200 for the new machine”
Here, from the company’s perspective again, it received insurance service. In return, it takes out another $200 cash from its coffers. The transaction can be expressed as:
|Dr. Insurance (Expense)||200|
|Cr. Cash (Asset)||200|
(5) “…bought some inventory (goods for resale) worth $400 and the seller agreed that your company do not need to pay immediately”
From the company’s perspective, it receives inventory. Therefore, we know that the transaction involves a “Dr. Inventory 400“. But what is the corresponding credit entry here? No, the company did not take out cash this time because it came to an agreement with the seller that cash will be paid later. We therefore cannot credit our cash today. Instead, we use the following entry:
|Dr. Inventory (Asset)||400|
|Cr. Accounts payable (Liability)||400|
The entry means that the company received inventory of $400. These inventories were taken out by the seller who is called an account payable as the company has not paid him/her yet. No exchange of cash is involved in this transaction.
Still confused? No worries. In the next part, we will look at debits and credits from another perspective.