Debit vs Credit: Bookkeeping 101

Bookkeeping relies on debits and credits to ensure that a company's financial records are balanced. Debits are used to increase asset or expense accounts, while decreasing liability, revenue or equity accounts. Credits do the opposite. Every transaction that's recorded must have both a debit entry and a corresponding credit entry of the same amount.

Double-entry bookkeeping relies on debits and credits as the backbone of the system. These entries are recorded in a business's general ledger, which tracks all the money coming in and going out of the business, as well as the movement of funds between different accounts.

In this article, we'll provide a detailed explanation of debits and credits, as well as show you how to use them to maintain accurate financial records.

Bookkeeping Chart of Accounts

Before you can grasp the concept of debits and credits, it's essential to have a solid understanding of accounts.

A chart of accounts is a list of all the accounts used by a business to record its financial transactions. It provides a systematic way of organizing and classifying accounting transactions to facilitate financial reporting and analysis.

The chart of accounts can vary depending on the size and complexity of the business. Generally, it includes assets, liabilities, equity, revenue, and expense accounts. By using a standardized chart of accounts, businesses can ensure consistency and accuracy in their financial reporting, which is important for making informed business decisions.

Asset Accounts

Asset accounts in bookkeeping refer to a category of accounts that record resources that a business owns or has control over. These resources are expected to provide future benefits to the business. Examples of asset accounts include cash, accounts receivable, inventory, property, plant and equipment, and prepaid expenses.

Here's a brief overview of the different types of asset accounts:

1. Current assets: These are assets that can be easily converted into cash within a year, such as cash in hand, accounts receivable, and inventory.
2. Fixed assets: These are long-term assets that are used in the business's operations, such as property, plant, and equipment.
3. Intangible assets: These are non-physical assets that don't have a tangible form, but still have value, such as patents, trademarks, and goodwill.
4. Other assets: This category includes any other assets that don't fit into the above categories, such as prepaid expenses and deposits.

Liability Accounts

A liability account represent obligations that a business owes to other parties. These obligations can be financial or non-financial and are typically expected to be settled or fulfilled in the future. Examples of liability accounts include accounts payable, loans payable, accrued expenses, and taxes payable.

Here's a brief overview of the different types of liability accounts:

1. Current liabilities: These are liabilities that are expected to be settled within a year, such as accounts payable, accrued expenses, and short-term loans.
2. Long-term liabilities: These are liabilities that are expected to be settled over a period of more than one year, such as long-term loans, mortgages, and bonds.
3. Contingent liabilities: These are potential liabilities that may arise from future events, such as pending lawsuits or warranty claims.
4. Other liabilities: This category includes any other liabilities that don't fit into the above categories, such as deferred revenue and customer deposits.

Equity Accounts

Equity accounts represent the residual interest in a business after all liabilities have been deducted from assets. Equity accounts are also referred to as owner's equity or shareholders' equity, depending on the legal structure of the business.

Equity accounts represent the value of a business that belongs to the owners or shareholders, and they include various types of contributions and earnings that the owners have made or received. Some common equity accounts include common stock, retained earnings, and dividends.

Here's a brief overview of the different types of equity accounts:

1. Common stock: This represents the initial investment made by shareholders to start the business, and it's recorded as a credit to the common stock account.
2. Retained earnings: This represents the portion of the business's earnings that have been retained or reinvested in the business instead of being distributed to shareholders as dividends.
3. Additional paid-in capital: This represents any additional amounts that shareholders have contributed to the business, over and above the initial investment represented by the common stock.
4. Treasury stock: This represents any shares of the company's own stock that the company has repurchased.

Revenue Accounts

Revenue accounts are a category of accounts that represent the inflow of assets resulting from the sale of goods or services to customers. Revenue is the income earned by a business from its primary operations and is a key component of a business's financial performance.

Revenue accounts are used to record all transactions related to the sale of goods or services, such as sales invoices, credit memos, and refunds. These transactions are recorded as credits to the revenue account, which increases the account balance. Conversely, returns or allowances are recorded as debits to the revenue account, which decreases the account balance.

Here's a brief overview of the different types of revenue accounts:

1. Sales revenue: This represents the revenue earned from the sale of goods or services to customers.
2. Service revenue: This represents the revenue earned from providing services to customers.
3. Interest revenue: This represents the revenue earned from investments, such as interest earned on bank accounts or bonds.
4. Other revenue: This category includes any other revenue that doesn't fit into the above categories, such as rental income or gains from the sale of assets.

Expense Accounts

Expense accounts represent the outflow of assets or incurrence of liabilities resulting from a business's operations. Expenses are costs that a business incurs to generate revenue and are a key component of a business's financial performance.

Expense accounts are used to record all transactions related to a business's expenses, such as invoices, bills, and credit card payments. These transactions are recorded as debits to the expense account, which increases the account balance. Conversely, returns or refunds are recorded as credits to the expense account, which decreases the account balance.

Here's a brief overview of the different types of expense accounts:

1. Cost of goods sold: This represents the cost of the goods or materials that a business sells to customers, including direct labor and overhead costs.
2. Operating expenses: This represents the day-to-day expenses that a business incurs to operate, such as rent, utilities, and office supplies.
3. Depreciation and amortization: This represents the systematic allocation of the cost of assets over their useful lives.
4. Interest expense: This represents the cost of borrowing money, such as interest on loans or credit card balances.

What Is the Difference Between a Debit and a Credit?

In bookkeeping, debits and credits work together to ensure that all transactions are accurately recorded. In a double-entry accounting system, each transaction affects at least two accounts, so if you debit one account, you must credit another (or more) accounts in your chart of accounts.

The main differences between debits and credits can be understood through the accounting equation:

Debits

Debits increase asset and expense accounts, while decreasing liability, equity, and revenue accounts. Debits are always recorded on the left side of an accounting ledger.

Credits

Credits increase liability, revenue, or equity accounts, while decreasing asset or expense accounts. Credits are always recorded on the right side of an accounting ledger.

Here's an example of how this might work in practice:

Matt runs a tutoring business and is about to open a new location. To pay for the space, equipment, and staff wages, he secures a bank loan. The money he receives from the bank increases his Cash account, which is an asset account. Therefore, it is recorded as a debit. At the same time, he credits the same amount to his Loans Payable account, which is a liability account, to record the debt she has taken on for the bank loan.

Debit and Credit Examples

To help you understand how debits and credits work in real-life scenarios, let's take a look at some examples of how these bookkeeping entries impact a small business's accounts.

Example 1: Recording a sale

Let's say a small retail store sells a product for $100. The sale is recorded as a credit to the store's Sales account, which is a revenue account. At the same time, the store's Cash account, which is an asset account, is debited for $100 to reflect the payment received from the customer. This transaction shows how a debit to an asset account and a credit to a revenue account work together to record a sale.

Example 2: Purchasing inventory

When a business buys inventory, it's recorded as a debit to the Inventory account, which is an asset account, and a credit to the Cash or Accounts Payable account, depending on how the purchase is paid for. If the purchase is paid for with cash, the Cash account is credited for the amount paid. On the other hand, if the purchase is made on credit, the Accounts Payable account is credited for the amount owed to the supplier. This transaction shows how a debit to an asset account and a credit to either a cash or liability account are used to record a purchase of inventory.

Example 3: Paying expenses

When a small business pays for expenses, such as rent or utilities, the expense account is debited, while the Cash account is credited. This shows how a debit to an expense account and a credit to an asset account are used to record an expense payment.

By understanding these examples, you can see how debits and credits are used in practical bookkeeping scenarios for a small business.

How Are Debits and Credits Recorded?

Debits and credits are recorded in a business's general ledger, which keeps a complete record of all financial transactions over a given period of time. Every change in the business's assets, liabilities, equity, revenues, and expenses is recorded as a journal entry in the general ledger.

Nowadays, most bookkeepers and business owners use accounting software to record debits and credits. However, in the past when accounting records were kept in paper ledgers, transactions were written out, with debits always placed on the left and credits on the right.

To better understand debits and credits, T accounts can be used as visual aids. These accounts are graphic representations of ledger accounts and can help illustrate how debits and credits work.

What About Debits and Credits in Banking?

Debits and credits in banking can seem counterintuitive, but they actually work the same way as in bookkeeping. When you make a debit-card transaction that reduces your bank account balance, it's called a debit, even though it decreases your assets. And if you report an error and the bank credits your account to increase your balance, it might seem like credits and debits are reversed.

However, from the bank's perspective, your business checking account isn't an asset; it's a liability, because it's money the bank is holding that belongs to someone else. So when the bank debits your account, they're actually decreasing their liability. And when they credit your account, they're increasing their liability.

While understanding bank debits and credits isn't crucial for managing your business's bookkeeping, it can help to know that the debits and credits on your bank statement reflect the bank's perspective, not your own.

Conclusion

If you're new to small business accounting, understanding the difference between debits and credits and how they affect account balances can be confusing. However, if you use accounting software to create invoices and track expenses, much of the guesswork is eliminated.

The most important thing to keep in mind is that your total debits must always equal your total credits when recording journal entries. By ensuring that your debits and credits are equal, your books will remain in balance, allowing you to generate accurate financial statements that provide valuable insights into your business's finances. This will also help to ensure that all of your general ledger account balances are correct.