At first glance, accounting can seem a difficult field to navigate. Even simple terms like debits and credits don’t have the same meaning in bookkeeping as in everyday life and initially can appear counterintuitive. Once properly understood, however, the double-entry system and its fundamentals (debits and credits) become an essential tool in every budding accountant’s kit.
What are Debits?
In simple terms, to debit means to reduce or deduct. In everyday life, our “debit” cards allow us to make payments from our savings or earnings accounts, which are “debited” every time we do so.
Similarly in accounting practice, when a pizza parlor purchases flour from the local supermarket it “debits” the company bank account.
What are Credits?
To go on credit, on the other hand, means to exceed your available finances. Credit Cards allow us to purchase items or cover expenses for which we may not necessarily have the requisite funds. In exchange for the line of “credit” we pay a monthly or annual fee. Often, we also must make interest payments depending on how much of our limit we have used up. Much the same way, when a burger shop seeks an overdraft facility from their local bank, they now have a “credit line”.
Debits and Credits and The Basic Accounting Equation
Modern accounting grows from the principle of debits and credits and applies them to items such as Assets, Liabilities, and Equity. These three in particular make up the basic accounting equation.
- Assets are the things you own, this can be the company premises, company bank balance, or even the company truck.
- Liabilities are the things you owe, such as utility expenses, or the interest payments on the overdraft facility provided by the bank.
- Equity is what is left over after you use your assets to pay off your liabilities.
Assets = Liabilities + Equity
The basic accounting equation asserts that your Assets must always equal your Liabilities and Equity. This has enormous implications for accounting practice.
Debits and Credits in Accounting Practice
Now, this is where things start getting more exciting. We already covered the meanings of Assets, Liabilities, and Equity. Let’s see how they behave in reference to debits and credits.
Recording Assets, Liabilities, and Equity
Assets are by nature, “debit” items. This means every time an Asset is increased in value, nature, or amount, you “debit” that account. And when an asset is decreased, you “credit” that account.
Liabilities and Equity are the opposite, they are “credit” items. So, every time a liability rises, you “credit” that line item, and when it is reduced, you debit it.
There are two more accounting items affected by the debits and credits system: Revenue and Expenses.
Recording Revenue and Expenses
Revenue is the money or cashflow we generate from selling a particular product or service. For example, revenue incoming from our product sales via our shop or online. Revenue is by nature a “credit” line item. So, every time it increases, we credit it and every time it decreases, we debit it. Just like our salary is being “credited” to our accounts every month, or withdrawn with a “debit card” at the ATM.
Expenses can be the costs of creating the product we are selling (known as cost of goods sold) , or the general costs of running our business. For example, utility bills or even the cost of fuel for our transport vehicles. A third type of expense is Depreciation and Amortization, which are costs a company incurs from the obsolescence and inadequacy of its fixed assets. Expenses by nature are a “Debit” line item. So, every time our expenses rise, they get “debited” in the ledger, and every time they fall, they are credited.
There is an important difference in the way these accounts are recorded. Revenues and Expenses are items of the Income Statement. Meanwhile Assets, Liabilities and Equity are part of the Balance Sheet. Both of these financial statements are governed by the double-entry principle, however.
What is the Double-Entry Principle?
The double entry concept is visible in the accounting equation itself. The assets of your business must equal what your business owes and owns (i.e. its liabilities and equity).
For double entry we traditionally use paper-and-pen “journal entries”, which we organize into General and Subsidiary Ledgers. Of course, advanced software such as Sage no longer requires us to maintain physical journals.
What is a General Ledger?
The General Ledger account is the name of the container where we store information about Balance Sheet and Income Statement items. Recall that these are Assets, Liabilities and Equity for the Balance Sheet, Revenue, and Expenses for the Income Statement. In the example above, a firm has the following general ledger accounts on the Asset side of its Balance Sheet: Cash, Accounts Receivable, Inventory, Property Plant & Equipment, and so on.
Usually, a General Ledger has Subsidiary Ledgers, which contain the respective details of the account. For instance, an accounts receivable General Ledger will have Subsidiary Ledgers that contain information about the amount that each customer owes. A General Ledger for Inventory will contain Subsidiary Ledgers that will show the breakdown between raw materials, work-in-progress, and finished goods.
The General Ledger accounts are known as “T-Accounts” because we draft them in the shape of the letter “T”. Debit items always fall on the left and Credit items on the right side of a T-Account.
Let’s illustrate everything we’ve said so far with an example.
A burger place called Burger Binge Ltd owns the following Assets:
- A delivery vehicle worth $10,000,
- A shop with a market value of $30,000,
- Burger making inventory totaling $8,000, and
- A bank balance of $5,000.
However, the burger place purchased part of its inventory on $2,500 credit from a supplier, and payment for it is now due.
Using the Accounting Equation let’s calculate the Equity of Burger Binge Ltd:
(Assets) $10,000 + $30,000 + $8,000 + $5,000 = (Liabilities) $2,500 + Equity
Equity will therefore equal $ 50,500.
Now, when Burger Binge Ltd proceeds to pay its Creditor $2,500, it will credit its bank balance of $5,000 by $2,500. This is because with their interest payment the Asset (bank balance) falls in quantity. At the same time, they will have to debit the creditors account, since they are eliminating a Liability. This preserves the balance in the Accounting Equation: Assets decrease and so do Liabilities, but Equity remains the same.
We record this transaction as follows:
Creditors $2,500 Dr | Bank account $2,500 Cr
Where Dr refers to Debit and Cr refers to Credit.
And this is how we can visualize the results of this transaction using T-Accounts:
The Accounting world has grown so much from being a basic bookkeeping profession to a more dynamic and exciting area. Knowledge of basic concepts enables you to quickly start auctioning the insights of your journal entries to inform decisions within the business. Moreover, accountants utilize the backbone of the system (debits and credits) to add value to the world of financial services via a set of functions known as financial accounting. Dig deeper into the multi-faceted roles they play in today’s corporate world and start gaining the skills you need to launch a career in Accounting with our Accounting and Financial Statement Analysis course.
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