You don’t have to be an accounting expert to have heard the words “debits” and “credits” thrown around. Anyone with a checking account should be relatively familiar with them. But while we might hear them a lot, that doesn’t mean debits and credits are simple concepts—it can be tricky to wrap your head around how each classification works. But as a business owner looking over financials, knowing the basic rules of debits and credits in accounting is crucial.
Understanding the difference between debit entries and credit entries in your books plays a large role in understanding the overall financial health of your business. That’s because they’re the foundation of your general ledger and every account in your chart of accounts.
What Exactly are Debits and Credits?
Put simply, whenever you add or subtract money from an account you’re using debits and credits. Generally speaking, a debit refers to any money that is coming into an account, while a credit refers to any money that is leaving one.
Accounts: The different reports your company keeps to sort and store your business transactions.
While this rule stands, it’s also where things get tricky. Depending on the account in question, debiting it can cause the number you see to increase or decrease. And the same is true for credits.
When Do You Use Debits and Credits?
To fully understand debits and credits, you first need to understand the concept of double-entry accounting. Double-entry accounting states that for every financial transaction recorded at least two accounts in your chart of accounts are affected—and they’re affected in equal and opposite ways.
This method is used within your business’ general ledger and ultimately gives you the basis for your financial reports such as the balance sheet and income statement. So every time you make money or spend money, just remember that at least one account will be debited and one will be credited. And this happens for every single transaction (which is part of why bookkeeping can be time-consuming).
Accounts Impacted by Debits and Credits
To recap: Debits generally happen when things are added to accounts. Credits happen when things are subtracted. Seems fairly simple right?
The tricky part in understanding these two categorizations is that both debits and credits have different impacts across different types of accounts. For example, what happens if you debit an account that shows how much you owe to someone else? Is it the same as debiting an account that shows how much you were just paid?
The answer lies in what kind of balance the account in question normally holds. Does it hold a debit balance normally? Or does it hold a credit balance?
The typical accounts in question are:
- Asset accounts
- Expense accounts
- Liability accounts
- Equity accounts
- Income accounts.
Rules of Debits by Account
The “rule of debits” says that all accounts that normally contain a debit balance will increase in amount when debited and reduce when credited. And the accounts that normally have a debit balance deal with assets and expenses. Here’s what happens in each account type when it’s debited.
To understand a type of transaction that would be labeled on the debit side of an account we can look at Bob’s Barber Shop. Bob sells hair gel to a customer for $45 and gets paid in cash. Looking at the chart above we can tell that assets (of which cash is a part) will increase by debiting it. You’d record this $45 increase of cash with a debit in the asset account of Bob’s books.
Note: A chart of accounts may contain dozens of accounts. There may be several accounts relating to assets, like a cash or accounts receivable.
Here’s what debiting that account would look like.
|Bob’s Barber Shop||Debit||Credit|
Rules of Credits by Account
Opposite to debits, the “credit rule” state that all accounts that normally contain a credit balance will increase in amount when a credit is added to them and reduce when a debit is added to them. The types of accounts to which this rule applies are liabilities, equity, and income. The chart below can help visualize how a credit will affect the accounts in question.
Remember when Bob’s Barber Shop sold some hair gel for $45 cash? Well, since we know there is always an equal credit entry to a debit entry, we know we must credit an account in order to balance out the transaction. The sale of the hair gel would also be labeled as income for Bob’s Barber Shop, meaning a $45 credit is in order for the income account.
Here’s what that would look like, alongside our debit. Note that debits are always listed first and on the left side of the table, while credits are listed on the right.
|Bob’s Barber Shop||Debit||Credit|
Since our debit is now complemented with an equal credit, the transaction is balanced and will be reflected properly on financial statements in the future.
Why Debit and Credits are Important
The most important concept to understand when dealing with debits and credits is the total amount of debits must equal the total amount of credits in every transaction. It is vital to balance each transaction in double-entry accounting in order to have a clear and accurate general ledger, financial statements, and look into the financial health of your business.
It can take time to learn which accounts to debit and which to credit, and it becomes more complex and businesses grow and transactions accumulate. Want to learn how software can help speed up the process of bookkeeping? Check out this post from our blog for more information.