Most business owners understand that they need to keep track of their income and expenses but many get tripped up when figuring out what accounts are debits and credits. By getting a firm grasp on the concept of debits and credits, you’ll have a leg up when it comes to completing your accounting accurately.
Debits and credits are used in double entry accounting to ensure that everything balances out at the end of the accounting period. With it, you record each transaction as a debit and a credit, hence the name double entry accounting. Because you are accounting for all movement of funds, you get a clear picture of your financial standing.
At any point, the total of the entries on the left side of the trial balance (debits) will equal the total of the entries on the right side (credits). A trial balance includes all accounts from the balance sheets and profit and loss statements. It also acts as a proof sheet for the books. Any difference between the totals on the right and left side means that there is an error in the books that should be investigated.
In this guide, we’ll go over the basics of bookkeeping—what accounts are debits and credits and how to record them in your books.
What Are Debits and Credits?
In accounting, debits and credits are used to record financial transactions. A debit is an entry on the left side of an account, while credit is an entry on the right side of an account. Debits and credits will increase and decrease account balances differently depending on the type of account, which we will look at more closely below.
In double-entry bookkeeping, each financial transaction is recorded as both a debit and a credit.
For example, when a company purchase supplies on credit, the transaction would be recorded as a debit to the supplies account and a credit to the accounts receivable account.
You also use a chart of accounts, that includes items like rent, utilities, payroll, and more. It helps you organize and index all your accounts and transactions, usually in a chart format.
While debits and credits may seem confusing at first, they provide a valuable way of tracking financial transactions. By understanding how debits and credits work, you can gain valuable insights into your business’s financial health.
What Is the Difference Between a Debit and a Credit?
In accounting, there are two fundamental types of transactions: those that result in a decrease in assets or an increase in liabilities (debits) and those that result in an increase in assets or a decrease in liabilities (credits).
The key difference between debits and credits lies in their effect on the accounting equation.
- Assets = Liabilities + Equity
A debit decreases assets or increases liabilities, while a credit increases assets or decreases liabilities.
In other words, debits always reduce equity while credits always increase it. For this reason, debits are sometimes referred to as “drawings” while credits are called “investments.”
At the end of the day, it all comes down to simple math: whatever is not an asset must be a liability or equity.
If you want to increase your assets without also increasing your liabilities, you need to find someone willing to invest in your business (i.e., give you a credit against an outstanding invoice).
If you want to decrease your liabilities without also decreasing your assets, you need to find someone willing to invest in your business. The goal is always to keep the accounting equation in balance.
How Do You Record Debit and Credit in Your Books?
When you’re keeping your own books, it’s important to understand how to record both debits and credits.
At its most basic, a debit is an entry on the left side of a ledger, indicating an increase in assets or a decrease in liabilities. A credit is an entry on the right side of a ledger, indicating a decrease in assets or an increase in liabilities.
In order to keep track of your finances, you need to be sure to enter both types of entries into your bookkeeping system.
There are a few different ways that you can do this. One option is to create two separate ledgers, one for debits and one for credits. Another option is to use a software program that will automatically keep track of both types of entries. Whichever method you choose, be sure to keep accurate records so that you can always know where your money is going.
Most accounting software forces you to keep your books in balance because it will not allow you to save an entry that doesn’t have equal credits and debits.
Types of Accounts and How They Are Recorded
There are several groups of accounts that are included in your financial statements. Debits and credits will affect each account differently.
When you debit an asset account, it goes up, and when you credit it, it goes down. That’s because assets are on the left side of the balance sheet, and increases to them have to be entries on the right side of the ledger (i.e., debits). On the other hand, decreases have to be entered on the left side (credits).
So if you’re adding cash to your checking account, that’s a debit to the account (increasing its value), but if you’re writing a check, that’s a credit (decreasing its value).
The same goes for your other asset accounts: inventory, investments, etc. The reason this is important to understand is that it will help you keep your books in balance. If you don’t debit and credit the accounts correctly, your books will be out of balance, and you won’t be able to prepare accurate financial statements.
When you debit a liability account, you’re increasing the amount of money that the company owes. For example, if you debit Accounts Payable, you’re decreasing the amount of money that the company owes to its suppliers.
On the other hand, if you credit a liability account, you’re increasing the amount of money that the company owes. For example, if you credit Accounts Receivable, you’re increasing the amount of money that the company owes to its vendors.
In general, debiting a liability account decreases the amount of money that the company owes, while crediting a liability account increases the amount of money that the company owes.
Equity accounts are records of a company’s ownership stake, so they are affected by debits and credits in different ways. When a company receives money from shareholders, it is recorded as a credit to the equity account.
This increases the company’s equity. Conversely, when the company pays out dividends to shareholders, it is recorded as a debit to the equity account. This decreases the company’s equity. By understanding how debits and credits affect equity accounts, businesses can keep accurate records of their financial position.
With regards to expense accounts, debits increase the balance of the account while credits decrease the balance. So, if you have an expense account with a balance of $1,000 and you make a purchase for $100, the new balance of the account would be $1,100 (a debit of $100 increased the balance by $100).
If you then made a payment of $50, the new balance would be $1,050 (a credit of $50 decreased the balance by $50). It’s important to keep track of both debits and credits so that you know what your current balance is at all times.
In a revenue account, an increase in debits will decrease the balance. This is because when revenue is earned, it is recorded as a debit in the bank account (or accounts receivable) and as a credit to the revenue account.
An increase in credits will increase the balance in a revenue account. So, if a company has more expenses than revenue, the debit side of the profit and loss will be higher and the balance in the revenue account will be lower. In summary, credits increase the balance in a revenue account while debits decrease the balance.
Debit and Credit Examples
Below are a few examples of transactions.
Purchase of Office Supplies on a Credit Card
The purchase of $150 of office supplies on a credit card would result in a debit posted to the office supply account and a credit to the credit card account. This would increase the office expense account and increase the credit card liability account.
|Office Supplies (Expense)||$150.00|
|Credit Card (Liability)||$150.00|
Taking Out a New Loan
A company takes out a new loan of $7,500 to increase its working capital. The funds from the loan are deposited directly into the company’s bank account. This results in an increase in the company’s bank account balance and increases the company’s liabilities.
|Bank Account (Asset)||$7,500.00|
|Loan Account (Liability)||$7,500.00|
When a shareholder takes a distribution, the cash in the company’s bank account decreases, and the shareholder’s distribution account increases.
|Shareholder Distribution (Equity)||$5,000.00|
|Bank Account (Asset)||$5,000.00|
As you can see from the debits and credits examples, each column balances the other out.
Cheatsheet Chart of Debits and Credits
We’ve put together a chart showing how debits and credits affect different types of accounts. Keep in mind that we’ve provided very basic examples above and many journal entries will use more than two accounts.
The best way to keep your books in order and protect yourself from financial mistakes is to understand what accounts are debits and credits and how to record them. By keeping track of every transaction, you can avoid any confusion or discrepancies that could lead to bigger problems down the road.
Bookkeeping is non-negotiable for a successful business, but it doesn’t have to be difficult. Xendoo can manage your bookkeeping for you, so you have an up-to-date, accurate ledger at all times.
Plus, you get financial reports like balance sheets and profit and loss statements prepared for you each month. You can easily outsource your bookkeeping and accounting with Xendoo. Learn more about Xendoo plans or schedule a call back to talk to the Xendoo bookkeeping team.