Book-keeping primer

33. Book-Keeping Primer

A Beginner's Guide On Book-Keeping

What Is Book-keeping?

Book-keeping is a way to record financial transactions of a business entity and to determine particularly its profits, assets, capital, and liabilities at particular intervals.

The first record is to record the capital introduced to start the business. The capital usually is in the form of assets (cash, vehicle etc). So, the first record looks like this:

CAPITAL = ASSETS

It has become a standard that the CAPITAL side is called CREDIT side and the ASSETS side is called DEBIT side. It may be written this way:

ASSETS = CAPITAL

but the fact remains that the CAPITAL side is called CREDIT side and the ASSETS side is called DEBIT side.

Alternatively, we also say that CAPITAL is a CREDIT item (because it always appears on the credit side) while ASSETS is a DEBIT item (because it always appears on the debit side).

We thus can deduct that CREDIT side contain items OWED BY the business and DBIT side contain items OWNED BY the busness.

Business Entity Vs Capital Provider

A business is an entity separate from the person who provides the capital for the business to start. The CAPITAL of the business is an amount OWED BY THE BUSINESS to the person who provides it. To the business, the CAPITAL is an amount LENDED BY the person who provided it. The provider can take back the capital (in whatever form), e.g. when the business ceases. So, the CREDIT side is actually to show amount owed by the business to another entity, while the DEBIT side is to show what assets the business has.

A book-keeper must be able to differentiate at all times a financial transaction belonging to a business entity and its capital provider, because he wants to record transactions of the business, not the capital provider.

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Profit And Loss

Over time, purchases and sales occur. These processes are simply a conversion of one form of assets into another form. For example, when the business uses cash to buy goods, it converts cash into goods, but the equation of CAPITAL = ASSETS still holds true. Now the assets side is represented by cash (reduced) and goods.

When the business entity sells the goods for cash, we convert the goods into cash. The equation of CAPITAL = ASSETS still holds true.

Most of the time, the business entity sell our goods at a price higher than the price it initially purchased the goods. The difference is a PROFIT. The PROFIT is represented in the form of cash (a form of assets). The PROFIT effectively belongs to the provider. It increases the value of the CAPITAL. That's why PROFIT is written in the same side as CAPITAL, i.e. the CREDIT side. Now the position is:

CAPITAL + PROFIT = ASSETS (partly from Capital and partly from Profit).

Sometimes, a business entity sell its goods at a price lower than the price it purchased the goods. The difference is a LOSS. The LOSS is represented in the form of the reduced cash (a form of assets). The LOSS is effectively belongs to the provider. It decreases the value of the CAPITAL. That's why LOSS is written in the same side as CAPITAL, i.e. CREDIT side. Now the position is:

CAPITAL - LOSS = ASSETS (partly from Capital and reduced by the Loss).

Debit And Credit

Sometimes the business borrows money from a bank. So, the business not only owes money to the provider but also to a bank. (Remember, the money owed by a business is shown on the CREDIT side). When a business borrows money from a bank, its assets (cash) increases and its liability (amount owed) also increases by the same amount. So, the amounts in DEBIT side and the CREDIT side will always be equal.

Sometimes the business buys goods on credit from a supplier. So, the business owes money to the supplier. (Remember, the money owed by a business is shown on the CREDIT side). When a business entity buys goods on credit from a supplier, its assets (goods) increases and its liability (amount owed to the supplier) also increases by the same amount. So, the amounts in DEBIT side and the CREDIT side will always be equal.

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Sometimes the business sells goods on credit to a customer. So, the business has assets with the customer. (Remember, assets of a business is shown on the DEBIT side). When a business entity sells goods on credit to a customer, its assets (goods) change into another form of assets (debtor).

The term ASSETS is too broad. Usually, further breakdown is identified, e.g. FIXED ASSETS, CURRENT ASSETS, INVESTMENTS etc. And it can further broken down into more identifiable categories.

The term LIABILITY is also too broad. Usually, further breakdown is identified, e.g. CURRENT LIABILITY, LONG TERM LIABILITY, etc. And it can further broken down into more identifiable categories.

When a credit item increases (e.g. due to credit purchase), we say we Credit the credit item. When a credit item decreasess (e.g. due to payment of liability), we say we Debit the credit item. When a debit item increases (e.g. due to a purchase), we say we Debit the debit item. When a debit item decreases (e.g. due to selling of goods), we say we Credit the debit item. So, debiting a credit item will decrease the amount of the credit item. Crediting a credit item will increase the amount of the debit item. Debiting a debit item will increase the amount of the debit item. Crediting a debit item will decrease the amount of the debit item.

Accounting Statements

Over time, we want to keep track of transactions which give rise to PROFIT or LOSS. For this, we use a special statement called PROFIT & LOSS ACCOUNTS statement to record items which give rise to PROFIT or LOSS. Another statement, BALANCE SHEET statement is used to record items which does not give rise to PROFIT or LOSS. The BALANCE SHEET will show the position of CREDIT side items and DEBIT side items. The net of PROFIT and LOSS will appear in the CREDIT side of the BALANCE SHEET.

The figures in the statements are obtained from acconting books.

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