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Cash Basis Accounting vs. Accrual Basis Accounting

Cash basis accounting and accrual basis accounting are two methods used by businesses to record financial transactions.
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Your Simple Guide to Debits and Credits + Examples

Most people know that debit cards let you spend out of a checking account, while credit cards let you borrow money to pay back every month.

In accounting, “debits” and “credits” have slightly different meanings — and this confuses plenty of people who aren’t too familiar with accounting jargon. 

Yet, debits and credits are foundational to doing your accounting in the first place. It helps immensely to understand them, even if your software or bookkeeper handles your bookkeeping.

Below is a simple guide to debits and credits. You’ll learn what they are (and the differences between them) and how they affect your firm’s financial accounts.

What Are Debits and Credits?

Debits and credits are simply types of accounting entries used to record changes in financial accounts that result from business transactions.

In general, a debit represents money coming into one of your financial accounts. Credits, on the other hand, show money leaving an account.

What do we mean by “accounts”?

Well, the double-entry accounting system used by nearly every business in existence breaks your firm down into individual accounts. Think of these like buckets containing defined amounts of money.

For example, your accounts receivable might be one bucket (an asset). Creating a new invoice would increase your accounts receivable, whereas receiving payment on an invoice would reduce it. 

Any transaction your business makes affects at least two buckets. One will go up, and the other will go down. 

Thus, every financial transaction consists of a debit portion and a credit portion to balance your books. Multiple accounts may be debited and/or credited in the same journal entry, too.

In an accounting ledger, you record debits on the left and credits on the right.

A Quick Table to Help You Out

Here’s a quick table showing how debits and credits affect each type of account. We’ll cover these transactions in more detail in the next section.

 

 

DEBITS

CREDITS

Transaction Location

Left

Right

Assets

Liabilities

Equity

Revenue

Expenses

 

It also helps to know the accounting equation: Assets = Liabilities + Owner’s Equity. You’ll see this in action below.

How Debits and Credits Affect Each Type of Account

Assets

Debits increase assets, whereas credits decrease them. 

Let’s look at a quick example.

Imagine you purchase $1,000 of inventory from a supplier with cash. Cash, of course, is an asset — and so is inventory.

Cash is flowing out of your hands in exchange for receipt of this inventory.

You’d record the transaction as follows:

 

ACCOUNT

  DEBIT

   CREDIT

Inventory

 $1,000

 

Cash

 

   $1,000

 

We received inventory, so we debit the inventory account, increasing its value. Meanwhile, we paid out cash, so we’d credit the cash account. The accounting equation stays in balance because the increase and decrease in assets cancel each other out.

Liabilities

Liabilities work in the exact opposite fashion as assets. Debits decrease them, while credits increase them.

Let’s modify our previous example. Say you purchased $1,000 of inventory on credit. You’d first record this entry:

 

ACCOUNT

DEBIT

CREDIT

Inventory

$1,000

 

Accounts Payable

 

$1,000

 

To keep the accounting equation in balance, you have to increase a liability. Accounts payable is a liability that represents money you owe to suppliers and vendors. You’re increasing your accounts payable by buying on credit since you now owe money.

Now, say you pay your $1,000 invoice 15 days later. You’d record the following:

 

ACCOUNT

DEBIT

CREDIT

Accounts Payable

$1,000

 

Cash

 

$1,000

 

Once you pay your $1,000 invoice, you no longer owe money. Thus, you debit accounts payable to “clear it out”. Meanwhile, you’re sending money to your supplier, so you credit cash to reduce the cash account. 

You’ve reduced both a liability and an asset, keeping the accounting equation balanced.

Equity

Equity works like liabilities — debits make equity go down, and credits make it go up. 

Here’s a simple example:

Say you persuade a friend to invest $2,000 into your burgeoning new business. You’d record the entry as follows:

 

ACCOUNT

DEBIT

CREDIT

Cash

$2,000

 

Equity (friend)

 

$2,000

 

Your business receives cash from your friend. Recall that cash is an asset, and debits increase assets, so you debit cash.

However, you must also record the equity you issued to your friend to balance the accounting equation. Thus, you credit that equity account (which increases equity) to balance out the transaction.

Revenue

Debits increase assets, so it must increase revenue, right?

Nope — it’s the opposite. Debits reduce revenue, while credits increase it. This is because revenues increase equity. In a corporation, revenues are closed out and transferred to the retained earnings account at the end of an accounting period.

This makes more sense if we look at an example.

Imagine you sell $1,000 worth of services on credit to a customer. Here’s what the incomplete journal entry looks like:

 

ACCOUNT

DEBIT

CREDIT

Accounts receivable

$1,000

 

???

 

$1,000

 

Selling something on credit increases your accounts receivable — an asset account — since someone now owes you money.

But what about that second line? You must credit something to balance the transaction. That something is revenue.

 

ACCOUNT

DEBIT

CREDIT

Accounts receivable

$1,000

 

Services Revenue

 

$1,000

 

We know that if assets increase, either liabilities or equity must as well. Earning revenue increases owner’s equity (by increasing profits), so we credit revenue here to raise it.

Expenses

Finally, expenses function opposite of revenue because they reduce owner’s equity. Debits increase expenses, while credits decrease them.

Here’s an example:

Perhaps you spend $1,000 on advertising. Here’s the incomplete journal entry:

 

ACCOUNT

   DEBIT

  CREDIT

???

$1,000

 

Cash

 

$1,000

 

Cash flows out of your bank account, so you credit cash $1,000, reducing your assets. You must balance the accounting equation by decreasing either liabilities or equity in some way.

Expenses decrease owner’s equity because they reduce profits, so you’d debit expenses to balance the entry out:

 

ACCOUNT

DEBIT

CREDIT

Advertising Expense

$1,000

 

Cash

 

$1,000

The Bottom Line

Accounting seems like a completely different language. In fact, it’s often called “the language of business.” It’s understandable if the terms are confusing.

Hopefully, though, this guide helped clear the air about the most fundamental parts of accounting, debits and credits. By the way, accounting software like ZarMoney handles this stuff for you, so you don’t have to figure 

 

Try ZarMoney free for 15-days with no credit card required!

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