The terms “debit” and “credit” are used regularly when dealing with your finances, but they can be confusing to understand at first. Most people are familiar with how debits and credits treat asset accounts, like your checkbook. However, it can get pretty confusing since debits and credits work differently in other accounts, like liability accounts. This article will explain debits and credits and how they work, so you can understand the accounting process a little better.
Let’s define debit and credit
In accounting, a debit is a record that increases an asset or expense account and decreases a liability, revenue, or equity account. A debit is listed on the left side of an entry. On the other hand, a credit decreases an asset or expense account and increases a liability, revenue, or equity account. A credit is listed on the right side of a journal entry.
|Account||When the Balance is Increased||When the Balance is Decreased|
|Assets (Cash, Accounts Receivable, Furniture, etc.)||Debit||Credit|
|Expenses (Rent, Utilities, Advertising, Supplies, etc.)||Debit||Credit|
|Liabilities (Accounts Payable, Loans Payable, etc.)||Credit||Debit|
|Revenue (Sales Revenue, Interest Revenue, etc.)||Credit||Debit|
|Equity (Stocks, Paid-in Capital, etc.)||Credit||Debit|
If you use the double-entry method of accounting, there will be a debit and credit for every single transaction. This allows you to balance the accounts and locate any errors quickly.
Let’s look at an example.
Imagine you bought 50 plain t-shirts for $250 in various sizes so you can put original designs on them to sell in your online shop.
- Asset Account: If you used cash (or a checking account) to buy those shirts, you would record entries like this:
Cash Ledger: (Remember, you took money out of this account to purchase your shirts, decreasing the balance.)
Inventory (t-shirts) Ledger:
- Liability Account: If you used a credit card to purchase the shirts, the entries would look like this:
Accounts Payable: (This represents a bill you need to pay, so you are increasing the amount you owe.)
Inventory (t-shirts) Ledger:
As you can see, no matter whether you use cash or credit, one account is credited and one account is debited, leaving the books balanced.
What is the point of recording everything as debits and credits twice (double-entry)?
As a business owner, knowing where your money is and what it is doing is vital information. Using the example above, if you just spent the $250 and noted that you spent it, you may look back at the end of the month wondering where that money went. If you used the double-entry method, you could match the amount and date and find exactly what it was used for, inventory (t-shirts) and exactly how much of it is left.
While it may not seem like a huge deal, if you don’t have enough money to pay the bills one month, you will want to have an idea of how to tackle the issue. You need to be able to look where you could cut costs, or how you could spend differently to not be put into the situation again.
Utilizing the double-entry accounting method gives you a clear picture of where your money is being made and where it is being spent.
Debit and Credit Entries for Equity Accounts
Our t-shirt example above gave us an idea of how to debit and credit asset accounts and a liability account, but what about equity accounts. Equity is the investments into your business, whether from yourself, from another party, or from the business itself from profits.
So, imagine you are starting up your business and you decide you want to invest $10,000 of your own personal money into the business. How would this look in the books? Let’s continue using the double-entry method.
Cash Ledger: (Your business now has $10,000 cash, increasing the balance of the account.)
Equity (Additional Capital) Ledger: (Remember, with an equity account, when the balance goes up, it is recorded as a credit.)
|Equity (Add’l Capital)||10,000|
As required with the double-entry system, we have a transaction recorded on the debit side and an equal transaction recorded on the credit side.
It may be a little difficult to grasp as to why money coming in would credit the equity account, but it is due to the fact that the money isn’t representing cash in the equity account, but rather the claim an investor has against the business.
Debits, Credits, and the Bookkeeping Process
Now that you have a basic understanding of how debits and credits work in the bookkeeping process, you may still be hesitant to take on the responsibility of recording all of this information. Every single financial transaction needs to be tracked, recorded, and organized into general ledgers and those ledgers must balance. Your accounts must also be reconciled to ensure accuracy. Without accurate and complete information, your financial statements are useless, and you will be making decisions blind. If your bookkeeping is taking too long, or it is just too tedious and causing you stress, it might be time to look into outsourcing your bookkeeping needs.