You need to implement a reliable accounting system in order to produce accurate financial statements. Part of that system is the use of debits and credits to post business transactions.
This discussion defines debits and credits and how using these tools keeps the balance sheet formula in check. You’ll find a cheat sheet that explains debits and credits, and a number of examples that explain the concepts.
Debit vs credit accounting: definition
To define debits and credits, you need to understand accounting journals. A journal is a record of each accounting transaction listed in chronological order, and accountants post activity using a journal entry.
Debits and credits are used in each journal entry, and they determine where a particular dollar amount is posted in the entry. Your bookkeeper or accountant must understand the types of accounts you use and whether the account is increased with a debit or credit.
What is a debit in accounting?
Debit entries are posted on the left side of each journal entry. Asset and expense accounts are increased with a debit entry—with some exceptions.
What is a credit in accounting?
Credit entries are posted on the right side of each journal entry. Liability and revenue accounts are increased with a credit entry—with some exceptions.
The total dollar amount posted to each debit account must always equal the total dollar amount of credits. Fortunately, accounting software requires each journal entry to post an equal dollar amount of the debits and credits. If the totals don’t balance, you will get an error message alerting you to correct the journal entry.
The number of debit and credit entries, however, may be different. Finally, the double-entry accounting method requires each journal entry to have at least one debit and one credit entry.
Journal entry: example
As an example, this journal entry is posted to record an asset purchase:
Debit #3000 Equipment $3,000
Credit #1000 Cash $3,000
(To record the purchase of equipment for cash.)
The debit increases the equipment account, and the cash account is decreased with a credit. Asset accounts, including cash and equipment, are increased with a debit balance.
The journal entry includes the date, accounts, dollar amounts, and the debit and credit entries. An explanation is listed below the journal entry so that the purpose of the entry can be quickly determined.
Your decision to use a debit or credit entry depends on the account you are posting to and whether the transaction increases or decreases the account.
The difference between debit and credit
The balance sheet formula (or accounting equation) determines whether you use a debit vs credit for a particular account. The balance sheet is one of the three basic financial statements that every owner analyses to make financial decisions. Owners also review the income statement and the statement of the cash flow.
If you understand the components of the balance sheet, the formula will make sense to you.
Balance sheet formula
A balance sheet reports your firm’s assets, liabilities and equity as of a specific date. Here are the components of a balance sheet:
- Assets: what your business owns. Assets are resources that are used to produce revenue.
- Liabilities: what your business owes to other parties. Liabilities include accounts payable and long-term debt.
- Equity: equity is the difference between assets and liabilities, and you can think of equity as the true value of your business.
The components are connected by the balance sheet formula:
Assets = liabilities + equity
The formula is used to create the financial statements, and the formula must stay in balance.
Keeping the formula in balance
Assets on the left side of the equation must stay in balance with the liabilities and equity on the right side of the equation:
Assets = liabilities + equity
Assume, for example, that a firm issues a $10,000 bond and receives cash. The company posts a $10,000 debit to cash (an asset account) and a $10,000 credit to bonds payable (a liability account).
Here is the impact on the balance sheet formula:
$10,000 increase in assets = $10,000 increase in liabilities + $0 change in equity
Accounting software ensures that each journal entry you post keeps the formula in balance and that total debits and credits stay in balance. This debit and credit cheat sheet will help you understand how to post transactions to each type of account:
The easier way to remember the information in the chart is to memorise when a particular type of account is increased. Assets, for example, are increased with a debit entry. The examples below will clarify these concepts.
When to debit and credit
If you’re struggling to figure out how to post a particular transaction, review your company’s general ledger. Review the activity in the accounts that will be impacted by the transaction, and you can usually determine which accounts should be debited and credited.
A company’s general ledger is a record of every transaction posted to the accounting records throughout its lifetime, including all journal entries. The data in the general ledger is reviewed and adjusted, and used to create the financial statements.
Here are some common debit and credit examples:
Asset accounts, including cash, accounts receivable and inventory, are increased with a debit. Expense accounts are also debited when the account must be increased.
Are assets a debit or credit?
Assets are resources used to produce revenue, and they are increased with a debit. Here’s an entry to purchase $10,000 of inventory on credit on 1 April:
Debit #4000 Inventory $10,000 (increase)
Credit #6000 Accounts payable $10,000 (increase)
(To record the purchase of inventory on credit.)
This entry increases inventory (an asset account) and increases accounts payable (a liability account). Cash in your bank account is also an asset account.
Is cash a debit or credit?
This entry is posted to record $5,000 in cash received when a customer pays an invoice on 2 April:
Debit #1000 Cash $5,000 (increase)
Credit #3500 Accounts receivable $5,000 (decrease)
(To record the cash payment received for a customer invoice.)
Both cash and accounts receivable are asset accounts. Cash is increased with a debit, and the credit decreases the accounts receivable. The balance sheet formula remains in balance because assets are increased and decreased by the same dollar amount.
Here are some credit examples:
Liabilities and equity are on the right side of the balance sheet formula, and these accounts are increased with a credit entry.
Is equity a debit or credit?
An equity account may include ordinary shares, additional paid in capital and retained earnings, and the balance is increased with a credit. Let’s assume that, on 3 April, a company increases its ordinary shares by $1,000 and additional paid in capital by $6,000 when it issues stock for $7,000 in cash. Here’s the entry:
Debit #1000 Cash $7,000 (increase)
Credit #8000 Ordinary shares $1,000 (increase)
Credit #8100 Additional paid in capital $6,000 (increase)
(To record the cash payment received for issuance of shares.)
Now, you see that the number of debit and credit entries is different. As long as the total dollar amount of the debits and credits is in balance, the balance sheet formula stays in balance.
Liabilities are amounts owed to third parties.
Are liabilities a debit or credit?
Here’s a 4 April entry to record $12,000 in IT expenses that were not paid in cash immediately:
Debit #7000 IT expenses $12,000 (increase)
Credit #6000 Accounts payable $12,000 (increase)
(To record IT expenses purchased on credit.)
The expense account is increased with a debit, and the liability account is increased with a credit. Here are some other payment situations and the accounting treatment for each:
- If you pay with a credit card, you have a liability balance with the credit card company. Getting cash back with a purchase increases your debt.
- Debit card payments reduce your checking account balance and are considered a use of cash. A cardholder should not confuse a “debit card” with the debit and credit rules explained here.
- When you swipe your card at an ATM, you’re decreasing the cash balance. Reconcile your bank account immediately after the end of the month to avoid overdraft charges and unnecessary fees.
The majority of activities in the revenue category are sales to customers.
Is revenue a debit or credit?
This 5 April entry posts $15,000 in sales to customers that are paid in cash:
Debit #1000 Cash $15,000 (increase)
Credit #9000 Revenue: sales $15,000 (increase)
(To record sales to customers paid for in cash.)
Both cash and revenue are increased, and the revenue is increased with a credit.
As you process more accounting transactions, you’ll become more familiar with this process. Cash is typically the account that includes the most accounting activities. When you need to post a new entry, decide if the transaction impacts cash.
Your use of credit, including traditional loans and credit cards, impacts your business credit score. Monitor your company’s credit score, and try to develop sufficient cash inflows to operate your business and avoid using credit.
If you don’t have enough cash to operate your business, you can use credit cards to fund operations, or borrow from a line of credit. You’ll pay interest charges for both forms of credit, and borrowing money impacts your business credit history.
If you use credit cards, check the card issuer’s website frequently to review your activity. Keep an eye out for fraudulent charges, and make all payments on time. Fortunately, the federal government has put stronger consumer protection laws in place to protect cardholders.
All credit card issuers offer perks, but don’t let that potential benefit determine your use of credit. Credit cards charge high interest rates, and you should limit your spending.
The information discussed here can help you post debits and credits faster and avoid errors. The final step is to write everything down.
Document your process
Document all of your routine tasks in a procedure manual. Using a manual reduces confusion about each task and serves as a training tool for your staff.
Your accounting system will work if everyone applies the debit and credit rules correctly. If you hire a bookkeeping service, the person working in your business must understand your accounting process. Train your staff so you can grow your business and post more transactions with confidence.