If you are a business owner, you likely have numerous business transactions that have an impact on your financial statements. In order to accurately account for all these business transactions, numbers are recorded in two different accounts: the debit column and the credit column. Understanding how these columns operate, and which transactions should be placed in each, can help you with the financial aspects of your business and provide an overview of how your business operates.
Debit and Credit Definitions
Debits are the use of value for a transaction and credits are the source of value for a transaction. If you pay cash for equipment for your business, the value you received was the equipment (debit) and the source of that value was the cash you paid for that equipment (credit).
Debits are used in accounting to express the increase of an asset or expense account, or the decrease of liabilities and equity. Credits refer to the increase of liabilities or equity accounts, or the decrease of an asset or expense account.
Debits usually denote the usage of one account, and credits usually denote the source of another account. Using this type of credit and debit system in accounting and bookkeeping provides accuracy in all financial statements and allows a business owner to understand their finances and each business transaction.
Overview of Debits and Credits
Under the General Accepted Accounting Principles (GAAP), debits and credits track the changes of an account’s value. In a sense, debits and credits are complete opposites. Every debit to an account must be accompanied by a credit to another account. The accounting term “double-entry bookkeeping” gets its name from this accounting principle. This double-entry system means that every business transaction would have two business accounts, one is a debit account and one is a credit account. Ultimately, debits and credits should cancel each other out, as a debit is placed in one account, a credit is placed in an opposite account.
The debit column is always on the left of an accounting entry, while credit columns are always on the right. Debits increase expense accounts or asset accounts and decrease equity or liability. Conversely, credits decrease expenses or assets and increase equity or liability.
Every business’s financial statements should include financial accounts that record business transactions. These accounts are typically listed out and identified in a chart of accounts. Depending on the size of a business, there may be as few as thirty financial accounts, or if a company is quite large, there could be thousands of accounts.
The accounts are typically organized in a chart of accounts as follows:
- Stockholder (Owner) Equity
- Revenues or Income
Using Debits and Credits
Whenever a business transaction is recorded and created, two different business accounts are affected. A debit will be recorded against one business account, and a credit will be recorded against a different business account.
Debits are always recorded first, and credits are recorded after debits. A credit is recorded after a debit account, followed by the word “To.”
A common formula found in basic accounting is Assets = Equity + Liabilities. Thinking of a typical business, assets are paid for by a business’ equity or liability. A business simply cannot have one without the other. Therefore, using this formula, if a business completes a business transaction that increases the assets, the asset account must be debited, and therefore the business owner must also increase and credit the equity or liability account. In this way, using the equation above, the Assets will remain equal to the Equity + Liabilities.
Maintaining account transactions that are in balance is critical since this is the foundation for accurate financial statements. While there are many different parts and components to business financial accounting, the recording of debits and credits is crucial to maintain accuracy.
Understanding Debits and Credits
Generally, these types of accounts are increased with a debit: Dividends (Draws), Expenses, Assets, and Losses. The acronym for this is DEAL.
The types of accounts that are increased with a credit are: Gains, Income, Revenues, Liabilities, and Stockholder (Owner) Equity. The acronym for this is GIRLS.
A simple way to remember all of this is with an example. When cash is received, you debit cash (and another account is credited). When cash is paid out, you credit cash (and another account is debited). While this may be confusing to those who are not accountants, becoming more comfortable with these accounting principles will make this process easier.
Mechanics of Debits and Credits
Many business owners who are not familiar with accounting can quickly become confused about the difference between a debit or credit. To be fair, these concepts can take a bit of getting used to and practice will help ensure that this becomes a habit for those who are not accountants by profession.
As an example, if you have an account that records your transactions related to cash, and you debit that account, that that means that the amount of cash you have on hand actually increases. If you debit an accounts payable account, this means the amount in the accounts payable account decreases.
A quick reference for some accounts follows below.
- Asset business accounts – Debits increase the balance and credits decrease the balance.
- Liability business accounts – Debits decrease the balance and credits increase the balance.
- Equity business accounts – Debits decrease the balance and credits increase the balance.
This system may seem to be reversed from what a person without accounting experience would think. However, this reversal of debits and credits is all related to the previously mentioned accounting equation regarding financial transactions: Assets = Liabilities + Equity.
Rules Involving Debits and Credits
There are several accounting rules that must be followed when recording debits and credits on the financial statements of a business. These rules are important to understand, but can be a bit challenging to process in a vacuum. Therefore, the next section will detail some common types of debits and credits found in accounting to help illustrate how these rules apply in typical and familiar business transactions.
- There are certain types of accounts, such as expense, asset, and dividend accounts, that will have a debit balance. This is because the debit balance increases when a debit is added and decreases when a credit is added.
- Conversely, there are other types of accounts such as liabilities, revenues, and equity accounts that will have a credit balance. This is because the credit balance increases when a credit is added and decreases when a debit is added.
- The total number of debits must always equal the total number of credits in every business transaction.
Familiar Business Transactions Using Debits and Credits
There are some business transactions that are quite common in many industries.
- Pay employees – The debit would be recorded in the wages expense account, and a debit would be recorded in the payroll tax accounts; credit would be recorded in the cash account.
- Buy goods with cash – The debit would be recorded in the supplies expense account, and the credit would be recorded in the cash account.
- Buy goods on credit – The debit would be recorded in the supplies expense account, and the credit would be recorded in the accounts payable account.
- Loan – The debit would be recorded in the cash account, and the credit would be recorded in the loans payable account.
- Loan Repayment – The debit would be recorded in the loans payable account, and the credit would be recorded in the cash account.
- Cash Sale – The debit would be recorded in the cash account, and the credit would be recorded in the revenue account.
- Credit Sale – The debit would be recorded in the accounts receivable account, and the credit would be recorded in the revenue account.
As you familiarize yourself with how common business transactions using debits and credits operate, you can begin working on creating your own financial statements for every business transaction that occurs.
Evaluate Each Transaction
Most accountants find recording debits and credits challenging at first. An important way to look at these business transactions is to consider the following question: “What is being exchanged in the transaction?” Every transaction involves an exchange of one thing for something else. For example, consider each transaction slowly and carefully at first. Determine which business accounts are affected, and then make sure that the debits and credits for that one transaction all balance each other out.
The ending balance in each account should be transferred to the balance sheet. This separate financial statement is named such because it must always stay in balance. Ultimately, the overall assets in your business must equal the value of your liabilities plus your equity, as the previous equation indicates.
Making Sense of Debits and Credits
If you are still struggling to understand how credits and debits work, it is likely because you are used to the following scenario at your banking institution: You deposit money into your checking account, and you hear the banker say that he or she will credit your checking account, meaning that your checking account will increase.
This appears to go directly against everything we just discussed about debits and credits. In business accounting, debiting a cash account increases its balance, but the banker just indicated that he or she is crediting your checking account to increase its balance. It’s no wonder that this is confusing to a layperson who is new to these accounting practices. However, in truth, the banker is still adhering to the principles of accounting.
If your company deposits $100 into its checking account at the bank, the bank is receiving cash of $100 and will debit its general ledger cash account for $100, thereby increasing the bank’s assets. Because the bank also follows the accounting principles of double-entry accounting, they will also enter a credit of $100 in your business’ checking account. The bank has not “earned” $100, but rather has an obligation and liability to return this $100 to you on demand whenever you as a business owner decide to withdraw it from the bank.
Recap of Debits and Credits
As you implement these terms into your business accounting, remember these key takeaways:
- Debits go on the left, and credits go on the right.
- Every transaction affects at least two accounts, and maybe more.
- Every transaction has one account that is debited and one that is credited.
- The total number of debits must always equal the total number of credits.
- To increase an asset, debit the asset account.
- To increase a liability, credit the liability account.
- To increase revenue, credit the revenue account.
- To increase expenses, debit the expense account.
- A debit to any expense account also decreases the business’s equity.
- If cash is received, debit cash. If cash is paid out, credit cash.
Contact Anderson Advisors
Understanding accounting principles can be challenging for non-accountants. If you feel overwhelmed by keeping up with accurate bookkeeping in your business, reach out for professional help. At Anderson Advisors, our experienced team of real estate and business accountants offers bookkeeping services to help you keep accurate financial data and ensure the financial health of your business. Call our offices at 866.896.6141 for a consultation today, or click here to learn more.