Debits and Credits - Commercial Understanding

Commercial Understanding

When dealing with one's own business, one must set up various accounts to record all transactions that may take place. When the owner of a business refers to their bank account, they are referring to the business's account, not to their personal account. In addition, all accounts referred to in bookkeeping belong to the business, not to other businesses, regardless of their title. For instance, if my business expects to receive money from another person or company and the account is labelled "Receivable A", this does not imply that the account in question belongs to "Receivable A". It is merely a recording of a current asset (a receivable) of one's own business. Therefore, when assessing any transaction, the transaction is from the point of view of one's own business or the business in question.

All accounts must first be classified as one of the five types of accounts (accounting elements). To determine how to classify an account into one of the five elements, the definitions of the five account types must be fully understood i.e. the definition of an asset according to IFRS is as follows, "An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity". To understand this definition we can break it down into its constituent parts with an example:

Example: Classify what type of account the business "Bank account" is.

The bank account of a business is "a resource controlled by the entity" as it belongs to the business. "As a result of past events" such as the opening of the business. "From which future economic benefits are expected to flow to the entity" – a business such as a grocery store can expect to make money due to the sale of their goods. This basic analogy can be applied to any asset account.

All of the five accounting elements have their own definitions (discussed in other articles see: asset, liability, equity, income and expense) that must be fully understood in order to classify an account correctly.

A business will most often have more than one asset account. An essential asset account in any business is the business's bank account (see: "Accounts pertaining to the five accounting elements" below for more examples) The same applies to liability accounts i.e. if I have borrowed money from two sources (called creditors or payables), then I must open two accounts to represent this present liability, called 'Creditor/Payable A' and 'Creditor/Payable B'. In this manner I may have multiple, different accounts. However all these accounts are all classified as one of the five types of accounts, therefore my entire business can be described in terms of its assets, expenses, liabilities, income and equity/capital (see extended accounting equation). This is the extent of "my" business in relation to accounts, regardless of the business' practices (the business may be a retail franchise, furniture shop, restaurant, etc.). With respect to my business, each of the five accounting elements will have a monetary value, and this can be used to assess the financial position of my business at any time (my success, failure, or any other attributes that I might need to know).

Traditionally, transactions are recorded in two separate columns of numbers (known as a ledger or "T-account"): debit transactions in the left hand column and credit transactions in the right hand column. Keeping the debits and credits in separate columns allows each column to be recorded and totalled independently. Accounts within the general ledger are known colloquially as "T-accounts" due to the "T" shape that the table resembles. Each column of a ledger account lists transactions affecting that account.