Debits and credits are two types of notation used in accounting to maintain account balance. A debit is a transaction that raises asset and prepaid expense balances while decreasing liability and equity account balances on the left side of the T-account. A credit is an entry on the right side of the T-account that is the polar opposite of a debit. It reduces asset and prepaid expense accounts while increasing liability, expense, and owner’s equity accounts. Debits and Credits in accounting can be often confusing.
What does it mean to “debit” or “credit” a bank account? Why does debiting certain accounts cause them to rise while debiting others causes them to fall? And why is any of this relevant to your company? Everything you need to know is right here.
Understanding the Concept of Credit and Debit
When bookkeepers and accountants record transactions in accounting records, they use the words debits and credits. Every transaction must be recorded as both a debit (on the left side of the account) and a credit (on the right side of the account) (right side of the account). This double-entry technique ensures that accounting records and financial statements are accurate.
To balance each recorded financial transaction for particular accounts on the company’s balance sheet and income statement, bookkeepers and accountants employ debits and credits.
The asset and cost accounts are both increased by a debit. The balance sheet contains the asset accounts, whereas the income statement contains the expense accounts. A credit raises the amount of money in a revenue, liability, or equity account. On the income statement, there is a revenue account.
What are Accounts?
Accountants devised a method for categorizing transactions into records known as accounts in order to keep a company’s financial data orderly. When a company’s accounting system is established, the accounts that are most likely to be impacted by the company’s activities are identified and listed. This is known as the company’s chart of accounts. The chart of accounts may include as few as thirty accounts or as many as thousands, depending on the size of the firm and the complexity of its business activities.
Structure of Chart of Accounts:
- Equity of Owners (Stockholders)
- Income or Revenues
What are Debits and Credits and How do They Work?
When you pay a bill or make a purchase, one account loses value (value is removed, which is a debit), while another account gains value (value is received which is a credit).
Consider the following example. A $550 monthly electric energy bill is received by a firm. You would debit your utility cost account by $550 and credit your accounts payable account by $550. On the income statement, utility expenditure is a sub-account of the expense account. Those are diary entries with equal and opposing meanings. Here is a debit vs credit comparison.
As an example:
- One bucket (the “cash” bucket) might hold all of the cash in your corporate bank account.
- Another bucket might represent the entire worth of all the furnishings in your company’s workplace (the “furniture” bucket).
- Yet Another bucket may indicate a recent bank loan (the “bank loan” bucket).
When your company does something—buys furniture, takes out a loan, invests in R&D—the quantity of money in the buckets changes. It would be difficult to record what occurs to each of these buckets using complete English phrases, therefore we need a shorthand. This is where debit vs credit accounting comes into play.
Debits and credits will always be in neighboring columns on a page in an accounting journal. Debits will be on the left, while credits will be on the right.
The difficult aspect is determining whether a transaction is a debit or a credit. This is when T-accounts come in handy. Accounting teachers utilize T-accounts to educate students on how to record accounting transactions.
Methods to Record Debit and Credit
For Asset Accounts
Assets are goods owned by a firm, such as inventories, accounts receivable, fixed assets such as plant and equipment, and any other account on the balance sheet that falls under either current assets or fixed assets.
Debits are asset account rises, whereas credits are asset account reductions. Increases in assets are documented as debits in an accounting journal. Asset decreases are documented as credits.
Here’s an illustration. A firm purchases a big quantity of goods in preparation for Christmas sales. Inventory is a current asset that the firm pays for with cash. The firm spends $10,000 on inventory.
For Liabilities Accounts
The amount owed by the firm to third parties is known as liability. They can be either current obligations such as accounts payable and accruals or long-term liabilities such as bonds due or mortgages payable.
You would debit notes payable since the firm made a loan payment, causing the account to drop. Cash is credited because cash is an asset account that was depleted when the bill was paid with cash.
For Equity Accounts
The owner’s equity accounts, like the liability accounts, are located on the right side of the balance sheet. Common stock and retained profits are two examples. The accounting journal entries are the same as liability accounts.
Here is an example: A company has two owners, and one of them wants to invest an additional $50,000 in the company.
For Expense Accounts
Expense accounts are income statement items that are not related to the sale of a specific product. Your list of expenditure accounts will most likely be the longest of all the accounts on your chart of accounts.
Expense accounts cover anything from advertising costs to payroll taxes to office supplies. Because you’ll have so many, it’s critical that you learn how to record accurate diary entries for each.
Here is an example of a business transaction using an expense account, as well as the resulting journal transaction. A firm spends $750 in cash on office supplies.
For Income Accounts
A company’s income statement includes revenue accounts. Investments can also provide money for a firm. Larger corporations will occasionally invest in smaller companies. Smaller businesses put their extra capital into marketable securities, which are short-term investments.
Here’s an example of a revenue transaction journal entry. On any given day, a small firm makes $5,000 in cash sales.
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