Debits and Credits Explained…But First, Accounts
To understand the intricate dance of debits and credits, one must first dive into the world of accounts. Picture this: every financial move your business makes is tucked neatly into a specific drawer of your financial cabinet. There are five primary drawers – assets, expenses, revenue, liabilities, and equity – as outlined in your chart of accounts.
Asset Accounts
Assets are like the golden tickets of your business; they’re the shiny objects that promise future economic gain. Think cash, those hopeful “receivables” you’re waiting on, stacks of inventory, and all that shiny equipment. These assets get their own spotlight on your balance sheet.
Liability Accounts
Liabilities are the pesky IOUs your business is bound to pay. We’re talking accounts payable, looming loans, and even those payroll taxes that nibble away at your cash flow. Just like assets, they too stand tall on your balance sheet.
Equity Accounts
Equity is the prize at the end of your business marathon. It’s the pot of gold that could be handed back to the owners (or shareholders) if you liquidate all assets and settle all debts. It chronicles the true ownership stake in your company’s financial playground.
Revenue Accounts
Here lies the glam – the revenue accounts. They log every dollar earned from the glorious efforts of selling products and services. This income struts its stuff on your income statement, basking in the glow of your business triumphs.
Expense Accounts
Expenses, on the other hand, are the unsung heroes working behind the scenes. These are the relentless costs your business shoulders to earn revenue – advertising, rent, wages, you name it. Just like revenue, they find their home on the income statement.
The Five Account Types
Imagine these five accounts as the drawers in your office filing cabinet. Each drawer has multiple folders – petty cash, accounts receivable, inventory, etc. – and each folder contains sheets of paper, each representing a single transaction, meticulously marked as debit or credit. It’s a system of poetic order, where every piece has its place in the puzzle of your financial story.
What Is the Difference Between a Debit and a Credit?
Debits and credits are fundamental elements of double-entry accounting, ensuring that every financial transaction impacts at least two accounts to maintain balance. When you debit one account, you must credit another, preserving the integrity of the accounts.
Debits (DR)
An accounting ledger’s left side is where debits are noted. Liability, equity, and income accounts are decreased while asset and expense accounts are increased.
Credits (CR)
In an accounting ledger, credits are noted on the right side. While asset and expenditure categories are reduced, liability, revenue, and equity accounts are increased.
For instance, if a tutoring business takes a bank loan, the Cash account (an asset) is debited to reflect the increase in cash, while the Loans Payable account (a liability) is credited to acknowledge the debt. This exemplifies how debits and credits work together to maintain balance.
How Are Debits and Credits Recorded?
Recording debits and credits is a key task in maintaining your business’s general ledger, the central record of all financial activities. Every transaction—whether it impacts assets, liabilities, equity, revenues, or expenses—is noted as a journal entry in this logbook. Today, sophisticated accounting software has largely automated this process, making it easier for business owners and accountants. However, traditionally, debits were marked on the left side of the ledger and credits on the right. To simplify, T accounts can be used, where the account name is at the top, debits on the left, and credits on the right, visually tracking each transaction’s impact and maintaining financial balance.
Debit and Credit Examples
Example 1: Sales Revenue
Picture this: Sal, the mastermind behind Sal’s Surfboards, has an amazing day at his surf shop. A customer walks in and buys three surfboards for $1,000 in cash. The excitement of the sale propels Sal to quickly deposit the money into the business account. Now, enters the magic of accounting. Sal logs into his accounting software and creates a journal entry: he debits the Cash account (an asset) by $1,000 and credits the Sales account (revenue) by $1,000. This entry perfectly balances the books, reflecting the transaction accurately in the financial records.
Example 2: Fixed Asset Purchase
Sal purchases a $1,000 piece of equipment, paying half of the price immediately and agreeing to a promissory note for the remaining balance. To accurately reflect this transaction, Sal will make the following journal entries in his accounting software: he debits the Fixed Asset account for $1,000, credits the Cash account for $500, and credits Notes Payable for $500.
Example 3: Getting a Loan
Picture this: Sal, eager to upgrade his surf shop, secures a $3,000 loan. He logs into his accounting software, adding credit to his Loans Payable account for $3,000 to acknowledge the new debt. Simultaneously, he debits the Cash account for $3,000, celebrating the influx of funds. This precise dance of debits and credits captures Sal’s business move while maintaining financial balance.
Example 4: Loan Repayment
In the next month, Sal makes a $100 payment towards the loan, with $80 allocated to the loan principal and $20 to interest. To record this transaction, Sal makes a debit entry of $80 to the Loans Payable account (reducing the liability), a debit entry of $20 to the Interest Expense account (an expense), and a credit entry of $100 to his Cash account.
What About Debits and Credits in Banking?
Debits increase assets and credits decrease assets in typical accounting, which might seem confusing when looking at your bank account. When you use a debit card, your balance reduces, and when an overcharge is corrected with a credit, your balance increases. This seems like a reversal, but it’s all about perspective.
From the bank’s perspective, your checking account is considered a liability because it represents money the bank owes you.
Therefore, when the bank debits your account, they are actually decreasing their liability to you, and when they credit your account, they are increasing their liability. This explanation helps clarify why transactions might appear reversed on your bank statements. While this perspective shift isn’t crucial for managing business bookkeeping, it does make it easier to interpret your bank statements accurately.
