Delving into DEAD CLIC – tips and FREE practice questions for AAT students.
Beginning to study a course in accounting can be like entering a foreign country. Everyone seems to be going about their business confidently and to you it seems like it is all in a completely different language. You have no problem with doing the mathematics and would gladly tell the examiner what 20% VAT on an item was, but even simple transactions appear to have been transformed into a bewildering swirl of entries and accounts. You begin to ask yourself “Where is this supposed to go?” and “why is that going up instead of down?”. You press on further into the swirl of new concepts, hoping that it will all somehow fall into place in the end.
For myself and many students, learning how to treat debits and credits was the important milestone where things started falling into place. Once you have a better understanding of how debits and credits work in a double entry bookkeeping system, you have a framework for how to view and treat transactions you haven’t encountered before.
Before we go further, we need to dispel some myths:
Are Debits bad and Credits good?
For most of us, our first experience of debits and credits is looking at our bank statements. A debit entry is not welcome as it sees our bank balance go down. A debit balance is really bad news, as it means we have gone overdrawn!
Whilst starting out learning double-entry bookkeeping, the best thing you can do is FORGET HOW THINGS GO ON YOUR BANK STATEMENT! The bank statement is back-to-front. It is written from your perspective, but from the point of view of the bank. If the bank statement shows a debit balance, your liability to repay the overdraft is seen as an asset (debit) for them. Similarly, where you have a “positive bank balance” from your perspective, the bank sees this as a liability (credit) to pay you when you choose to withdraw your money.
So bank statements are not technically wrong, they just aren’t very helpful starting out.
So, are Debits good and Credits bad, then?
Not really, it is more helpful to see them as neutral – two sides of the same coin, which balance each other out, like yin and yang, or a see-saw. Let’s take a look at the definition of Debits and Credits:
What is a Debit?
A debit is an accounting entry which either increases an asset or decreases a liability. In double entry bookkeeping debits are displayed on the LEFT hand side of the accounts.
The following types of transactions are recorded as Debits:
- Expenses (will be dealt with in Part II of this series of posts)
- Assets
- Drawings (will be dealt with in future posts)
An Asset is something that is owned or controlled by a business that is expected to provide a future benefit to the owner. Examples of assets include cash, receivables, inventory, property, machinery and intellectual property (such as licences, copyright and trade marks)
If your company were to purchase £20,000 of new machinery, the Machinery account would be debited by £20,000 to show that increase in assets.
What is a Credit?
A credit is an accounting entry which increases a liability or decreases an asset. In double entry bookkeeping credits are displayed on the RIGHT hand side of the accounts.
The following types of transactions are recorded as Credits:
- Liabilities (the counterpart of assets)
- Income (the counterpart of expenses)
- Capital (the counterpart of Drawings)
To expand on the example above, imagine that your company had £100,000 in the bank as of 1 March. Cash is an asset, so the cash account at 1March would look like this:
Now say that on 2 March your business spent £20,000 of that cash to buy the machinery. That transaction would have two effects in double entry bookkeeping. Firstly, as discussed above, the amount in the Machinery account would be increased. As this is an increase in an asset (machinery) then it would be a debit entry. The transaction would be recorded as highlighted:
(the description is ‘Bank/Cash’ as it shows where the other half of the double entry is made and that the purchase was made with cash)
The other recorded effect of this transaction is that the amount of cash in the bank will decrease by the £20,000 that has been paid out. As this is the decrease of an asset, it is a credit transaction and would be entered in the right hand columns of the Bank/Cash account:
Test your understanding of debit and credit transactions by answering these questions for free!
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