Sunday, March 04, 2007

Debit or Credit ??

The three simple rules of Debit and Credit:
  1. Debit what comes in, Credit what goes out. (Real A/C)
  2. Debit the receiver, Credit the giver. (Personal A/C)
  3. Debit all expenses and loses, Credit all profits and gains. (Nominal A/C)
Real A/C : These include accounts like the cash a/c, furniture a/c, machinery a/c, etc.

Personal A/C : These include accounts for the proprietor, creditor, debtors, etc.

Nominal A/C : These include accounts for salary, interest, discounts, etc.

So far, so good. And I thought, oh that's easy. One look at point 1, and I went on to summarize that whatever is received by the account is debited, and whatever is taken out of the account is credited. I even went on to visualize a neat little cash box that a firm maintains on the part of each debtor, creditor, cash a/c, et. all. So when you put in the box, you do debit and when you take out you credit that account. And then wow! Then same visualization works for the second rule.

Just as I was thinking that this was going to be easy, up comes the third point. Whose account is it anyway?? Far as I could reason the expense/loss a/c cash box was always giving out things to others so it was always going to be in credit. But with no debit, there was little chance that the account was going to be balanced. Also need to consider that where does the money come in from. Phew! Things started going over my head.

Then somebody showed me the light of the day. My visualization while not completely wrong was misleading me. These accounts in accounting practice should not be treated as just money, as in cash. Treat them as they are, i.e. an entity called account, and they will behave fine. Waah! After all that hullabaloo about accounts being about money, about changing every possible transaction to talk in terms of money, my concepts were about to go up in smoke.

And I came across this case:

"Interest charged by creditor XYZ Co. Ltd. Rs. 2000"

Hitting the roof was never easier earlier to this. How much ever way I tried to apply the three rules, or any combination thereof there was simply no way I could balance this. My explanation: Rs. 2000 paid as interest. So considering that there is an interest expense a/c I debited the account by the same amount according to rule three. Now I took a look at XYZ Co. and applying rule 2, I debited their a/c. Now wait! How is this going to be balanced?? When an a/c is debited another is to be credited, right?? But here both are being debited. That angel came to rescue with an explanation. You always treat the creditor (the debtor for that matter) as a liability. So when the creditor pays you money (which you are supposed to pay back), according to rule 2, the creditor goes into credit. Similarly, the interest that you are paying your creditor is a liability. It is a sum of money that you are supposed to pay your creditor, although the creditor has never actually paid you the amount. So, to show that the you owe such an additional sum to the creditor, you need to credit the creditor a/c with the additional amount to balance your books.

These concepts are supposed to be grasped by a student in the 11th grade studying in India. I started to wonder at that social notion that the Indian society attaches to a student taking up commerce/ accounts papers. It's as if they are the lower of the student fraternity. All bright students are supposed to take up science and become doctors or engineers. Far as I am concerned, this simple thing was no less than "Rocket Science". (been long since I used that phrase; the last time I remember having that feeling was when I read "Analysis of Mind" by Bertrand Russell)

I am just beginning to learn such concepts in finance. I maybe wrong or right. If you are reading it, keep that pinch of salt with you (Don't forget the lemon and the shot!)

Update: Found this site with an explanation of the Accounting Equation, which is what I have been talking about above. Good examples.