Money Matters

What are debits and credits?

Demystify accounting fundamentals with this comprehensive guide to debits and credits, their roles in transactions, and double-entry bookkeeping.

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If you’ve ever peeked into the world of accounting, you’ve likely come across the terms “debit” and “credit”. Understanding these terms is fundamental to mastering double-entry bookkeeping and the language of accounting.

But what are debits and credits exactly? Why are they so important in the accounting world? Continue reading to discover how these fundamental concepts are the heartbeat of every financial transaction and the backbone of the accounting system.

Understanding the basics: Debit vs Credit

In accounting, every financial transaction affects at least two accounts due to the double-entry bookkeeping system. This system is a cornerstone of accounting that dates back centuries.

Unpacking the double-entry bookkeeping system

The double-entry bookkeeping system requires that every business transaction is recorded in at least two accounts, ensuring that the accounting equation (Assets = Liabilities + Equity) stays in balance.

This system is based on the concept of debits and credits. In this context, debits and credits represent two sides of a transaction. Depending on the type of account impacted by the entry, a debit can increase or decrease the value of the account. The same is true for a credit.

If a transaction increases the value of one account, it must decrease the value of at least one other account by an equal amount.

Why is this system so vital? Here are a few key reasons:

  • Ensures accuracy: The double-entry system acts as a check and balance mechanism. If the total debits do not equal the total credits on the trial balance, it’s a clear sign that an error has occurred somewhere in the recording process.

  • Provides a complete transaction picture: Unlike single-entry bookkeeping, which only records one aspect of a transaction, the double-entry system gives a comprehensive view of the transaction, showing both where the resource came from and where it went.

  • Facilitates financial analysis and decision-making: By providing a complete picture of a company’s financial activities, the double-entry bookkeeping system enables detailed financial analysis. This can help business leaders make informed decisions, from operational changes to investment strategies.

What is a debit and a credit in accounting?

One or more accounts get a debit entry, while other accounts receive a credit entry. But what does it mean for an account to be debited or credited? In order to understand this, it’s important to consider the accounting equation: Assets = Liabilities + Equity.

This equation, the heart of accounting, provides a logical structure for recording and interpreting every financial transaction in the double-entry bookkeeping system. Understanding this equation is vital for grasping the concept of debits and credits, as the equation helps us decide whether to debit or credit an account in a transaction. Let’s take a look at each part of the equation.

Assets

Assets are resources owned by the company that are expected to provide future benefits. They can include cash, accounts receivable, inventory, buildings, and equipment. When you increase an asset account, you debit it, and when you decrease an asset account, you credit it.

For example, when a company receives cash from a sale, it debits the Cash account because cash—an asset—has increased. On the other hand, if the company pays a bill, it credits the Cash account because its cash balance has decreased.

Liabilities

Liabilities represent obligations the company has. Accounts payable, notes payable, and accrued expenses are common examples of liability accounts. When a company incurs a new liability or increases an existing one, it credits the corresponding liability account. Conversely, when it pays off or reduces a liability, it debits the liability account.

For instance, if a company purchases supplies on credit, it increases its Accounts Payable—a liability account—by crediting it. When the company later pays off this payable, it reduces the liability by debiting Accounts Payable.

Assets and liabilities are on the opposite side of the accounting equation. Notice they are increased by using opposite actions. Assets are increased with debits and liabilities are increased with credits. If I was using a spreadsheet to demonstrate this, I would put a negative sign before each credit entry, even though this does not indicate the account is in a negative balance.

Equity

Equity, often referred to as shareholders’ equity or owners’ equity, represents the ownership interest in the business. It’s the residual interest in the assets of the entity after deducting liabilities. In other words, equity represents the net assets of the company.

Equity accounts, like common stock or retained earnings, increase with credits and decrease with debits. This is the opposite of asset accounts. For example, when a company earns a profit, it increases Retained Earnings—a part of equity—by crediting it.

Understanding how the accounting equation interacts with debits and credits provides the key to accurately recording transactions. By maintaining balance in the accounting equation when recording transactions, you ensure the financial statements accurately reflect a company’s financial health.

A debit (abbreviated as Dr) increases the balance of an asset or expense account, while a credit (abbreviated as Cr) does the opposite—it decreases the balance of these accounts. However, for liability, equity, and revenue accounts, the rules are flipped: debits decrease their balances and credits increase them. This might sound complicated, but it all comes down to the fundamental accounting equation and where individual accounts fit.

Are balance sheet accounts debits or credits?

In short, balance sheet and income statement accounts are a mix of debits and credits. The balance sheet consists of assets, liabilities, and equity accounts. In general, assets increase with debits, whereas liabilities and equity increase with credits.

For instance, when a company purchases equipment, it debits (increases) the Equipment account, which is an asset account. If the company owes a supplier, it credits (increases) an accounts payable account, which is a liability account.

When a business incurs a net profit, retained earnings, an equity account, is credited (increased).

What about Income Statement Accounts: Where do debits and credits apply?

Income statement accounts primarily include revenues and expenses. Revenue accounts like service revenue and sales are increased with credits. For example, when a company makes a sale, it credits the Sales Revenue account.

Expenses, including rent expense, cost of goods sold (COGS), and other operational costs, increase with debits. When a company pays rent, it debits the Rent Expense account, reflecting an increase in expenses.

Debits and credits in day-to-day business operations

In daily business operations, it’s essential to know whether an account should be debited or credited. The easiest way to understand this is to think of the accounting equation and remember what type of account you are dealing with.

Let’s say a company purchases inventory on credit. Inventory is an asset, which we know increases by debiting the account. When an item is purchased on credit, the company now owes their supplier. This is an account payable which is a liability. Liabilities are on the opposite side of the accounting equation to assets, so we know we need to increase the liability account by crediting it.

What about a cash sale? Is that a debit or a credit?

Let’s break it down:

Both the cash and the sales (or revenue) accounts increase in this transaction. Cash is an asset, so it increases with a debit. Sales are part of equity, so they increase with a credit. If the cash sale was for £2,000, your entry would look like this:

Cash (Dr) £2,000

Sales or Revenue (Cr) £2,000

More examples of how to debit and credit business transactions

Let’s consider another example. Suppose a company provides services worth £500 to a customer who promises to pay at a later date. In this case, the company would debit Accounts Receivable (an asset) and credit Service Revenue.

In another scenario, if a company rents a warehouse for £1,000, it would debit the Rent Expense account (an expense) and credit the Cash or Accounts Payable account (depending on how the customer paid).

Special considerations: Unusual cases of debits and credits

While we’ve covered the general rules for debits and credits in relation to the accounting equation, there’s an important exception worth noting: contra accounts.

Contra accounts are unique types of accounts that have an opposite balance to the normal balance of their associated accounts. They are used to reduce the value of the related account without impacting the balance of the related account.

The most common contra account is Accumulated Depreciation. This is a contra asset account used to record the use of a capital asset. Because this is a contra account, increasing it requires a credit rather than a debit. To record depreciation for the year, Depreciation Expense is debited and the contra asset account Accumulated Depreciation is credited. The balance of both accounts increases.

Final thoughts: Mastering debits and credits

Understanding debits and credits is foundational in accounting. They’re the building blocks that help us record, analyse, and interpret financial transactions. Despite feeling a bit daunting, with a firm grasp on the basics and practice, these concepts will become second nature.

To know whether you should debit or credit an account, keep the accounting equation in mind. Assets and expenses generally increase with debits and decrease with credits, while liabilities, equity, and revenue do the opposite.

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