You’ve probably already heard of the terms “debit” and “credit.” After all, most of us no longer carry cash and use our debit or credit card to make purchases. When related to accounting, though, these terms take on completely different meanings.
Confused already? You’re definitely not alone. The concept of debits and credits can be difficult to grasp if you don’t have prior accounting experience. In this post, we’ll break down these accounting terms in their simplest forms, helping you understand debits and credits and why they’re so important to accounting. So, sit back, push aside everything you thought you knew about debits and credits, and get ready to learn more about this basic bookkeeping concept.
First, The Accounting Basics
Before we dive headfirst into debits and credits, it’s critical to understand a few other accounting terms. Don’t get overwhelmed with all of this terminology — we’ll tie it all together as you move further into this post.
Double-entry accounting is an accounting system where each transaction is posted in a minimum of two accounts. Though more time-consuming, double-entry accounting offers many benefits to small business owners; notably, it ensures more accurate reporting and makes it easier to spot errors.
Let’s step away from the numbers for a second and look at double-entry accounting on a more scientific level. Sir Isaac Newton’s Third Law states that “For every action, there is an equal and opposite reaction.” Though this typically applies to motion, we can also use this idea to understand double-entry accounting.
Let’s take a look at a basic example. Your business purchases supplies that are needed for operations. You spend $5,000 from your business checking account. You now own $5,000 in supplies, which you’ll record in your books. However, double-entry accounting requires each transaction to be posted to at least two accounts. So, while you now have supplies, the cash in your account decreased by $5,000 — equal but opposite.
|Assets =||Liabilities +||Owner’s Equity|
How do debits and credits tie into all of this? We’ll get to that in a minute. For now, though, you should have at least a basic understanding of double-entry accounting. If you want to learn more, be sure to check out our post What Is Double Entry Accounting (And Do You Need It)? which dives into this concept in greater detail.
Double-entry accounting means that transactions are posted to two or more accounts. But what exactly is an account? A simple way to explain it is by thinking of accounts as categories that are used to organize your transactions. Sorting your transactions by account helps you easily track how money is coming into your business, as well as where it’s being spent.
There are five main types of accounts, although these can be further divided into sub-accounts. For now, though, we’ll focus on five core accounts that every business owner should know: assets, liabilities, equity, revenue, and expenses.
- Assets:Â Assets are everything that is owned by your business. This includes but is not limited to your equipment, commercial vehicles, commercial real estate, computers, and cash. These are known as tangible assets — in other words, physical property. There are also non-physical assets — or intangible assets — that belong to your company. Examples of intangible assets include your logo and trademarks.
- Liabilities:Â Liabilities are your debts, or money that you owe to other people. Some examples of liabilities include a business loan from a bank or other lender, money that you owe to your suppliers, or payroll taxes. Accounts payable (or money that is owed but is not paid upfront) is considered a liability.
- Equity:Â Equity reflects the owner’s interest in the business. In addition to retained earnings, equity also includes stock.
- Revenue:Â Revenue, or income, is money that is earned by your business. This is typically through the sales of products or services, but the business may also receive other types of revenue, such as earned interest.
- Expenses:Â Expenses are costs that are needed to keep your business in operation. Expenses may include office supplies, insurance, and rent. While liabilities are paid in the future, expenses are paid immediately.
When posting transactions to your accounts, debits and credits are used to balance your books. In the next section, we’ll take a look at debits and credits, what they are, and how they’re used in accounting.
What Are Debits & Credits?
A debit is an accounting entry made in your books that reflects an increase in assets, revenue, or expenses. A debit is also used to record a decrease in liabilities or equity. Debits are recorded in the left column of a journal or general ledger.
A credit the exact opposite. It is an accounting entry that is recorded to show an increase in liabilities or equity. A credit also reflects a decrease in assets, revenue, or expenses. Credits are recorded in the right column of a journal or general ledger.
|Account||Increased By||Decreased By|
How Do Debits & Credits Work?
Now, let’s start tying debits and credits back into double-entry accounting. Remember, when using double-entry accounting, transactions are posted to a minimum of two accounts. When recording these transactions, at least one debit should be recorded in the left column, while at least one credit should be recorded in the right column. The left column and the right column — your debits and credits — should be equal.
If, for example, you obtain a loan to purchase a piece of equipment, you now have the equipment as an asset. Since your assets increased, a debit is recorded in the left column. Now, we need to balance this out with a debit. Because you obtained a loan from your bank, you now have a liability. Since your liabilities have increased, a credit is recorded in the right column. Your transactions should always balance out. If not, an error has been made somewhere in the process and will need to be corrected.
An Example Of Debits & Credits In Action
Now, let’s circle back to the example that was used when explaining double-entry accounting to see how debits and credits work. You purchased $5,000 worth of supplies using funds from your checking account. Remember that money is an asset, and an asset that decreases is recorded as a credit in the right column.
Because double-entry accounting requires you to post each transaction under two accounts, we need to balance this out. Since supplies are an expense, your expenses have now increased. Therefore, the $5,000 is posted as a debit in the left column.
Now, both columns are balanced.
Subcategories such as “Cash” and “Supplies” may be used to further sort your transactions. However, even when using subcategories, the credit and debit in this example remain the same.
Let’s change the example a bit. In this instance, you have purchased $5,000 in supplies. However, you don’t pay your supplier upfront and will receive an invoice at a later time. The supplies also still an asset, but the credit would be recorded under the “Accounts Payable” subcategory instead of “Business Checking.” Because “Accounts Payable” is still an asset account, your supplies are still entered as a debit.
Now, what if you paid some money down to receive your supplies? For example, let’s assume that you paid $1,000 from your checking account now, and $4,000 will be due to the supplier at a later time. The supplies are still an asset and would be recorded as a debit. The full $5,000 would be entered under your Supplies subcategory on the left side. However, the right column (your credits) would now have two entries. The $1,000 paid from your own account would be recorded under the subcategory “Business Checking,” while the $4,000 that will be invoiced would be entered under the subcategory “Accounts Payable.” Both debits and credits remain balanced.
The Importance Of Debits & Credits
We’ve established what debits and credits are, but why are they so important? One of the reasons that debits and credits are so important is because using them helps maintain balance. Let’s take it back to the basics by looking at the accounting equation. This equation states:
Assets = Liabilities + Equity
By using the system of debits and credits, we can maintain this balance.
What if the accounting equation — or our books — aren’t equally balanced? Then there is an error somewhere that will need to be corrected. With the double-entry accounting system, recording your credits and debits allows you to quickly spot errors and easily correct them. While using debits and credits doesn’t eliminate errors completely, it does reduce them and make errors easier to identify.
Using debits and credits also gives you a more accurate picture of your finances. By tracking your revenue and expenses in an organized way, you’ll have a clearer view of the profits and losses of your business.
Sound Complicated? Let Accounting Software Handle Debits & Credits For You
If you’re still feeling overwhelmed, you’re definitely not alone. Accounting concepts can be difficult to grasp, especially when trying to learn them while also running your own business. Fortunately, it’s rare that you’ll have to manually handle debits and credits if you have the right accounting software. Today’s accounting software does most of the heavy lifting for you, meaning the double-entry accounting and the balancing of debits and credits happens behind the scenes. All you have to worry about is setting up your chart of accounts, and entering your income and expenses into the appropriate account categories.
|Business Size||Pricing||Ease of Use||Customer Support|
|QuickBooks Online||Small – Large||$20 – $150/mo||Good||Fair|
|Zoho Books||Small||$9 – $29/mo||Good||Excellent|
|Xero||Medium – Large||$9 – $60/mo||Fair||Fair|
|FreshBooks||Small||$15 – $50/mo||Excellent||Excellent|
|Sage Business Cloud||Small – Medium||$10 – $25/mo||Excellent||Fair|
It is, however, important to have a grasp of these accounting concepts. This allows you to be able to spot potential errors, understand the numbers on your financial statements, and be able to select the software that’s best suited for your business. Not sure of what software to check out first? Take a look at our accounting software reviews to see which options are out there. And if you want to get into the nitty-gritty of accounting and expand your knowledge, download our free Beginner’s Guide to Accounting.
The post What Are Debits And Credits? appeared first on Merchant Maverick.