Archive for May 10th, 2014

Understanding Debits and Credits

May 10th, 2014

Bean Counting-Debits & CreditsFor many business owners the debit/credit system is one of the great mysteries of accounting. And a good reason to let someone else handle it. Which accounts are debits? Which are credits? Why are debits on the left and credits on the right? Why not just say plus and minus? Why use such an system at all?

What are debits and credits?

A set of accounting books has two separate lists of numbers, one list called the “debits,” the other called the “credits.” It is a cardinal rule that total debits must equal total credits in every single transaction and in the set of accounting books as a whole.

You could define “debits” and “credits” as the two separate classes of numbers in your books.

Debit accounts and credit accounts

There are five basic elements of the financial statements:

  1. Assets (such as Cash, Inventory, Accounts Receivable, and Fixed Assets)
  2. Liabilities (such as Accounts Payable and Mortgage Payable)
  3. Owners’ Equity (for a Sole Proprietorship, Partnership, or Corporation)
  4. Revenues (such as Sales)
  5. Expenses (such as Cost of Goods Sold, Salary Expense, or Tax Expense)

Of these, Assets and Expenses are considered to be debit accounts, while Liabilities, Owners’ Equity, and Revenues are considered to be credit accounts. Every student of accounting should know these classifications cold.

How to remember which accounts are debits and which are credits

Having the debit accounts be Assets and Expenses, while the credit accounts are Liabilities, Owners’ Equity, and Revenues, doesn’t seem to make much sense. After all, most people think of Assets and Expenses as opposites. Likewise, Liabilities, Owners’ Equity, and Revenues don’t seem to have much in common.

What these accounts have in common is their relationship with cash. Credit accounts; Liabilities, Owners’ Equity, and Revenues are sources of cash. This is where the money comes from. You can borrow it, you can raise it from investors, or you can earn it from customers. Debit accounts – Assets and Expenses – are things you spend money on. Use your cash to buy Assets, or spend it on Expenses.

Journal entries

In accounting, transactions are represented as journal entries. Each journal entry consists of equal values of debits and credits. Debiting a debit account increases it. Crediting a debit account decreases it. On the other hand, crediting a credit account increases it. Crediting a debit account decreases it.

Suppose you sell a service for cash. You would debit the account Cash (an Asset), thus increasing it. You would credit the Account Revenues (a Revenue account), thus increasing. Hence, both your cash and your revenues will be increased.

Debits and Credits aren’t good or bad

Some people think credits are “good,” while debits are “bad.” Indeed, revenues could be considered to be good because they increase net income, while expenses could be bad because they decrease net income. However, on the balance sheet, one might say that liabilities (debts) are evil even though they are credit accounts, while assets are good even though they are debit accounts. This approach to understanding debits and credits doesn’t work.

Debits and credits form the building blocks of accounting. Assets and Expenses are debit accounts. Liabilities, Owners’ Equity, and Revenues are credit accounts. Journal entries have equal values of debits and credits affecting the accounts. In a company’s books as a whole, all debits must equal all credits.