Accountancy/Principles of Accounting
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[edit] Accounting Operations: Credit & Debit
Accounting approaches the world of economic transactions from the viewpoint of Capital Transformation. Accounting books record the source of the Capital and the form it takes after passing through a company's productive & administrative mechanism. Since Accounting wants to capture these two pieces of information (whence the Capital comes - to what it is transformed), it needs two operations - and Accounting has indeed two and two only operations: Credit & Debit. Traditionally we always say "Debit & Credit" and we always put "Debits" to the "left" (of a page) and "Credits" to the "right" (of a page). But causally speaking, the act which the operation "Credit" captures comes first: because Credit shows the source of the Capital, while Debit shows to what the capital has been transformed before. That's why "A Debit must always equal the corresponding Credit".
Suppose now that the company's Board of Directors, after receiving the cash from the shareholders, decides to spend it in order to buy new productive equipment, striking a deal with a supplier to pay him or her after 60 days from purchasing the equipment. In order to reflect this transaction we need to record two different Accounting Entries.
A) The purchasing of the equipment under 60 days credit terms. Here, since we are buying "on credit", the supplier essentially supplies us with Capital (for 60 days). So we will Credit the Suppliers Account in order to show that we initially are buying the equipment using the suppliers capital, and we will Debit a Fixed Assets account (with equal amount) in order to show that we transformed this capital into Equipment.
B) The cash payment for the equipment after 60 days. Here Accounting sees that capital available to us in the form of Cash (the initial shareholders capital increase in cash), is transformed into Capital returned to supplier. So we will Credit our Bank Account (to show whence capital comes), and we will Debit the Suppliers Account to show to what we have transformed this capital (into Capital Returned to the Supplier).
[edit] Forms of Capital
As the above example indicated, "capital" in the world of Accounting, can take many forms. We can state the following all-encompassing definition: Any debt of a company, with or without interest, that is not paid in cash or otherwise settled, at the moment it is recorded in the Accounting Books, becomes capital given to the company.
Essentially then, "capital given to a company" is the amount that the company must return to its creditors. And we record as "capital" even temporarily unpaid debt. For example, suppose that from the payroll of a certain month, you have deducted from the employees' salary a payroll tax that you should pay to the State. If this payment, according to the relevant laws, must be executed three months after the month to which it originates, then for these three months, the state has given to you an amount of capital equal to the Payroll tax amount.
[edit] So what are we actually seeing in a Balance Sheet?
In a Balance Sheet we have three main headlines: Assets, Liabilities, Owner's Equity. In many countries, Assets are shown in the left of the page, while Owners' Equity to the top right and Liabilities to the lower right.
Now, it is a fundamental Accounting rule that "Assets = Owners' Equity + Liabilities". But why?
...If we use the "Capital Transformation" approach, we can understand why: "Assets" are of course what the word Assets means. But at the same time they show to us to what the company has transformed the capital given to it by... whom?
a) The Shareholders ("Owner's Equity"), and b) Everybody Else (Liabilities). In Equity we see the amount that is to be returned to the Shareholders, after all Assets are liquidated and all Liabilities are paid in full. In that sense, "Owners' Equity" is also a liability for the company: A company does not own anything - it owes all of its Assets to somebody, Third Parties or its Shareholders. A company is a separate entity from its owners.
In Liabilities, we see the amounts that the company owes to third parties - Suppliers, Banks, Internal Revenue Service, etc. At the same time they show to us "whence the capital came".
So the right side of a Balance Sheet shows how much capital and from whom the company has managed to get at the specific moment of the balance sheet (from third parties-"Liabilities" or from its own shareholders-"Equity"). On the left side of the Balance Sheet, we see to what the company has transformed this capital-"Assets". Again, we are talking about the same capital, the same quantity. So the "right side" (Equity + Liabilities) must equal the "left side" (Assets).
