If one took a bird eye’s view of all financial transactions, one would realize that eventually all transactions can be classified into four types viz. expenses, incomes, liabilities and assets. And therefore, if somebody who had no accounting knowledge, wished to prepare a balance sheet, all he had to do was, to take a look at the transaction that had taken place, examine it, classify it into one of the above – mentioned four types, and transfer it to the appropriate quadrant in either the profit and loss account or the balance sheet.
I mean, how does an accountant prepare these statements? He starts with the transactions that have taken place, takes them through a series of processes, and eventually prepares a profit and a loss account and a balance sheet (which between them contain expenses and incomes and liabilities and assets). All I am suggesting is that, as a layman, what you don’t understand is the process. Therefore by-pass the process.
By-pass the accounting system. Examine the transaction at the root itself and directly transfer it to either the relevant side of the concerned statement. Believe me, it really is as simple as this.
The reason I’m emphasizing so much on the fact that you don’t need to be a rocket scientist to make these financial statements is that in my experience a number of people carry a mental block that since they will not understand how to make financial statements they will not understand how to read financial statements. Which, of course, is absolutely untrue. However, for those who do suffer from this delusion, what I’m trying to convey is that, if you think an inability to make financial statements is hindering your understanding, then let me show you a simple way in which to make them.
What is important is that every entrepreneur, every CEO, every key executive, must learn how to read, appreciate, understand and interpret numbers. Because on this depends the growth, prosperity, welfare and the very survival of your business. If you understand numbers, you can lead your business to great heights and if you don’t, it can well spell your undoing.
But before I proceed further, I think it will be time, (or rather, space) well spent if I devote some discussion towards clarifying two very commonly used but often misunderstood words. These are accounting words which have become entrenched in our daily language. Everybody uses them but if you ask any two people what these words mean, chances are you will receive contradictory answers. These two words are: debit and credit, written in abbreviated form as DR and CR(Please don’t ask me why is debit written as DR i.e. with an R. I have no clue whatsoever.)
Common perception about these words is that they represent loss and gain, good and bad and probably are the counterparts in accountancy of the words plus and minus in arithmetic. To the question about what represents loss and gain, the commonly received answers are debit is equivalent to loss and credit gain; debit connotes minus and credit plus.
First, let us see where do these words come from. Are these English words or accounting words? Answer is, these are accounting words. And what is an account. An account is the name given to a T-shaped thing, with figures appearing either on the left of the T or to the right or on both sides. For example if you sell goods, then in your books there will be a T-shaped ‘Sales Account’, if you pay salaries, there will be a ‘Salaries Account’ and so on. And, conventionally, debits are written to the left of the T and credits written on the right. So, if I ask you to debit Salaries A/C with 10,000, what I’m asking of you is to write 10,000 on the left side and if you are told to credit Sales A/C BY Rs. 20,000 on the right hand side of the Sales A/C.
Now it is important that, even though you may not be an accountant or may know nothing about accounting, nevertheless accounts must make sense for you. You may be browsing through somebody’s or your own books of accounts, you should be able to make sense of what you see. So suppose you are checking the books on my company Lamcon, and you come across two accounts one named Rita and the other John. And you
Find an amount of Rs. 5000 appearing on the debit or the left side of Rita’s account and 10,000 on the credit or the right side of John’s account. How would you interpret this? It will, of course, be apparent to even a novice that whatever relationship John and Rita have with Lamcon must be opposite of each other. One must be a customer of and the other a vendor to Lamcon. To one person Lamcon owes money and the other person owes money to Lamcon. One must be Lamcon’s debtor and the other creditor. My question is, can you tell me who’s who?
Now, again when I ask this question to an audience attending a seminar on finance, I never get an uniform answer. To find out who is the debtor and who the creditor, we must go to the genesis of these two words, i.e. why is a debtor called a debtor and also where does the word creditor come from. Most people think that a debtor is so called because he is in debt and the word creditor can be attributed to the fact that something was purchased on credit. It is necessary to remove this illusion. The word ‘debt’ is in no way connected to the word ‘debtor’, nor the fact that there has been a credit transaction is in any way responsible for the word ‘creditor’. Then why is a ‘debtor’ called a ‘debtor’? The answer is so simple, you are going to laugh. A ‘debtor’ is so called because while making the accounting entry the figure was written on the debit side, debit for debtor. In case of a creditor the entry appears on the credit side.
Thus, in the above case Rita is the debtor and John is the creditor. There is no scope for ambiguity any more. This is what I meant. Accounts should be user- friendly and not intimidating. Everybody should be able to make sense out of accounts.
Similarly, most people think that debits denote ‘minus’ or negative and credits the counterpart of ‘plus’. The reason for this impression can, perhaps, be traced to their first interaction with these two words. I think, most of us, for the first time in our lives hear of these words when we open our first bank account. The banker gives you a bank statement or a pass book, and each time you deposit money the figure is written on the credit side and withdrawals appear on the debit side, and therefore one has a clear picture in one’s mind that credits indicate gain and debits loss, credits plus and debit minus.
But what you also have to understand is that, in the above referred example, wher Lamcon shows Rita as it debtor, if one goes across to Rita’s accounts would be mirror images of each other.
Therefore, when you look at a pass book and reach a conclusion that credit is plus and debit minus, what you must understand is that the pass book is an extract of accounts maintained by the banker and not by you. Therefore all your conclusions have been arrived at by looking into the mirror. So tell me which is plus and which minus.
You will now be thinking that debit should be plus and credit the negative one. Even this is also not entirely true.