What exactly do “debit” and “credit” in an account mean? Why does it increase when some accounts are debited, but decrease when others are debited? Are all these important to your company?
Everything you need to know is here to clear your accounting concepts.
Table of Contents
- What are Debits and Credits?
- Basis of Accounting
- Common Types of Accounts
- Difference Between Debit and Credit
- Are Debits and Credits Used in a Single-Entry System?
- Examples for Debits & Credits in Double-Entry Accounting
- Debits & Credits Accounts
- Debit & Credit Charts
- FAQs: Frequently Asked Questions
What are Debits and Credits?
Debits and credits are used in company accounting to balance the books. Expenses increase asset or expense accounts and decrease liability, income, or equity accounts.
Credits are the opposite. When entering transactions, each charge transaction must have a corresponding credit transaction of the same amount and vice versa.
Definition of Debit: Debit is an accounting entry that increases an asset or expense account or decreases a liability or equity account. Placed to the left of the accounting entry.
Definition of Credit: Credit is an accounting entry that increases a liability or equity account or decreases an asset or expense account. Placed to the right of the accounting entry.
Basis of Accounting
Every time a posting transaction is made, at least two accounts are involved, with one account creating a debit entry and the other account creating a credit entry. There is no upper limit to the number of accounts involved in a transaction, but the minimum is 2 accounts. An accounting transaction is always said to be “balanced” because the sum of debits and credits for each transaction must always be the same. Financial statements cannot be prepared if the transactions are not balanced. Therefore, the use of debits and credits in a two-column transaction record format is the most important of all controls over accounting accuracy.
There can be considerable confusion about the original meaning of debit or credit. For example, debiting a cash account means increasing your cash balance. However, debiting the vendor account means that the vendor’s liability amount is reduced. These differences arise because debits and credits affect several common types of accounts differently.
Common Types of Accounts
Asset = Equity + Liability
Assets are items that provide future economic benefits to the enterprise.
Examples of subsets of Asset Accounts include:
- Cash Amount
- Total Inventory
- All Prepaid Expenses
- Vehicles (Car, Motorbike, etc.,)
- Property & Machinery
A liability is an obligation that a company must pay.
An example of the Liability Accounts subgroup is:
- Payable Accounts
- Payable Income Tax
- Loans & Debt
- Bank Fees & Charges
These are the net worth entries (or the value of the company’s non-operating assets after paying off the debt). The example of the subset of the “Equity account” is as follows.
- Stocks & Shares
- Mutual Funds
- Real Estate
- Debt Securities
- Pension & Retirement Plans
- Derivative Instruments
Revenue Account or Income Account
Revenue accounts are associated with income from products and services or interest from investments.
The example of the “Revenue Account” subgroup is as follows.
- Bank Interest Income
- Sales Revenue
- Investment Incomes
- Service Revenues
These are commissions related to daily business management.
The example of the “Expense Account” subgroup is as follows.
- Rent Amount
- Advertising Amount
- Utilities Bill
- Travel Expenses
Difference Between Debit and Credit
A debit is an accounting transaction that increases either an asset account, such as cash, or an expense account, such as a business expense. Debits are always entered on the left side of the journal entry.
A credit is an accounting transaction involving a liability account. Like, Borrowed money, stock accounts, etc. Credits are always entered on the right side of the journal.
Mathew sells three bicycles to customers for $1,000. Invoices are paid immediately in cash. Mathew deposits the money directly into the company’s business account. Next, he updates his company’s online accounting information.
Mathew goes online and, in this transaction, he records a debit of USD 1000 from his cash account (under Assets). On his sales (earnings) he will be credited $1,000.
A few weeks later, Mathew received a $3,000 loan to modernize his store. Then in the Accounts Payable account (under Accounts Payable) he credits $3,000 and the same amount is debited in the Cash account (under Assets). Once he has paid off the $3,000 loan in full, he debits the loan account and deposits it into the cash account.
Are Debits and Credits Used in a Single-Entry System?
Debits and credits are not used in single-entry systems. Transactions are recorded only once in this system. It is usually an entry in a checkbook or ledger indicating receipt or issuance of cash. A single-entry system is designed only for producing income statements. To create a balance sheet, it is necessary to convert from single-entry bookkeeping to double-entry accounting.
Examples for Debits & Credits in Double-Entry Accounting
Below are a few examples of Double Entry Recordings of Debits & Credits:
Sales Transaction Recordings
Recording sales transactions is more detailed than many other journal entries because you need to track the cost of goods sold and the sales tax charged to the customer.
For example, on August 1st, a customer sells 10 products for $10 each. After deducting 5% sales tax, the customer will be charged $105.00. To journalize these charges and credits:
|1-Aug-22||Cost of Goods Sold||$50|
|1-Aug-22||Sales Tax Payable||$ 5|
You add (debit) the customer balance with the invoice amount of $105 and revenue is recognized when the transaction occurs. The cost of goods sold is an expense account and should be incremented (debited) by the cost of the leather magazine.
Your sales will be increased (credited) by $100.
The inventory account, which is an inventory account, is reduced (credited) by $50 because of the selling of the product.
Finally, posting the unpaid sales tax as credit increases the balance of this accounts payable account.
Business Loan Recordings
On August 1, 2022, your company receives a loan of $25,000 paid annually at 5% interest rate. How to capture them:
Debit (increase) cash when you credit a loan as a bill of exchange or a loan liability. You must also record the interest paid for the year.
Bill Recording in Payable Account
When you receive an invoice from a vendor or utility company, record the invoice in Accounts Payable as it will be paid soon. The entry looks like this:
Debit (increase) the service charge account and credit (increase) the accounts payable at the same time.
Payment Recording of any Bill
If you pay your electricity bill in the next month, your entry will look like this:
You pay the bills, so you bear (relieve) the debt. They also deposit (reduce) cash.
Debits & Credits Accounts
|Account||When to Debit||When to Credit|
|Cash & bank accounts||While depositing funds or while making payment||When utility bills & other bills are paid|
|Receivable accounts||While the sale is made on credit||When the user pays|
|Various expense accounts like Utilities, Rent, Payroll, & office supplies.||While a purchase is made, or a bill paid||When a refund is received from a shopping sites or other resource.|
|Payable Accounts||While a bill is paid||While entering a bill for the payment in the future.|
|Revenues||While returning a product, or any extra discount & offer is given.||While a sale is made.|
Debit & Credit Charts
Most people know how to properly record debits and credits using a list of accounts.
A cheat sheet like this is an easy way to remember your accounting debits and credits.
|Asset accounts will increase.||Asset account will decrease.|
|Expense accounts will increase.||Expense accounts will decrease.|
|The liability account will decrease||The liability account will increase.|
|Equity account will decrease.||Equity account will increase.|
|Revenue will decrease||Revenue will increase.|
|All the Debit amounts are recorded in the left.||All the credit amounts are recorded in the right.|
Moreover, how we can forget the famous tagline given by accountant Charles E. Sprague:
“Debit what comes in, Credit what goes out”.
Whether you’re creating a business budget or tracking receivable sales, you need to use debits and credits appropriately.
In fact, the accuracy of everything from net income to balance sheet ratios depends on entering debits and credits correctly. Taking the time to figure it out now will save you a lot of time and extra work later.
Further Readings: Click on the below links to read further relevant articles to boost your understanding in finance.
- What is Net Worth?
- What are SMART Goals?
- What is interest in banking?
- What is Time Management?
- What are Time Management Techniques?
- What are Asset Management?
- What are Asset Management Companies and its role?
FAQs: Frequently Asked Questions
What is a credit balance?
The balance on your statement is the amount owed to you by your card issuer. Credits are added to your account with each payment. A credit will be added when you return an item purchased with a credit card.
What is a credit account?
An arrangement by a bank, store, etc., that allows customers to purchase things with a credit card and pay for them later
Is income a debit or credit?
Income increases capital so it strikes a normal balance. Spending and withdrawals, on the other hand, reduce capital, so there is usually a debit balance.
What are 3 types of credit?
Installment credit, Revolving credit, and Open credit
What is cash account?
A cash account is a type of custody account in which an investor must deposit the full amount of the securities purchased. An investor with a cash account cannot borrow money from a brokerage firm to pay for trades on the account (margin trading).
Is a loan a debt or credit?
The most common forms of debt are loans such as mortgages, car loans, personal loans, and credit card debt. Under the terms of the loan, the borrower must repay the balance of the loan by a certain date. It is usually dated several years in the future.
What is the rules of debit and credit?
Debit and credit rules:
Assets are increased by debits and decreased by credits. Liabilities increase with credits and decrease with debits. Equity accounts are increased by credits and decreased by debits. Income increases with credits and decreases with debits.
What is debit balance?
The debit balance of a margin account is the total amount owed by a client to a broker or other lender for funds borrowed to purchase securities.
What is DR and CR in accounts?
The terms debit (DR) and credit (CR) have Latin roots.
Debit comes from debitum, which means “due”, and credit comes from creditum, which means “something entrusted to someone else, or a loan.” An increase in debt or equity is referred to as “CR.
What is a 20 10 rule?
The 20/10 rule requires you to limit your non-residential debt to 20% of your annual net income and keep your monthly payments on that debt to less than 10% of your monthly net amount.