What are debits and credits?

Understanding debits and credits is vital to keeping your finances in order and ensuring accurate reports.

Debits and credits aren’t just about tracking expenses or revenue—they are the foundation of how every financial transaction affects your company’s overall financial health.

These fundamental principles are at the heart of double-entry bookkeeping, the backbone of accurate accounting.

These entries ensure that the accounting equation—assets = liabilities + equity—remains balanced, giving you a clear and accurate picture of your business’s financial position.

Here’s what we’ll cover

What are debits and credits?

While “debit” and “credit” may evoke thoughts of everyday banking products like debit and credit cards, their role is more sophisticated in accounting.

• A debit increases assets or expenses and decreases liabilities or equity, showing how your company uses its resources.
• On the flip side, a credit increases liabilities or revenue and reduces assets or expenses, reflecting incoming value or new obligations.

Understanding how these movements affect your financial statements is crucial for informed decision-making, compliance, and maintaining stakeholders’ trust.

In this guide, we will explore how debits and credits work, their impact across different account types, and how modern automation tools can streamline your financial processes, ensuring accuracy and efficiency in managing your company’s accounts.

The definitions of debits and credits

At their core, debits and credits are the 2 sides of every financial transaction recorded in the accounting system.

They aren’t inherently “positive” or “negative”—they represent account changes based on predefined accounting rules.

• Debit (Dr): an entry on the left side of an account ledger that increases assets (what a company owns) or expenses (costs of operating) and decreases liabilities (debts), equity (ownership value), or revenues (income).
• Credit (Cr): an entry on the right side of an account ledger that increases liabilities, equity, or revenues and decreases assets or expenses.

Remember that in every transaction, the total debits must equal the total credits to keep the accounting equation balanced:

Assets = liabilities + equity

This equation reflects that everything a company owns (assets) is either financed by borrowing (liabilities) or by investments from owners (equity).

Debits and credits ensure that every transaction adheres to this equation, maintaining the accuracy and integrity of financial statements.

The double-entry system: A foundation of accuracy

The double-entry bookkeeping system is built on the principle that every financial transaction affects at least 2 accounts.

This system ensures that the accounting equation—assets = liabilities + equity—remains balanced.

Why is this important?

1. Ensures accuracy and integrity: if debits don’t match credits, they signal errors in your financial recording.
2. Gives a complete financial picture: tracking both sides of a transaction allows you to understand where the money comes from and where it goes.
3. Supports compliance and reporting: accurate use of debits and credits aligns with accounting standards (GAAP, IFRS), aiding in compliance, audits, and financial statement preparation.
4. Enables financial analysis: a detailed ledger of debits and credits provides insights into your cash flow, expenses, and overall financial health, supporting informed decisions.

Debits and credits across different account types

Here’s a rundown of how debits and credits affect various accounts.

Let’s explore how they impact assets, liabilities, equity, revenue, and expenses:

1. Assets

Assets are your company’s resources, such as cash or inventory, that provide future economic benefits.

• A debit increases assets, while a credit decreases them.
• For example, when a company receives R5,000 in cash from a sale, it debits cash (the asset) and credits sales revenue.

2. Liabilities

A company’s liabilities are obligations or debts to others, such as loans or accounts payable.

• A credit increases liabilities, while a debit decreases them.
• For example, when a company buys R10,000 worth of inventory on credit, it debits inventory and credits accounts payable (the liability).

3. Equity

Equity represents the owner’s claim on the company’s assets after liabilities, such as retained earnings or common stock.

• A credit increases equity, while a debit decreases it.
• For example, when a company posts R50,000 in profit at the end of a period, it debits income summary (a temporary equity account) and credits retained earnings.

4. Revenues

Revenues are the income earned from business operations, like sales or service income.

• A credit increases revenues, while a debit decreases them.
• For example, when a company sells goods for R2,000, it debits cash and credits sales revenue.

5. Expenses

Expenses are costs incurred in generating revenue, such as rent or salaries.

• A debit increases expenses, while a credit decreases them.
• For example, when a company pays R3,000 in rent, it debits rent expenses and credits cash.

Debits and credits in action

Here are examples of debits and credits in action, explaining how each calculation follows this equation:

assets = liabilities + equity

1. A child receives an allowance and buys a toy

Receiving allowance

The child gets R10 from their parents.

This increases the child’s assets (money in the piggy bank) and creates a “liability” (an IOU to the parents).

• Debit: piggy bank (asset increases) R10
• Credit: parents’ IOU (liability increases) R10

Impact: assets (+R10) = liabilities (+R10) + equity (R0)

Buying a Toy

The child spends R5 to buy a toy.

The money in the piggy bank decreases (cash decreases), but now they have a new asset (the toy).

• Debit: toy (new asset increases) R5
• Credit: piggy bank (asset decreases) R5

Impact: Assets (R5 Toy + R5 Piggy Bank) = Liabilities (+R10) + Equity (R0)

2. A cash sale

The business sells goods for R2,000 in cash.

This increases the business’s cash (asset) and increases equity through revenue earned from the sale.

• Debit: cash (asset increases) R2,000
• Credit: sales revenue (equity increases) R2,000

Impact: assets (+R2,000) = liabilities (R0) + equity (+R2,000)

3. Providing services on credit

The business provides R500 worth of consulting services, and the client promises to pay later.

This creates an asset (accounts receivable) and increases equity through earned revenue.

• Debit: accounts receivable (asset increases) R500
• Credit: service revenue (equity increases) R500

Impact: assets (+R500) = liabilities (R0) + equity (+R500)

4. SaaS company subscription

A SaaS company sells a 1-year subscription for R1,200, billed annually.

The company receives cash upfront but recognises the revenue over time.

A. Recording the sale:

The company receives R1,200 in cash from the customer upfront.

However, since the service will be provided over 12 months, the R1,200 is initially recorded as a liability (unearned revenue), reflecting the obligation to deliver the service.

• Debit: cash (asset increases) R1,200
• Credit: unearned revenue (liability increases) R1,200

Impact: assets (+R1,200) = liabilities (+R1,200) + equity (R0)

B. Monthly revenue recognition:

As the company delivers the service monthly, it gradually recognises R100 as revenue. This reduces the liability and increases the company’s equity through revenue earned.

• Debit: unearned revenue (liability decreases) R100
• Credit: service revenue (equity increases) R100

Impact (after 1 month): assets (R1,200) = liabilities (R1,100) + equity (+R100)

This process continues monthly until R1,200 is recognised as revenue over the year.

Are balance sheet accounts debits or credits?

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—a liability account.

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

Example 1: Purchasing equipment with cash

A business purchases R10,000 worth of equipment in cash.

The company receives equipment (asset increases) but decreases its cash (asset decreases).

• Debit: Equipment (asset increases) R10,000
• Credit: Cash (asset decreases) R10,000

Impact: Net change in assets (R0) = liabilities (R0) + equity (R0)

Example 2: Purchasing inventory on credit

A business purchases R5,000 worth of inventory on credit.

The company receives inventory (asset increases) but also incurs a liability (accounts payable).

• Debit: inventory (asset increases) R5,000
• Credit: accounts Payable (liability increases) R5,000

Impact: assets (+R5,000) = liabilities (+R5,000) + equity (R0)

Example 3: Incurring net profit

A business posts a net profit of R20,000 at the end of the period. The company increases its retained earnings (equity increases).

• Debit: income Summary (temporary equity account decreases): R20,000
• Credit: retained earnings (equity increases:  R20,000)

Impact: assets (R0) = liabilities (R0) + equity (+R20,000)

What about income statement accounts: Where do debits and credits apply?

Income statement accounts primarily include revenues and expenses.

Revenue accounts, such as 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 expense increase.

Example: Paying rent for a warehouse

The business pays R1,000 in rent for its warehouse in cash. The cash asset decreases, and the rent expense reduces equity.

• Debit: rent expense increases (equity decreases) R1,000
• Credit: cash (asset decreases) R1,000

Impact: assets (-R1,000) = liabilities (R0) + equity (-R1,000)

Special considerations: Contra accounts

Contra accounts reduce the value of a related account without altering the original account directly.

For example, accumulated depreciation is a contra account to assets, gradually reducing the book value of equipment or other assets over time.

Example – accumulated depreciation:

• Debit: depreciation expense (reflects the use of an asset).
• Credit: accumulated depreciation (reduces the asset’s book value).

This process ensures that the financial statements show a more accurate value of assets without directly adjusting the asset’s ledger.

Technology: Handle debits and credits better with AI and automation

Traditional accounting practices, like double-entry bookkeeping, still form the backbone of financial management.

However, as companies grow and transactions become more complex, manually handling debits and credits can be time-consuming and prone to error.

This is where today’s technology comes into play

With advanced software, businesses can better manage their accounting processes, ensuring accuracy, compliance, and efficiency.

Double-entry bookkeeping remains critical for maintaining balanced financial statements.

But by embracing automation, companies can reduce human error and free up their finance teams for more strategic activities.

Technology is essential for keeping financial records accurate and current, whether managing accounts payable, generating real-time reports, or ensuring compliance.

Mastering debits and credits: Final thoughts

Managing debits and credits is essential for keeping financial records accurate and ensuring smooth operation.

While they may seem straightforward, using them without mistakes is critical to maintaining financial health.

Now’s the time to put these concepts into practice.

Understanding debits and credits will give you a solid accounting foundation, whether you manage your own business finances or oversee finances as a CFO.

Consider tools like Sage Intacct to help automate tasks, reduce mistakes, and allow you to focus on the bigger financial picture.

With the right tools and a clear understanding of debits and credits, you can improve your financial reporting and set your business up for long-term success.