Wednesday, 2 January 2013

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Classification of accounts and Rules of Debit and Credit

Normally there are five categories of accounts (First category). They are;

1.      Asset Accounts (Buildings, plant, furniture, cash, inventory, debtors etc.)
2.      Expense Accounts (salary, rent, electricity, depreciation etc.
3.      Liability Accounts (debentures, loans, creditors, outstanding expenses etc.
4.      Income Accounts (interest, dividend, commission, fees etc. received)
5.      Capital Accounts. (Equity share capital, preference share capital etc.)

There is another categorization of accounts. (second category)
1.      Personal Accounts
2.      Real Accounts
3.      Nominal Accounts

Rules of debit and credit (when to debit an account and when to credit an account)

Rule of debit and credit based on first categorization;
Account
Effect
Debit/Credit
Assets
increase
debit
decrease
credit
Expenses
increase
debit
decrease
credit
liabilities
increase
credit
decrease
debit
Incomes/revenue
increase
credit
decrease
debit
capital
increase
credit
decrease
debit














Rule of debit and credit based on second categorization;

Name of Account as per first categorization
Name of Account as per second categorization
Rule
Capital Account
Liabilities Accounts
Personal Account
Debit the Receiver
Credit the Giver
Assets
Real Account
Debit What Comes In
Credit What Goes Out
Income/Revenue
Expenses
Nominal Account
Debit All Expenses and Losses
Credit All Incomes and Gain

Let us go through some examples

Example 1. Mr. Kevin started a business with £50000.
Step 1- Identify the two accounts involved in this transaction
1.      Capital Account
2.      Asset Account (cash is an asset)
Step 2- Understand the nature of the impact of the transaction on the two accounts (capital and cash)
            For the business the amount of capital is increased by £50000 as result of the transaction
            Cash is also increased by £50000
Step 3- Decide which account is to be debited and which is to be credited.
            We know that when capital account increases it is to be Credited and,
            When asset account (here it is cash) increases it is to be Debited


So, 
Debit Cash Account with £50000
Credit Capital Account with £50000