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 credit to post business transactions.
This article will break down what debits and credits are and how using these tools help to balance your company's balance sheet.
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 journal entries are used by accountants for post-activity.
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.
Debit entries are posted on the left side of each journal entry. An asset or expense account is increased with a debit entry, with some exceptions.
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 debits and credits. If the totals don’t balance, you 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.
As an example, this journal entry is posted to record an asset purchase:
March 5th
Debit #3000 Equipment $3,000
Credit #1000 Cash $3,000
(To record 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 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 balance sheet formula, or accounting equation, determines whether you use a debit or credit for a particular account. The balance sheet is one of the three basic financial statements that every owner analyses to make financial decisions. Business owners also review the income statement and the statement of cash flow.
If you understand the components of the balance sheet, the formula will make sense.
A balance sheet reports your firm’s assets, liabilities, and equity as of a specific date.
Here are the components of a balance sheet:
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.
Assets on the left side of the equation must stay in balance with 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 assets = $10,000 increase liabilities + $0 change 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 business transactions to each type of account:
The easiest 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.
If you’re struggling to figure out how to post a particular transaction, review your company’s general ledger. Review activity in the accounts that will be impacted by the transaction, and you'll usually be able to determine which accounts should be debited and credited.
General ledgers are records 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. Learn more about general ledger template.
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.
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 April 1st:
April 1st
Debit #4000 Inventory $10,000 (increase)
Credit #6000 Accounts payable $10,000 (increase)
(To record 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.
This entry is posted to record $5,000 in cash received when a customer pays an invoice on April 2nd:
April 2nd
Debit #1000 Cash $5,000 (increase)
Credit #3500 Accounts receivable $5,000 (decrease)
(To record 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 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.
Equity accounts may include common inventory, additional paid in capital and retained earnings, then the balance is increased with a credit. Let’s assume that, on April 3rd, a company increases common inventory by $1,000 and additional paid in capital by $6,000 when it issues inventory for $7,000 in cash.
Here’s the entry:
April 3rd
Debit #1000 Cash $7,000 (increase)
Credit #8000 Common Inventory $1,000 (increase)
Credit #8100 Additional paid in capital $6,000 (increase)
(To record cash payment received for the issuance of inventory)
Now, you see that the number of debit and credit entries is different. As long as the total dollar amount of debits and credits are in balance, the balance sheet formula stays in balance.
Liabilities are amounts owed to third parties.
Here’s an April 4th entry to record $12,000 in IT expenses that are not paid in cash immediately:
April 4th
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 liability accounts are increased with a credit. Here are some other payment situations, and the accounting treatment for each:
The majority of activity in the revenue category is sales to customers.
This April 5th entry posts $15,000 in sales to customers that are paid in cash:
April 5th
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 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 activity. 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 website frequently to review your activity. Keep an eye out for fraudulent charges and make all of your payments on time. Fortunately, federal governments have put stronger consumer protection laws in place to protect cardholders.
All credit card issuers offer perks, but don’t let those potential benefits 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 all of your routine tasks in a procedures manual. Using a manual reduces confusion about each task and serves as a training tool for your staff.
Your accounting system will work, whether its for debit or credit accounting, if everyone applies the debit and credit rules correctly. If you hire a bookkeeping service, the person working on your business must understand your accounting process, as well as how debit and credit in accounting work. Train your staff so you can grow your business and post more transactions with confidence.
