“Debits and credits” is the phrase that causes the most confusion among those who are not familiar with accounting terminology.
What exactly does it mean to “debit” or “credit” an account, and when would you perform any of these things? Why is it that debiting some accounts causes the balances of those accounts to increase, while debiting other accounts causes the balances of those accounts to decrease?
And how exactly does any of this pertain to the success of your company? In this guide, we will provide an explanation of what is credit and what is debit and we will show you how to use both to keep your books balanced.
“In this guide, we will provide an explanation of what is credit and what is debit and we will show you how to use both to keep your books balanced.”
To understand what is credit and what is debit and they work, you first need to understand accounts.
Each and every financial transaction that has an effect on a business must be recorded in accounts so that the books may be kept accurately. Assets, liabilities, revenue (income), equity, and expenses are the five types of accounts used in financial reporting.
All of these are detailed on the chart of accounts that you have. Your balance sheet will include accounts for your assets, liabilities, and equity. Your income statement will include accounts for both your revenues and your expenses.
A company’s cash on hand, accounts receivable, inventory, and equipment are all examples of assets, which are things that will provide the company with future economic benefits.
Accounts payable, loans payable, and payroll taxes are examples of liabilities. Liabilities are obligations that the organization is required to pay in the future.
Owner’s equity (or shareholders’ equity) is a term used in accounting to describe the amount of money or other assets that would remain in the hands of the company’s owners (or shareholders) if all of the company’s assets were sold and all of its liabilities were settled. In other words, if all of the company’s liabilities were satisfied.
The term “revenue accounts” refers to accounts that are associated with the income derived from the sale of goods and services.
Expenses are the day-to-day costs of running a company that a company must bear in order to turn a profit. Some examples would be the rent, salary, and advertisements.
The five different types of accounts are comparable to the drawers in a filing cabinet. You are possible to maintain several accounts within each (like Accounts Receivable, Petty Cash, and Inventory within Assets). These financial accounts are comparable to file folders. Each sheet of paper contained within the folder represents a transaction that is recorded in the ledger as either a debit or a credit.
The origin of the words “debit” and “credit” can be traced all the way back to the Latin language. The term “debit” comes from the Latin word “debitum,” which translates to “what is owing,” whereas the term “credit” comes from the Latin word “creditum,” meaning “that which is entrusted or loaned.”
It is essential to use both debits and credits when maintaining a corporation’s books in order for them to balance. When debits are recorded, the liabilities, revenues, or equity of the accounts are decreased while the asset or expense balances are raised. For credits, the opposite is true. Every debit input must have a corresponding credit entry for the same monetary amount, and vice versa, when you are documenting a transaction.
In the world of double-entry accounting, each transaction has an impact on at least two financial accounts, with a debit representing incoming funds and a credit representing outgoing funds. The use of debits and credits is an essential component in double-entry accounting. These are the entries that are made in the general ledger of a company that record the movement of money into and out of the company as well as the movement of money between the many accounts that make up the company.
In an accounting transaction, the abbreviation for a debit is typically written as “dr.”, while the abbreviation for a credit is written as “cr.”
In bookkeeping, debits and credits are two different types of entries that work together to create a balanced ledger. A company’s debits and credits are like the yin and yang of accounting; they are interconnected and are responsible for ensuring that the company’s bookkeeping entries remain in balance and harmony. There is no debit without a credit. Double-entry accounting requires that every transaction impact at least two accounts. Your chart of accounts requires that if you debit one account, you credit one (or more) other accounts in the same row.
The accounting equation is what ultimately determines the key distinctions between debits and credits: Assets = Liabilities + Equity + Revenue – Expenses
Debits are always recorded on the left side of an accounting ledger. When debits are recorded, they provide an increase to the accounts for assets and expenses while bringing a decrease to the accounts for liabilities, equity, and revenue.
Credits are recorded on the right side of an accounting ledger. Credits raise the value of an account’s obligation, revenue, or equity but lower the value of an account’s asset or expense
The following is an example of how that might play out in real life:
Jan Mark is opening a new location for the tutoring company that he operates. He obtains a bank loan in order to pay for the rent of the space, the equipment, and the salaries of the employees.
His cash account increases as a result of the money he receives from the bank. Since funds are flowing into the Cash account, it is reported as a debit. Meanwhile, he credits the same amount to his Loans Payable account to record the obligation she has taken on for the bank loan.
A transaction can only be completed successfully if the total amount of debits and credits are equal to one another.
Your company’s general ledger is where all of the company’s debits and credits are recorded. A general ledger is a type of book that keeps a detailed account of all of a company’s financial dealings over a certain period of time.
The general ledger is updated with journal entries to reflect any changes that have been made to the company’s assets, liabilities, equity, revenues, or expenses.
Using T Accounts is one technique to get a visual representation of debits and credits. A collection of financial records that employ double-entry accounting is referred to informally as a T-account. The phrase defines how the bookkeeping entries appear. On a page, a huge letter T is first drawn. The account name is then written directly above the top horizontal line, and below that, split by the vertical T of the letter, debits are reported on the left and credits are recorded on the right. Simply said, T accounts are graphical representations of traditional ledger accounts.
These days, the majority of bookkeepers and owners of businesses maintain track of debits and credits with the help of accounting software.
Both debits and credits are utilized in the process of maintaining a corporation’s records balanced. Since they are recorded in pairs for every transaction, if there is a debit to one account, there must also be a credit or a sum of credits to other accounts that are of comparable value. This process is the most essential component that makes up the double-entry accounting system. Because of the crucial role that these two financial statements play in painting a picture of a company’s overall financial health as well as its value and profitability, it is imperative that these statements be accurate. They also provide data for internal and external stakeholders’ decision-making processes, including those of the company’s management, lenders, investors, and tax authorities, among other groups.
If this is your first time dealing with the accounting for a small business, keeping track of the difference between what is credit and what is debit, as well as which one you use to boost or reduce an account balance, may seem complicated at first.
The good news is that if you utilize accounting software to generate invoices and keep track of your spending, the program takes a lot of the guesswork out of the process.
When you are recording entries in your diary, the single most crucial thing to keep in mind is that the sum of all of your debits and all of your credits must equal each other exactly. Your books will be considered balanced so long as you take the necessary precautions to guarantee that all of your debits and credits are equal to one another. This will help to guarantee that all of the account balances in your general ledger are correct, and it will allow you to compile accurate financial statements that will provide you insight into the finances of your company.