Introduction to debits and credits
All about Debits and Credits! This post is part of our accounting education series. Finance and accounting, just like taxes, are all around us. To add, it surrounds us like the air we breathe. Finance, accounting, and taxes touch our lives. Like death, we cannot escape them. Ignoring these topics in your life is like ignoring that a cup of tea is hot. At one point, it will burn and burn it will. This is especially true for entrepreneurs and investors. No matter what business you engage in, a sound knowledge of at least the basic principles of finance, accounting and taxes is simply a must. Why let other people do the understanding for you?
Financial transactions find their way into our books and from there into our financial statement through Journal Entries. Whether you are doing them in handwriting or via an Accounting System, the concepts will always be the same. Every Journal Entry contains at least one debit and at least one credit.
Positive or negative
Debits and Credits add up. If the amount is to be added or deducted from an account, is determined if we debit or credit that account. Debits are positive number and credits are negative numbers. Now all you need to do is add all positive number and deduct all negative numbers within the account details view to get the balance of an account. In addition, some account love to be positive and some love to be negative. The accounts that love to be debited are asset and expense accounts. Accounts that love to have credit balances are liability, equity and income account accounts. That means a credit account is at its normal state if it has a credit balance and vice versa. More about this in just a bit. Debits are abbreviated as Dr or D and credits are abbreviated as Cr or C.
Double Entry System
When making a journal entry, debits must always equal credits. Debits and Credits are always equal. Thus, their sum is always zero. If you keep all your entries that way, summing up all accounts will give you “always” zero. It has been known that some accountants manage to produce a balance of accounts of more or less than zero, that is using a fully automated accounting system already. Anyway, this concept is known as the double entry accounting system. We always debit at least one account and always credit at least one account.
To give an example, consider this scenario: you received cash of $1Kfor sales performed. Obviously, you are some business owner, right? What is the journal entry?
The simplified journal entry would be:
Dr. Cash $1,000 (Asset)
Cr. Sales $1,000 (Income)
To record sales.
We can see that we debit the account “Cash” and credit the account “Sales”.
T-Accounts: record debits and credits
It is a common way of presenting individual transaction within an account using the t-account presentation. It is called t-account because it is presented like a T. T-accounts usually contain the date of a transaction, the transaction description and the amount of the transaction, at a minimum. In our example, we just show transaction description and amount. Just to keep it simple.
Let’s have a look at the account details of above accounts using the T-Account presentation:
Let’s make some more observation from the above t-accounts. Debits are written on the right side. Credits are written on the left side. A debit to the cash account would increase our cash account, as we obviously received cash. Conversely, a credit to the cash account would decrease our cash account. A credit to the sales account increases our sales account, as we made a sale. Conversely, a debit to the sales account decreases our sales account. That’s a lot of observation, JA?
Don’t sell something, not in your inventory
Let’s assume now that we sent the customer his or her product and recorded the inventory given to the customer. The cost of the product was $999 and we also paid cash for it. The entries would be:
Dr. Inventory $999 (Asset)
Cr. Cash $999 (Asset)
To record the purchase of inventory some time ago
Dr. Cost of Goods Sold $999 (Expense)
Inventory $999 (Asset)
To record cost of goods sold
We now have 4 accounts. Let’s have a look at how their account details developed:
We make some more observations
The inventory account was increased by a debit to it and decreased by a credit to it. The expense account “Cost of Goods Sold”, was increased by a debit to it. The sum of all transactions makes up the balance of an account. It the debits are bigger than the account has a debit balance. If the credits a higher, than the account has a credit balance.
More rules on debits and credits
Balance Sheet Accounts
- Assets (Cash and Inventory) are increased by debits and decreased by credits
- Liabilities (Payables) are increased by credits and decreased by debits.
- Equity (Ownership) is increased by credits and decreased by debits.
Income Statement Accounts
- Income is increased by credits and decreased by debits (like liabilities and equity)
- Expenses are increased by debits and decreased by credits (like assets)
Mysteries of our daily life
Your bank credits you something?
So what does it mean when your bank tells you that your bank account has been credited with something?
To understand this, you first need to know what your “bank account” is in the books of your bank. The bank owes you the money that you deposit with them. From the point of view of the bank, bank accounts are liabilities and usually have a credit balance, assuming you have money in it. If the bank credits a liability account, that account increases in balance. So the bank owes you more. So cool to think your bank credits sometimes something, too. Assuming that was not a deposit from you? Maybe some interest earned? Better look! Not just those awful debits from account maintenance fee and service charges.
Receiving a credit for a purchase you made
What does that mean? If you buy something, the company you bought something from will record a receivable from you. Here is the entry
Dr. Accounts Receivable
To record sales
Info: It is usual to record a receivable first even if you pay cash. This is done so that the sale transaction goes through the receivable account first. The receivable account usually contains a subsidiary ledger behind it that identifies you as the customer. More on subsidiary ledgers in the future. In any case, the cash payment transaction will just be done right after the receivable has been recorded. Like so:
Cr. Accounts Receivable
To record customer payment
Note that the Accounts Receivable was initially debited to increase it. So it must be an asset account. If your account with the company you bought something from subsequently credits it with something that seems to be a good thing, too. It will decrease your account with them. Credits are, thus, price correction to your advantage, such as discounts. They reduce the receivable the company recorded in their books from you.
Hint: always try to understand what your account is with the other company to understand what a debit or a credit charge may mean to you.
What should you book?
By the way, from your vantage point, you would record a Liability
Dr. Bought a cool thing
Cr. Accounts Payable
To record a purchase
Dr. Account Payable
To record payment of the cool thing
From the account’s description, we presume that the account “Bought a cool thing” is an expense account or an inventory?
Here are the important concepts and keywords you have learned on debits and credits: double entry accounting system, account details through t-accounts, assets and expenses are naturally debit accounts, liabilities, equity and income accounts are naturally credit accounts, debits always equal credits within a journal entry and within all accounts. Now you are set to understanding those invoices and credit notes and debit notes you keep getting from your utility companies. You are also set to understand the Financial Statement of a large conglomerate a lot more. Ah jaahh. Debits and Credits! The foundation of all in finance.