01Debits and Credits: Why Are They Important?
Every business transaction has a buyer and a seller. The business sells a product or service to a customer or client. Most companies use a system of double-entry bookkeeping to keep track of their transactions. Double-entry bookkeeping requires a recording system using debits and credits.
Debits and credits are challenging to understand because they're not very intuitive. Debits are always shown on the left of a T-account and credits are always shown on the right.
When you understand this first step, you've come a long way toward understanding debits and credits. The challenge becomes knowing when to debit or credit an account.
02How to Record Debits and Credits As Journal Entries
T-accounts are used by accounting instructors to teach students how to do accounting transactions. They show which side of the ledger debits and credits go on for a particular business transaction.
In actuality, accounting transactions are recorded by making accounting journal entries. Just like everything else in accounting, there's a particular way to make an accounting journal entry when recording debits and credits.
Debits get recorded on the first line of the entry, flush with the left margin. Credits get recorded on the second line and are indented to the right a couple of spaces.
03How to Record Debits and Credits for Asset Accounts
Assets consist of items owned by a company, such as inventory, accounts receivable, fixed assets like plant and equipment, and any other account under either current assets or fixed assets on the balance sheet.
Debits are recorded on the left side of a T-account and credits are recorded on the right. Memorize the rules that debits are increases in asset accounts, while credits are decreases in asset accounts.
In a general ledger, increases in assets are recorded as debits, meaning they're recorded on the left side of the ledger. Decreases in assets are recorded as credits and get recorded on the right side of the ledger.
Let's say a company buys a large quantity of inventory to gear up for holiday sales. Inventory is a current asset, and the company pays for the inventory with cash. The company purchased $10,000 of inventory. The journal entry would look like this:
Inventory has increased so it is a debit and cash decreased, so it requires a credit entry.
If the company decided to sell a building for $250,000 and it received cash for the property, the journal entry would look like this:
Fixed Assets $250,000
Cash, an asset, increased so it would be debited. Fixed assets would be credited because they decreased.
04Recording Debits and Credits for Liability and Owner's Equity Accounts
Liabilities are items on a balance sheet that the company owes to vendors or financial institutions. They can be current liabilities, such as accounts payable and accruals, or long-term liabilities, such as bonds payable or mortgages payable.
Owner's equity accounts sit on the right side of the balance sheet, such as common stock and retained earnings. They are treated exactly the same as liability accounts when it comes to journal entries.
Debits are decreases in liability accounts. Credits are increases in liability accounts. Here's the rule for liability accounts:
Increases in liabilities are recorded as credits. They're recorded on the right side of the ledger. Decreases in liabilities are recorded as debits and are recorded on the left side of the ledger.
Let's say a company owes one of its suppliers $1,000 and that bill is now due. What companies owe their suppliers are typically accounts payable and a liability on the balance sheet. Here is how the journal entry would look:
Accounts Payable $1,000
You would debit accounts payable because you paid the bill, so the account decreases. Cash is credited because cash is an asset account that decreased because cash was used to pay the bill.
If this company decided to purchase $15,000 in inventory from a supplier and do it on credit (accounts payable), the journal entry would look like this:
Accounts Payable $15,000
You would debit inventory because it is an asset account that increases in this transaction and accounts payable is credited to a liability account that increases because the inventory was purchased on credit.
Let's look at a journal entry for the owner's equity account. Say a business has two owners and one owner wants to invest an additional $50,000 in the business. Here's the resulting journal entry:
Owner's Equity $50,000
Cash increases when you make the investment. It's an asset account, so an increase is shown as a debit and an increase in the owner's equity account shows as a credit.
05How to Record Debits and Credits for Expense Accounts
Expense accounts are items on an income statement that cannot be tied to the sale of an individual product. Of all the accounts in your chart of accounts, your list of expense accounts will likely be the longest.
Expense accounts run the gamut from advertising expenses to payroll taxes to office supplies. It's imperative that you learn how to record correct journal entries for them because you'll have so many.
Debits are increases in expense accounts. Credits are decreases in expense accounts. Increases in expenses are recorded as debits on the right side of the ledger. Decreases in expenses are recorded as credits and are recorded on the left side of the ledger.
Here's an example of a business transaction involving an expense account and the resulting journal transaction. Let's say a company needs to stock up on office supplies. It purchases $750 in office supplies using cash. Here's the resulting journal entry:
Office Supplies $750
"Office supplies" is an expense account on the income statement, so you would debit it for $750. Cash is an asset account. You credit an asset account, in this case, cash, when you use it to purchase something.
06How to Record Debits and Credits for Revenue or Income Accounts
Revenue accounts come from a company's income statement. A company's revenue usually includes income from both cash and credit sales.
A company can also have investment income. Larger companies sometimes invest in other companies. Smaller firms invest excess cash in marketable securities which are short-term investments.
Debits are decreases in revenue accounts. Credits are increases in revenue accounts. Increases in revenue or income are recorded as a credit on the left side of the ledger. Decreases in revenue or income accounts are recorded as debits on the right side of the ledger.
Let's look at a sample journal entry for a revenue transaction. A small business has $5,000 in cash sales on a given day. Here's how those sales, revenue for the firm, would be recorded:
Sales Revenue $5,000
You would post sales revenue as a credit. Increases in revenue accounts, the cash sales, are recorded as credits. Cash, an asset account, is debited for the same amount. An asset account is debited when there is an increase, such as in this case.
These steps cover the basic rules for recording debits and credits for the five accounts that are part of the expanded accounting equation.
Understanding and Using Debits and Credits
Debits and credits form the basis of the double-entry accounting system. Without understanding how they work, it becomes very difficult to make any entries to a company's general ledger.
Bookkeepers and accountants use debits and credits to balance each recorded entry for a company's balance sheet and income statement accounts. Double-entry accounting, debits, and credits all tie into the accounting equation, Assets = Liabilities + Owners' Equity.