Debits and credits work together like the math of money. Debits add to accounts or expenses, while credits subtract from them, ensuring the numbers add up correctly in your financial records. Understanding this balance can help small business owners like you maintain accurate books and avoid financial discrepancies.
Why did the accountant bring a ladder to work? To climb the “credit” ladder and avoid falling into the “debit” pit!
Didn’t find that funny?
As a small business owner, you’re likely to DIY your bookkeeping, and distinguishing between debits and credits while understanding their impact on account balances can be confusing. Due to these confusions, our joke may not have tickled your funny bone.
Let’s change that.
So, what does it mean to “debit” or “credit” an account? Why do some accounts increase with a debit while others increase with a credit? And why is this crucial for your business?
In this blog, we’ll dive deep into the mechanics of debits and credits and show you how to use them effectively to maintain balanced books.
Let’s first understand accounts
In accounting, the terms debit (DR) and credit (CR) can seem confusing because they don’t align with everyday language.
- Debits typically record amounts of value flowing into an asset or expense account. This is different from what ‘debit’ implies in everyday usage, such as a debit card, where money is taken out of your bank account.
- Credits usually record amounts of value flowing out of an asset account, or into a liability, equity, or revenue account. This differs from what ‘credit’ implies everyday usage, where credit means receiving a loan or refund, implying money is added to your account.
Imagine your business’s financial system as a filing cabinet. The cabinet is divided into five main drawers, each representing a different type of account. Every financial transaction you do in your business is recorded in one of these specific accounts.
The five main types of accounts are assets, expenses, revenue (income), liabilities, and equity.
1- Assets
Assets are items that provide future economic benefits to a company.
Examples include:
- Cash
- Property
- Equipment
- Vehicle
- Accounts Receivable
2- Liabilities
Liabilities are obligations that the company must pay.
Examples include:
- Bank Loans
- Accounts Payable
- Credit Cards
- Unearned Revenues
- Customer Credits
3- Revenue
Revenue accounts are related to income earned from the sale of products and services.
Examples include:
- Sales
- Royalties
- Cost of Goods Sold
4- Expenses
Expenses are the costs of operations that a business incurs to generate revenues.
Examples include:
- Wages
- Rent
- Phone Bills
- Utilities
5- Equity
In accounting, owner’s equity (or shareholders’ equity) represents the money or property that could be returned to owners (or shareholders) if all of the company’s assets were liquidated and all of its debts were paid off.
Examples include:
- Owner’s Equity
- Owner’s Draw
- Owner’s Contribution
- Common Stocks
- Retained Earnings
These accounts are listed in your chart of accounts. Assets, liabilities, and equity appear on your balance sheet, while revenue and expenses show up on your income statement.
Through general entries, debits and credits document the flow of money into and out of your business and between these five different accounts in your business’s general ledger, which contains a detailed record of all financial transactions over a period of time.
To clearly understand debits and credits, you need to get the hang of the basic accounting equation:
Assets = Liabilities + Equity.
Understanding the fundamental accounting equation
This equation is the cornerstone of double-entry accounting, ensuring that every financial transaction maintains balance.
In this accounting system, there is supposed be an equal debit and credit entry for each transaction. This ensures that a company’s books are “in balance.” Achieving this balance is crucial, as it allows the creation of accurate financial documents like the income statement, balance sheet, and other essential reports.
Debits and credits play crucial roles here:
- Debits increase asset and expense accounts and decrease liability, revenue, and equity accounts.
- Credits increase liability, revenue, and equity accounts, and decrease asset and expense accounts.
With this basic understanding of how debits and credits interact with the accounting equation, let’s understand the specific impact of debits and credits on the accounts that make up this equation—liability accounts and equity accounts.
| Account Type | Impact of debits | Impact of credits |
| Liability Accounts | Increases when the company borrows money or accrues expenses. Example: Loan payable account is debited when a loan is taken. |
Decreases when a debt is repaid or an expense is settled. Example: Loan payable account is credited when a loan payment is made. |
| Equity Accounts | Decreases when the company incurs a loss or owner withdraws funds. Example: Drawing account is debited when owner withdraws cash. |
Increases when the company earns a profit or owner injects capital. Example: Retained earnings account is credited when a profit is earned. |
What are debits and credits?
Debits are crucial in managing your business’s finances, representing both the inflow of resources—like cash from sales or asset acquisitions—and the outflow, such as expenses and losses.
Understanding debits is essential for tracking the movement of money and resources, providing a clear and accurate picture of your business’s financial health.
Here’s how they work:
A debit is an entry on the left side of an account in a ledger.
Debits increase asset and expense accounts, reflecting money or resources coming into your business or spent on its operation. At the same time, a debit decreases liability, equity, or revenue accounts, indicating a reduction in what your business owes or earns.
Debits are fundamental to double-entry accounting (we mentioned it above, remember?), where every transaction has both a debit and a corresponding credit entry to balance the accounting equation.
Example: If you buy office supplies for $100, you debit (increase) your Office Supplies Expense account.
Credits are just as fundamental to your financial records as debits, but they work in opposition to them.
A credit is an entry made on the right side of a ledger account. It typically signifies an increase in liabilities, equity, or revenue, or a decrease in assets, expenses, or losses.
They are used to record transactions that either bring in revenue, increase liabilities or equity, or reduce assets or expenses. This system requires that every transaction be recorded with equal and opposite effects in at least two different accounts.
Example: If you take a $500 loan, you credit (increase) your Loans Payable account.
Do debits always represent money going out, and credits represent money coming in?
No, this is a common misconception.
In accounting, the meaning of debits and credits depends on the type of account involved.
Debits increase asset and expense accounts. This means that when you debit these accounts, it can represent either money coming into the business or money going out.
For example, when you receive cash from a sale, you debit the Cash account, indicating an increase in assets. Conversely, when you pay for office supplies, you debit the Supplies Expense account, reflecting an increase in expenses.
Credits, on the other hand, increase liability, revenue, and equity accounts. This can also mean money coming in or going out, depending on the account type.
For instance, when your business earns revenue from sales, you credit the Revenue account, indicating an increase in income. Similarly, if you take on a loan, you credit the Loans Payable account, which increases your liabilities.
To put it in a banking context, when you use your debit card and see a “debit” on your account, it means your bank balance goes down. This is because, from the bank’s perspective, they owe you less money. Conversely, when your account is credited, your balance increases because the bank owes you more money.
Double-entry accounting vs. single-entry accounting
We’ve mentioned double-entry accounting so many times that you’re probably wondering how it differs from single-entry accounting.
We’ve already established that in double-entry accounting, every transaction affects at least two accounts, with one account debited and another credited; the total debits must always equal the total credits, ensuring that the books are always balanced:
- The $1000 sale is recorded as a debit to accounts receivable and a credit to sales revenue.
- The $800 purchase is recorded as a debit to the inventory account and a credit to accounts payable.
Ensuring accuracy, accountability, and compliance with accounting standards, this accounting system provides a more comprehensive and accurate way to track financial transactions and offers better insights into a company’s financial health.
In single-entry bookkeeping, transactions are recorded only once, typically in a simple ledger or cash book. It’s a straightforward method but may lack the accuracy and detail provided by double-entry bookkeeping.
For example, when Photon Electronics makes a $50 sale, they simply record the increase in their cash account. When purchasing $30 in supplies, they record the decrease.
Which one works better?
To answer your question: Single-entry bookkeeping is simpler, cost-effective, and suitable for straightforward transactions.
On the contrary, double-entry bookkeeping ensures accuracy and compliance, making it ideal for businesses with more detailed financial analysis and accountability. It helps prevent errors and fraud, and is necessary for auditing purposes. This system is particularly useful for organizations that must manage multiple accounts, track large volumes of transactions, or adhere to financial reporting standards.
Debits and credits: a practical illustration
Let’s see how this foundational knowledge enables us to understand and apply debits and credits in practical scenarios.
1- Transaction recording
When a business engages in a financial transaction, such as making a sale or purchasing supplies, it impacts multiple accounts.
For example, when a company sells a product, it receives cash (an asset) while also recognizing revenue.
This transaction involves both a debit and a credit. The cash account is debited to increase it, reflecting the cash received, while the sales revenue account is credited to recognize the increase in revenue.
2- Balancing entries
Every debit must have a corresponding credit to ensure that the accounting equation remains balanced. This principle is fundamental to double-entry bookkeeping, as we explored earlier.
For instance, if a company purchases inventory on credit, the inventory account is debited to increase it, reflecting the increase in assets, while the accounts payable account is credited to reflect the increase in liabilities. This maintains the equilibrium between assets and liabilities.
3- Financial reporting
Debits and credits play a crucial role in generating financial statements, such as the balance sheet and income statement. By accurately recording transactions with debits and credits, businesses can produce reliable financial reports that stakeholders rely on for decision-making purposes.
For instance, the balance sheet summarizes a company’s financial position by listing its assets, liabilities, and equity, with debits and credits ensuring that these accounts reflect the company’s true financial status.
4- Maintaining balance and financial statements
This dual recording method helps stakeholders assess the company’s financial health accurately. Changes in liability and equity accounts directly influence the financial statements:
- Liabilities: An increase in liabilities, such as through borrowing, may indicate higher financial leverage, while a decrease from debt repayment can improve the company’s solvency ratios.
- Equity: An increase in equity due to profit or capital injections might signal a stronger financial foundation, whereas a decrease from withdrawals or losses might point to potential financial instability. These changes are reported on the balance sheet, significantly affecting the company’s overall financial position.
The bottom line
Debits and credits are fundamental to accurate bookkeeping and financial health. Understanding these concepts ensures that your business’s financial transactions are recorded correctly, keeping your books balanced and reliable.
However, managing this on your own can be time-consuming and prone to errors because—while these concepts may seem straightforward in theory—applying them in day-to-day financial management can often be complex for small business owners.
CoCountant offers bookkeeping services designed to simplify your small business financial management. With our certified professionals, every transaction is accurately recorded and categorized, providing you with clear daily records and precise monthly statements. This allows you to focus on growing your business with confidence, knowing your finances are in expert hands.
Do you understand why the accountant brought a ladder to work now? 😆
FAQs
What are account credits and debits?
In accounting, credits and debits are used to record transactions in a standardized manner. A debit represents an increase in assets or expenses or a decrease in liabilities or equity, while a credit represents the opposite: a decrease in assets or expenses or an increase in liabilities or equity.
What is debit in accounting?
In accounting, a debit is an entry made on the left side of an account, representing an increase in assets or expenses or a decrease in liabilities or equity. Debits are recorded to reflect transactions such as purchases, expenses, or withdrawals.
Why is it called credit?
The term “credit” in accounting derives from the Latin word “credere,” which means “to believe” or “to trust.” When a transaction is credited, it signifies trust that the party receiving the credit will fulfill its obligation to pay in the future.
What are the 5 rules of debit and credit?
The five rules of debit and credit are:
- Debit the receiver, credit the giver (for transactions involving assets)
- Debit what comes in, credit what goes out (for transactions involving expenses)
- Debit expenses and losses, credit income and gains
- Debit the decrease in liability and equity accounts, credit the increase
- Debit the increase in liability and equity accounts, credit the decrease
