Accounting serves is pillar of any business, enabling efficient financial management by tracking the inflow and outflow of money. At its the core lies the concepts of debits and credits, which form the basis of double-entry accounting.
Let’s figure out what debit and credit accounting is, and how you can handle it.
Contents:
1. Debit & credit accounting: What is difference between debit and credit?
2. Accounts and their relationship to debits and credits
- Assets
- Is a company checking account an asset? And what else besides it?
- Expenses
- Liabilities
- Revenue/Income
3. Debit and credit under the double-entry principle
4. Debit and credit in a journal entry
5. Leveraging accounting software for accuracy
Key takeaways
- Debits and credits help track the money flow, with debits representing incoming funds and credits representing outgoing funds, forming the basis of double-entry accounting.
- Debits increase assets or expenses while decreasing liability or equity accounts. Credits have the opposite effect, leading to a systematic approach to recording financial transactions and maintaining balance in various account types.
- Accounting software streamlines the recording, organization, and analysis of financial transactions, ensuring accuracy, efficiency, and compliance. It ultimately supports informed decision-making and contributes to long-term success and growth.
Debit vs credit accounting: What is difference between debit and credit?
To effectively balance a business’s general ledger, it is essential to record the flow of money and ensure that the entries balance each other out. These entries, known as debits and credits, form the basis of bookkeeping. In double-entry accounting, debits represent incoming money, while credits represent outgoing money. Every debit in one account must have a corresponding credit of equal value to maintain balance.
In simple terms, debits and credits are equal but opposite entries in your general ledger, acting as a two-sided system for recording transactions. Debits record money coming into the business, while credits record money going out. By using this system, businesses can accurately track and analyze their financial activities.
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Understanding debits
Debits increase asset or expense accounts and decrease liability or equity accounts. They reflect money coming into an account and are recorded on the left side of the ledger as positive numbers.
When an asset increases, such as receiving cash from a customer, it is recorded as a debit. Similarly, when an expense occurs, such as purchasing supplies, it is also recorded as a debit, according to the small business accounting basics.
Understanding credits
Credits increase liability, revenue, or equity accounts and decrease asset or expense accounts. They represent money leaving an account and are recorded on the right side of the ledger as negative numbers. For instance, when an SMB pays a vendor for goods or services, it would record the transaction as a credit entry in the accounts payable account.
Accounts and their relationship to debits and credits
We mentioned that debits and credits increase or decrease certain accounts correspondingly. So, let’s look at those in more detail to get a better grip of how double-entry accounting works.
In accounting, an account refers to a specific asset, liability, equity, revenue, or expense. Different types of accounts are used to categorize and track financial activities. The equation, Assets = Liabilities + Equity, illustrates the relationship between these elements. When one side changes, the other side also adjusts accordingly.
Assets
Assets are fundamental components of accounting. They encompass various resources that a company relies on to generate current and future revenue. These resources can take the form of inventory, accounts receivable, and cash accounts, among others. When it comes to recording transactions involving asset accounts, the principles of debit and credit play a crucial role.
As mentioned, debit and credit are essential terms, describing the recording of financial transactions. Representing the opposite sides of the accounting equation, they are used to maintain the balance in the general ledger. When an asset account experiences an increase, it is recorded as a debit entry, signifying the addition of value or resources. Conversely, a decrease in an asset account is recorded as a credit entry, indicating the reduction in value or resources.
Is a business checking account an asset? And what else besides it?
A checking account is typically considered one of the current assets on a company’s balance sheet. Current assets are resources you expect to be converted into cash or used up within one year or one operating cycle, whichever is longer. It falls into this category because the funds held on them are readily accessible and can be used to meet the company’s short-term financial obligations.
Other assets include:
- Cash – physical currency, coins, and any other negotiable instruments that are readily accessible.
- Accounts receivable – amounts owed to the company by customers for goods or services sold on credit.
- Inventory – The value of goods held by the company for resale.
- Prepaid expenses – expenses paid in advance, such as insurance premiums or rent, which will be utilized over time.
- Investments – securities, bonds, or other company’s financial instruments for investment purposes.
- Property, Plant, and Equipment (PP&E) – tangible assets such as land, buildings, machinery, and vehicles used in the operation of the business.
- Intangible assets – non-physical assets such as patents, copyrights, trademarks, and goodwill.
These are just a few examples, and the specific asset accounts a company uses can vary depending on its industry, size, and unique circumstances.
Expenses
Expense are the costs incurred during the process of generating income for a business. These costs may include delivery expenses, advertising expenses, or rent expenses. Similar to assets, an expense account is debited to increase, illustrating the rise in expenses. A decrease in an expense account is recorded as a credit, showcasing a reduction in incurred costs.
Let’s look at some examples.
- Cost of Goods Sold (COGS) – direct costs associated with producing or purchasing goods sold by the company.
- Salaries and wages – compensation paid to employees for their work.
- Rent – the cost of leasing or renting office space, equipment, or other assets.
- Utilities – the costs associated with electricity, water, gas, and other utilities necessary for business operations.
- Advertising and marketing expenses – the costs of promoting the company’s products or services.
Liabilities
Liabilities are the obligations owed by a company to its creditors or suppliers. These can encompass accounts payable, loans payable, or taxes payable. When a liability account experiences an increase, it is recorded as a credit entry, denoting the growing amount owed. Decreasing a liability account is recorded as a debited entry, indicating a reduction in the outstanding obligations.
Equity
Equity represents the owner’s share in the business. When an equity account sees an increase, it is recorded as a credit entry, symbolizing the rise in the owner’s investment. To lower the balance on an equity account, you might want it debited, indicating a reduction in the owner’s stake.
Here’s what you can find under equity.
- Common stock – the initial investment made by shareholders in exchange for ownership shares of the company.
- Retained earnings – accumulated net profits or losses retained by the company after dividends have been paid out to shareholders.
- Additional paid-in capital (APIC) – funds received from shareholders in excess of the par value of the stock issued.
- Treasury stock – shares of the company’s own stock that it has repurchased.
- Dividends – earnings distributed to shareholders.
Revenue/income
Revenue is the income generated by a business. When revenue is generated, it is recorded as a credit entry, illustrating the increase in the company’s earnings. To reduce revenue account a debit entry is recorded, signifying a reduction in the generated income.
Amonr the rebvenue accounts are
- Sales revenue – revenue generated from the sale of goods or services.
- Service revenue – earnings from providing services to customers.
- Interest revenue – Income earned from loan interest, investments, or bank accounts.
- Rental revenue – income generated from renting out property or equipment.
- Licensing revenue – earnings from licensing intellectual property rights or technology.
By employing these basic accounting principles, you can accurately enter transactions in the general ledger. The systematic approach ensures that the records reflect the true financial position of the business, allowing for effective management, decision-making, and analysis.
It’s worth noting that changes in one account impact others. By correctly recording debits and credits in each account, you can maintain accurate financial records.
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Debit and credit under the double-entry principle
Double-entry accounting is a method that records two book entries for each transaction to maintain balance.
This system reduces the likelihood of accounting errors, as the entries must balance each other out.
Debits are recorded on the left side, while credits are recorded on the right side. For example, an increase in revenue would be documented as a credit to the revenue/income account. This method provides a complete view of a business’s financial transactions and helps in preparing accurate financial statements.
Look at the relationship between debits and credits in different account types.
| Account Type | Debit | Credit |
| Asset Accounts | Increase | Decrease |
| Expense Accounts | Increase | Decrease |
| Liability Accounts | Decrease | Increase |
| Equity Accounts | Decrease | Increase |
| Revenue/Income Accounts | Decrease | Increase |
Debit and credit in a journal entry
You can visualize transactions using T-accounts or journal entries.
T-accounts resemble a T-shape and allow for the recording of bookkeeping entries. Alternatively, journal entries present transactions in a journal format.
For example, consider a company owner who pays their employee’s salary. The cash used for the payment decreases the asset account (cash) on the credit side (right), while the salary expenses increase on the debit side (left) in the expenses account.
Sample journal entry:
| Account | Debit | Credit |
| Expenses | Salaries, $4,000 | |
| Assets | Cash, $4,000 |
Examples of debits and credits
To further illustrate the practical application of debits and credits, consider the following examples:
Documenting a sales transaction
A catering company provides services for a client’s party and issues a bill to the client instead of receiving immediate payment. The asset account increases as accounts receivable, while the revenue account also increases.
| Account | Debit | Credit |
| Asset | Accounts Receivable, $3,000 | |
| Revenue | Service Revenues, $3,000 |
It;s worth adding that many businesses conduct transactions online, whether through their website, third-party platforms, or marketplaces. These transactions often involve a similar accounting process as traditional in-person transactions
Recording a cash transaction
Let’s say a small retailer makes a cash sale of a product to a customer. The customer pays the full amount in cash at the time of the transaction. Here’s how the transaction would be documented:
| Account | Debit | Credit |
| Cash | Received cash, $500 | |
| Revenue/Income | Income from the cash sale, $500 |
In addition to cash transactions, businesses often process payments through a credit card or debit card. When a customer makes a purchase using a credit card, the transaction involves both debiting the revenue account and crediting the corresponding asset account, representing the increase in revenue and the inflow of funds into the business’s bank account.
Documenting receipt and payment of a bill
The owner of a coffee shop purchases an espresso maker from a supplier and agrees to pay the bill at a later date. The asset account for equipment increases, while the liability account for accounts payable increases.
| Account | Debit | Credit |
| Asset | Equipment, $5,000 | |
| Liability | Accounts Payable, $5,000 |
Documenting a business loan
A pet grooming company owner receives a bank loan to establish the business. This loan, being a cash inflow, increases the assets, while the liability account for the bank loan also increases.
| Account | Debit | Credit |
| Asset | Cash in Bank Account, $10,000 | |
| Liability | Bank Loan Debt Amount, $10,000 |
Leveraging software for accuracy
With the advent of technology, accounting software has become an invaluable tool for businesses. These software solutions automate many accounting processes, providing enhanced accuracy and efficiency.
- Accounting software simplifies the recording of journal entries by automatically incorporating debits and credits based on predefined rules. This reduces the chances of manual errors and speeds up the data entry process.
- Accounting software also allows for real-time tracking and reconciliation of accounts. As transactions are recorded, balances are automatically updated, enabling businesses to have a clear and up-to-date view of their financial standing. This feature is particularly beneficial in identifying discrepancies and promptly resolving them.
- Generating accurate financial statements and reports is another advantage of accounting software. With a few clicks, businesses can generate comprehensive financial statements that provide a holistic view of their financial performance..
- Accounting software also enhances data security. By centralizing financial information in a digital platform, the risk of data loss or theft is significantly reduced. Additionally, software solutions often have built-in error detection mechanisms that alert users to inconsistencies or imbalances in their accounts.
Bottom line
Having a strong grasp of accounting fundamentals, including debits and credits, is essential for business owners. These concepts enable accurate record-keeping, balance the general ledger, provide insights into financial health, and support management in informed decision-making. Implementing double-entry accounting and following best practices ensure precise financial reporting, minimize errors, and contribute to the long-term success of the business.
Accounting software helps businesses implement double-entry accounting hassel free. It simplifies the recording, organization, and analysis of financial transactions, ensuring accuracy, efficiency, and compliance. Businesses can focus more on growth management, strategic financial planning and decision-making, leading to improved financial performance.
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