The Supporting Concepts for Debits and Credits
To properly understand Debits and Credits you will need to first understand the concepts that underpin the whole accounting process. Some of these are called Accounting Conventions and others are simply re-enforcing the way that the accounting systems looks at and records financial transactions.
Basic Accounting Concept 1 – The business or firm is an entity.
In simple terms, the legal system defines an entity as a person or non-person that is capable of suing or being sued under the laws of the land. In most countries of the world, companies are given this ‘non-person’ entity status and are given the same rights and obligations of individual persons. Accounting takes this concept a step further by stating that every firm (including sole traders and partnerships), creates its own ‘accounting entity’ and that the income and net worth of each entity must be calculated based on its own financial transactions.
Basic Accounting Concept 2 – The business (firm) is a separate entity distinct from the owners
A firm, while it has ‘legal’ control over items of value, it is not the ultimate owner of those things. In other words, if the firm sold everything it had, it would be obliged to distribute all those monies to meet the claims made by other people or entities. The firm’s first obligation is to pay the claims made by external people (i.e. loans and creditors) with the balance being given to meet the claims made by the owner(s). The business would then return to how it all began, as a blank sheet without obligations or the control of any items of value.
Basic Accounting Concept 3 – People can wear multiple hats.
While this not a strict accounting concept, it is an important one to understand when getting the right perspective on financial transactions. Just like one person can be a parent, sibling, cousin or an offspring, so too a person can be an investor in a firm, a creditor/debtor of a firm, the manager of a firm or a director of a company that controls the operations of a firm. The important thing to remember is, that in accounting the financial transactions are always analyzed and recorded from the firm’s point of view with you as the manager (not owner).
Basic Accounting Concept 4 – Every financial transaction has two sides to it and involves a source and a destination of economic resources.
The financial world is a closed system. That is, money does not just arrive from nowhere and it is not just paid into thin air. If money is received by one person or entity, it must have been given by another person or entity and that in every transaction involving financial resources there must be a source and a destination. This gives us our first insight into the Debits and Credits system that we use in accounting today.
Basic Accounting Concept 5 – The profit from the firm’s activities belongs to the owners.
As understood from Concept 2, the firm does not really own anything, from an accounting perspective. It may have legal rights of ‘ownership’ or control, but fundamentally in accounting terms it is an accounting entity set up by the owners to manage their affairs. So, when a firm makes a profit it does so for the owner’s benefit, not for the firm’s. Remember, if everything was sold off the firm would be left with nothing because everything of value would be used to first pay off liabilities with the remainder going to the owners.