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The banking system is an integral part of the financial system of many countries. In fact, as we have discussed in the previous articles, many countries base their entire financial system on the banking system. The central bank plays a very important role in the financial system of any country. This is the reason why […]
How Pre-Revenue Companies are Valued?
Valuation of any company can be a very complex task. However, when it comes to pre-revenue companies, this complexity is magnified. This is because of the fact that valuation is generally the discounted value of the future cash flows which are likely to arise in the future. The current cash flows are used as a […]
Debits and credits are the building blocks of the double entry accounting system. Many accounting students find the usage of these words confusing. Many try to understand them by trying to draw an analogy with something they already know like plus and minus. However, debits and credits are distinctly different from plus and minus.
Sometimes a debit entry may make an account balance go up whereas other times it will make an account balance go down. Let’s try and understand how this debit and credit system works.
The debit credit system can be understood to be a two layered system. The steps involved in deciding whether an account needs to be debited or credited are as follows:
Accounts are of two types the debit and the credit types. Here is how they are distinguished
Any item can be classified as exactly one of these classifications. However, the same item may be split into two and be part asset and part expense and so on.
Thus accounts can be classified as outflow and inflow
When you debit an account which has a default debit balance, you increase its value. When you credit an account which has a default debit balance, you decrease its value. The same is true for credit accounts as well.
Now you can decide whether to debit or credit an account. Let’s say you have to increase the cash balance. Cash is an asset and therefore has a default debit balance. When you debit it further, you increase its balance. Therefore, you will debit the cash account.
Similarly you can ascertain whether an item needs to be debited or credited. As a check, you must ensure that the debits in every transaction are equal to the credits. This is like the fundamental principle of accounting.
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