Exploring Debits and Credits
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 explains what debits and credits are and how to use them in accounting.
Debits and Credits
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
Debits 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, liability accounts, equity account, revenues account (or accounts), expense accounts, 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. 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
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.
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.
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.
Understanding debits and credits helps you improve accuracy in recording business transactions. Achieving better accuracy in bookkeeping is essential for preparing reliable financial statements.