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Business Accounting Explained

Having a good understanding of business accounting is essential to run a successful company. Even with the best products and services and millions of dollars in sales, without knowledge and ...
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What are Debits and Credits in Accounting

Introduction

Accountants use debits and credits to record each business transaction and generate financial statements. Every business transaction affects at least two accounts. To accomplish this, accountants use a balancing Double-Entry Bookkeeping System. In practice, computer-based cloud accounting software is used to create and summarize transactions.

This article will guide you on what Debits and Credits are, what is Debit and Credit Chart, and how to use them in accounting. 

Debits and Credits 101

Debits are on the left side. Credits are on the right side.

In total, they balance. This balancing effect is also reflected in the balance sheet equation:

Assets = Liabilities + Owners Equity.

On the balance sheet, assets usually have a debit balance and are shown on the left side. Liability accounts and owners equity accounts typically have a credit balance and are shown on the right side.

As the following chart shows:

  • assets, expenses, losses and draws increase with a debit
  • liabilities, equity, revenue, and gains increase with a credit
  • assets, expenses, losses and draws decrease with a credit
  • liabilities, equity, revenue, and gains decrease with a debit

Debit vs Credit terminologyDebits are used to record transactions to accounts that are summarized in the balance sheet and the income statement. Account names are numbered and included in a chart of accounts, which is arranged in numerical account number order.

Types of accounts include:

  • Asset Accounts (a general ledger account used to sort and store the debit and credit amounts from a company's transactions involving the company's resources). Read more about Asset Account here.,
  • Liability Accounts (a company’s financial obligations, like the money a business owes its suppliers, wages payable and loans owing,...),
  • Equity Account (an account recording ownership interests in a company),
  • Revenues Accounts (often accounts including Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed and/or billed and therefore often have credit balances),
  • Expense Accounts, (refer to costs incurred in conducting business. Among them we can often find Cost of Sales, Purchases, Freight in, Advertising Expense, Bank Service Charges, Delviery Expenses, Depreciation Expense, Interest Expense, Rent Expense, Repairs and Maintenance, Representation Expense, Salaries Expense, Supplies Expense, License Fees and Taxes, Telecommunications Expense, Training and Development, Utilities. Read more about Expense accounts here.), and
  • Gains or Losses.  

A Balancing Transaction Entry is called a Journal Entry. Transactions including Journal Entries are summarized in a Trial Balance, then a General Ledger by the source of the transaction.

Discover more about these three important terms at these handly guides by wikipedia at links below:

  • Journal Entry (act of keeping and/or making records of any transactions - could be of both economic and non-economic nature)
  • General Ledger (also known as a nominal ledger, it is a bookkeeping ledger that serves as a central repository for accounting data transferred from all subledgers like accounts payable, accounts receivable, cash management, fixed assets, purchasing and projects),
  • Trial Balance (list of all the general ledger accounts),

The transactions summarized by account in the trial balance should be the same as those summarized by account in the general ledger. Before closing the books, accountants generate a trial balance which lists accounts in numerical order with debit and credit accounts balances. If the debits equal the credits on a trial balance, then the next step is to create the general ledger for each company.

Companies with subsidiaries or divisions would have multiple general ledgers.

If debits and credits don’t balance on the trial balance, then a search for errors requiring correction is the next step.  

Given this explanation of debits and credits and how they are used to create financial statements, the next step is to look at sample business transactions.

Sample Entries with Debits and Credits

Cash Contribution

Debit Cash  $100,000

Credit Owners Equity Account  $100,000

The cash account is debited because cash is deposited in the company’s bank account. Cash is an asset account on the balance sheet. The credit side of the entry is to the owners equity account. It is an account within the owners equity section of the balance sheet.

Stock Sale

Debit Cash $50,000

Credit Common Stock (at par value)  $500        

Credit Paid-in Capital $49,500    

(the amount received exceeding the legal stated par value of the stock)

If your corporation issues stock, then certain employees and outside investors may be offered shares to purchase.

Check the Securities and Exchange Commission (SEC) and your state’s rules for stock offerings.

For these cash purchases of stock, debit the cash account and credit common stock. The cash account is increasing. The common stock and paid-in capital accounts in the owners equity section of the balance sheet are also increasing. Note that the par value of the stock may be a very minimal amount per share.

Travel Expenses


Debit  Travel expenses $2,250

Credit  Accounts payable           $2,250


Travel expenses may be broken into separate accounts like airfare, hotels, and travel meals if separate tracking is desired. Travel expense, like most expenses, usually has a debit account balance. When you incur the obligation to pay for the travel expense, the credit side of the entry is to accounts payable. When you pay the vendors or employee expense reports, then accounts payable is debited (reduced), and the cash account is credited (also reduced).

Buy Computer Equipment


Debit  Fixed Assets - Computer equipment  $12,000

Credit Accounts payable $12,000


Debit  Accounts payable $12,000

Credit  Cash $12,000

         

Calculate monthly depreciation on fixed assets:

Debit   Depreciation expense $1,000

Credit Accumulated depreciation $1,000

When you buy fixed assets like computer equipment, you first record the purchase as a debit to fixed assets and a credit to a liability account called accounts payable (unless you pay in cash).

When you pay the invoice, you debit accounts payable because the liability or obligation to pay is reduced and credit cash because your cash balance is reduced. Every month, you make an entry to record depreciation expense for book purposes on a straight-line basis. (Tax basis depreciation may be calculated on an accelerated basis using an approved IRS method to reduce the amount of taxes that will be paid for the tax year.)

Buy Business Insurance

Debit  Prepaid insurance (12 months expense) $12,000

Credit Cash $12,000

Related journal entry for each month:


Debit  Insurance expense (one month has expired) $ 1,000

Credit Prepaid insurance $ 1,000

When you purchase business insurance, you usually buy the insurance policy for one year. The debit side of the entry is prepaid insurance, which is an asset account that generally has a debit balance.

When you pay for the insurance policy, you credit cash because cash is reduced. As time elapses, you allocate the insurance expense to each month in a journal entry that can be automatically created (dividing an annual policy cost by twelve months). The account debit is insurance expense, which is increased. The credit entry is prepaid insurance, which is reduced as it is recognized monthly through expense recording.

Record a Credit Sale

Debit  Accounts receivable $1,495

Credit Sales $1,495


Record the credit sale upon shipment or other delivery. If cash is received immediately, then the debit side of the entry would be cash instead of accounts receivable.

Record Cost of Goods Sold (at the same time as the sale)

Debit  Cost of goods sold  $900

Credit Inventory   $900

The debit side of the entry is to an expense called cost of goods sold. The credit side is inventory, which is reduced as the sale occurs.

Collect Cash on a Credit Sale

Debit  Cash $1,495

Credit Accounts receivable $1,495


Debit increases in cash. Credit accounts receivable to reduce its balance.

Allowance for Doubtful Accounts

Debit  Accounts receivable $1,495

Credit Allowance for doubtful accounts  $1,495


Debit accounts receivable to reduce it. The allowance for doubtful accounts is a contra-account that reduces accounts receivable. It usually has a credit balance, although it is an asset account. The allowance for doubtful accounts includes a balance of the estimated amount of Accounts receivable that is uncollectible in the future (because customers are unable or unwilling to pay). It is recorded through a Journal Entry. The allowance for doubtful accounts is adjusted as new information is available and also at year-end.

Closing the Books for the Year

Debit  Net income $520,000

Credit Retained Earnings $520,000


At year-end, you close the books for the year. Revenue and expenses will start from zero in the next year. If your company has a profit, you debit net income (or the accounts included in net income like revenue and expense accounts) and credit retained earnings, which is an owners equity account. If your company has a loss for the year, you will debit retained earnings and Credit net loss (or the underlying accounts) instead.

Double-Entry Bookkeeping Conclusion

Understanding debits and credits helps you improve accuracy in recording business transactions. Achieving better accuracy in bookkeeping is essential for preparing reliable financial statements which are essential for all your stakeholders, all interested parties and importantly, for your government, especially for tax purposes. 

This is especially important as there is generally a 0.5% penalty for tax underpayment per month of the not-paid value, which, for larger companies can already mean tens of thousands $ per month in penalties - money that would be well spent elsewhere. For instance on your new accounting software, that could cost as little as nothing, yet to keep the errors at bay. 

That there is no free accounting software? 

Check out ZarMoney Cloud Accounting Solution, especially tailored for small and middle sized businesses, offering its base plan for free, flexibly scaling as you go.

Check out its pricing plans now or contact our professional help for FREE consultation today.

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