Elavasam's Third Law of Accounting!

"I don't understand accountancy. They say debit what comes in, credit what goes out. I wish they follow it when it comes to my bank account. But they credit my account when money comes into my account. There is no logic." That was my friend, reacting to a Facebook post. 

 

Is the bank really screwing up things by doing what it is doing? Is accounting that difficult to understand? Let us talk about it. And like Trevor Noah says, "We will tell you about basics of accountancy in another installment of - If you don't know, now you know' 

 

Newton's third law of motion says, 'Every action has an equal and opposite reaction'. The accounting equivalent would be that every debit has a corresponding credit. There are exceptions to this rule but for now, let us keep it simple. In addition to that there are three golden rules of accounting

 

• Debit what comes in, Credit what goes out
• Debit the receiver, Credit the giver
• Debit all expenses and losses, Credit all incomes and gains

 

And I will add another one to make it easier for us to understand. 

• All assets have debit balances, all liabilities have credit balances

 

The most important thing to understand is that these rules are to be applied from the point of view of the person who is doing the accounting. So, if I am buying a phone and paying cash for it, then phone comes in and cash goes out. So as per the first rule, I would debit the phone account and credit the cash account, because the phone is coming in and the cash is going out. But the seller, would record the transaction in reverse by debiting his cash account and crediting his phone account because from his point of view the cash is coming in and the phone is going out. This is a very important distinction. 

 

In the example above, I have used both the debit and credit from the first rule itself. But that need not be the case always. The debit can be from one rule and the credit can be from another rule. For example, if I am borrowing money from Suresh, at this point, Cash is coming in, but nothing is going out. But as per the second rule, I need to credit the giver. I will record this by debiting my cash account and crediting the account of Suresh. Similarly, if I pay rent in cash, to me rent is an expense and cash is going out. I will debit my rent expense account and I will credit my Cash account. 

 

But in real life, we don't maintain such detailed accounting records for our personal transactions. Especially when it comes to banking transactions, we rely on the accounts that are maintained by the bank and so we have gotten used to looking at the transactions from their point of view subconsciously. This is what causes the confusion that my friend had, and this makes people think that the rules of accounting do not have logic. We will try to understand this by using some examples again. 

 

Let us say Suresh deposits $100 cash in his bank account. How would the bank account for this? It has cash coming in and the cash is given by Suresh. Therefore, it would debit Cash account and it would credit Suresh's account. This is from the point of view of the bank. Just to explain this a bit more, when this transaction is done, assuming there is no other transaction that has happened, the cash account would have a debit balance of $100 and Suresh's account would have a credit balance of $100 in the bank's records. The physical cash is an asset to the bank and therefore, a debit balance in its cash account makes sense as per the fourth rule I mentioned. 

Similarly, the bank is liable to pay Suresh back, the $100 he deposited when he asks for it. So, there is a liability the bank has towards that. Suresh's account having a credit balance also matches the fourth rule that a liability would have a credit balance. 

 

Suppose Suresh is very organized and has an accounting system in his house, when he deposits the money in the bank, he would credit his cash account as the money is going out and debit his bank account as the bank is the receiver. His balance in the bank is an asset to him and therefore the bank account having a debit balance holds good in line with the fourth rule. 

 

When we ask a banker. 'Is my account credited?', we are actually asking him, 'Is my account credited, in your books?'. This is because we have been talking to the banker only from their point of view. And this is why, the confusion was created in Junior's mind at the start. He spoke the rule from his point of view but talked about his account from the banker's point of view. 

 

Junior @mahaan Dubukku woke the beast inside me, giving me the chance to write this and for what he gave, he gets 'credit'!