The theory of debit and credit in its application to income and expense accounts is based on the relationship of these accounts to capital. The net profit or the net loss for a period, as reported on the income statement, is the net increase or the net decrease in capital resulting from operations.
Income increases capital; and just as increases in capital are recorded as credits, increases in income during an accounting period are recorded as credits.
Expenses have the effect of decreasing capital; and just as decreases in capital are recorded as debits, increases in expenses accounts are recorded as debits. Although debits to expenses accounts signify decreases in capital, they may also be referred to as increases in expense. The usual practice is to consider debits to expenses accounts in the positive sense (increases in expenses) rather than in the negative sense (decreases in capital). The rules of debit and credit as applied to income and expense accounts are shown in the diagram below.
CAPITAL ACCOUNTS
DEBIT CREDIT
Decreases in capital Increases in capital
Expense Accounts Income Accounts
Debit Credit Debit Credit
for for for for
increases decreases decreases increases
At the end of the accounting period, the balances of the income and expenses accounts are reported in the income statement. The accounts balances are then transferred to a summary account, after which the income and expenses accounts are said to be closed. The summary account, which represents the net income or the net loss for the period, is then closed by transferring the balance to the capital account. Because of this periodic closing of the income, expenses and summary accounts they are sometimes called nominal accounts or temporary accounts. The balance of each asset and each liability account and the balance of the capital account are carried forward to succeeding accounting periods. They are more permanent in nature and are sometimes referred to as real accounts.
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