How to do debits and credits

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History of Debits and Credits

‘Debits and credits’ is a financial transaction classification system that was first used by the Venetian merchants in Italy in the 15th century. While it was widely used by the Venetian merchants, its took a mathematician by the name of Luca Pacioli to document and publish this system in a book.

The book Luca wrote to codify the Venetian method of bookkeeping in 1494 was one of the first published by Gutenberg on his innovative printing press. Today Luca is revered widely as ‘The father of accounting’ . Luca’s book explained the whole bookkeeping system of which Debits and Credits were a key part. The overall system that he documented has come to be known as the “Double- entry bookkeeping” system. Now while this system was developed over 500 years ago, its principles and processes are still followed by today’s accountants and bookkeepers the world over.

Latin terms – “Credre” and “Debere”

It is interesting to note that the concept of negative numbers was not generally accepted in mathematics in the 1500s when Luca first codified the double-entry bookkeeping system. This may further explain why he used “Debits and Credits” rather than + and – which is the system that the accounting software of today uses to process financial transactions. Still, let’s not get any more confused other than point out that a lot has changed in the world in past 500 years, but the double-entry bookkeeping system is not one of them.

Luca’s book was written in the vernacular of the age – Latin. So the terms he used for Debit and Credit in his book were “Credre” and “Debere” . In Latin the word “Credre” means “to entrust” and “Debere” means “to owe”. These Latin meanings give us our first glimpse into the underlying principles that the “Debit and Credit” classification system seeks to maintain. These principles will be explained in greater detail later in the series of articles on this topic. It is also clear that we got the Debit abbreviation of “Dr.” from the Latin, because unlike the Latin term, there is no ‘r’ in the English term Debit.

The evolving English language

Other confusions that cloud the understanding of “Debits and Credits” for most accounting students, is the fact that English as an evolving language has developed many different meanings for the terms “Debits and Credits” other than the ones originally coined by Luca in 1494. In fact, look at most dictionaries and you will discover over 10 different meanings for the term credit apart from the one we use in accounting. Some students even try and assimilate the terms Debit with debt, yet the two terms have no similarity in meaning even though they may have similar sounding tones.

Definition of ‘Debits and Credits’ in accounting

The very important point for accounting students to understand is that the Debits and Credits in accounting has its own special meaning and that meaning is not to be assimilated with any other English meanings of the terms.

The definition of “Debits and Credits” that this series of presentations will adhere to is:

Debits and Credits is a classification method that is used for coding the financial transactions of a business and recording them in the bookkeeping system.

In essence, this series will show that the Debits and Credits method captures and records the flow of economic resources that take place in a financial transaction as economic resources transfer from a source (credit) to a destination (debit). The Debit and Credits classification method also ensures that the accounting equation, which is the foundation stone on which the entire double-entry bookkeeping system is build, remains in balance after each transaction is recorded.

Summary – Debits and Credits

In summary then we can say that:

  • “Debits and Credits” are a key component of a 500 year old double-entry bookkeeping system.
  • “Debits and Credits” are English terms that were translated from the Latin “Credre‟ and “Debere‟
  • English has evolved to create many different meanings for the terms “Debit and Credit” in the 500 years since they were first coined.
  • The meaning of “Debits and Credits’ in accounting is unique to accounting and is not to be assimilated with other meanings of these terms.
  • Debits and credits is a classification method that is used for coding the financial transactions of a business and recording them in the bookkeeping system.
  • Debits and Credits reflects the flow of economic resources that takes place in a financial transaction as the economic resources transfer from a source (Credit) to a destination (Debit).
  • The Debits and credits system ensures that the accounting equation remains in balance after each new transaction entry.
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How to do debits and credits

Accounts receivable credit balance refers to the outstanding loans that are owed to a company by virtue of granting credit to customers. Most companies, such as retailers and other merchants, often grant their customers different forms of credit in order to expedite the sales process as in the form of layaways to both customers and employees. This is in contrast to the transfer of goods or service in exchange for cash, which is more straightforward in terms of the fact that it offers the business the opportunity to collect its payment up front, without any need to resort to another extra process. The collection of cash by the business also means that it has needed revenue it can use to service the business and to meet its other numerous obligations. An accounts receivable credit balance is the opposite of a debit balance, even though both are included on the balance sheet, since only the debit balance will include overpayments on accounts held by customers.

Most companies cannot operate without the application of some form of accounts receivable credit balance in its balance sheet flowing from the fact that such businesses cannot make any meaningful sales if they do not grant some form of credit to their customers. The process of granting such credit to customers may be through the application of layaways to their accounts, whereby they will only pay a stated incremental amount until the total balance has been paid off. This kind of an accounts receivable credit balance will still be listed in assets and income statements of the company since the sale has already been completed, and it is only left for the customer to pay the agreed balance in the agreed format. The exact mood for the payment of the outstanding balance will be determined by the company’s policies regarding such transactions.

Most companies are aware that there is always the risk that some of the people owing such money will default in their repayment of the same. The risk is even more so when the people who owe the money are employees of the company due to the fact that they are not often as motivated as customers to pay off the debt. This consideration causes such companies to list outstanding debts from customs and employees differently under an accounts receivable credit balance.

This article was co-authored by Ara Oghoorian, CPA. Ara Oghoorian is a Certified Financial Accountant (CFA), Certified Financial Planner (CFP), a Certified Public Accountant (CPA), and the Founder of ACap Advisors & Accountants, a boutique wealth management and full-service accounting firm based in Los Angeles, California. With over 26 years of experience in the financial industry, Ara founded ACap Asset Management in 2009. He has previously worked with the Federal Reserve Bank of San Francisco, the U.S. Department of the Treasury, and the Ministry of Finance and Economy in the Republic of Armenia. Ara has a BS in Accounting and Finance from San Francisco State University, is a Commissioned Bank Examiner through the Federal Reserve Board of Governors, holds the Chartered Financial Analyst designation, is a Certified Financial Planner™ practitioner, has a Certified Public Accountant license, is an Enrolled Agent, and holds the Series 65 license.

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In bookkeeping under General Accepted Accounting Principles (GAAP), debits and credits are used to track the changes of account values. They can also be thought of as mirror opposites: Each debit to an account must be accompanied by a credit to another account (that’s how the phrase “double-entry bookkeeping” gets its name). [1] X Research source Understanding debits and credits is essential for bookkeeping and analysis of balance sheets.

Introduction

Debit and credit are the opposite sides of the same coin in accounting terms. When an entry is done, at one side it is entered as debit, while on the other side of the accounts book, it is entered as a credit.

This is known as the double-entry bookkeeping method. It is the standard across every financial industry. The history of double-entry bookkeeping goes back to almost a thousand years!

The debit and credit entries create double entries for every single transaction. This makes it easy to track any issues, financial imbalances, or any other problem by checking both the debit and credit entry.

For an accounts book to balance, the credit side of the accounts book must be equal to the debit side of the accounts book. The debit goes to the left side of a T-accounts book, whereas on the right side is where the credit is entered.

Example

Consider, for example, a Business called company A, which receives orders worth ten thousand dollars from one of its suppliers. Company A is expected to pay for that product after three months, but it has already received the products. Now, to accounts, the company has ten thousand dollars worth of products which it is not expected to pay for after three months.

How would this order of ten thousand dollars worth of product go into the accounts book of company A? Ten thousand dollars would be entered as both a credit and debit? It would be entered as an increase on the debit side because the company has received products worth ten thousand dollars, while at the same time, the ten thousand dollars would also be taken out of the credit side, but after three months, because the company is expected to pay for it after three months.

The increase in ten thousand dollars on the debit side is equal to the decrease of ten thousand dollars on the credit side. As a result, the accounts book of Company A is balance. This is the advantage of double-entry bookkeeping.

Rules of debits and credits in accounting

There are four simple rules to remember when doing entries in an accounts book regarding debits and credits in accounting. The four rules are visualized in figure 1 below:

Figure 1: The four rules of Debit and credit in accounting

The four rules shown in figure one for debit and credit in accounting are when does credit side increases, when do debit side increases, what are contra accounts, and it is extremely important to balance the credit and debit side.

When does credit side increase?

This is the very first rule in debit and credit in accounting. The credit side, which is on the left side of the T-Balance sheet, increases when credit is added to it. The credit side only decreases when the debt is added to it. This is because the debt is on the opposite side of the balance sheet.

The addition of the debit means, either the suppliers have received payments, or if your company is the one which is supplying, it has supplied products to the other company. The credit side of the balance sheet includes liabilities, revenues, and equity.

A simple example of this can be seen when you take out money from your bank account, you would receive a message from your bank that one hundred dollars have been debited from your account. The bank transaction follows the same logic.

When does the debit side increase?

It follows the same principle as when the credit side increases. But, in this case, the debit side increases when debt is added to the left side of the T-account balance sheet and decreases when credit is added to the right side of the T-account balance sheet.

This happens because in the double-entry bookkeeping both sides of the accounts balance sheet must balance. The increase in credit must be balanced by an equal decrease in debit. The debit side includes assets, dividends, and expenses.

Keep in mind above stated example of the bank transaction. The other side of it would your credit side of the bank would decrease, as you have debited your account for one hundred dollars.

Contra Accounts

A contra account is a connected account that offsets the balance in another account, related to that account. Contra accounts are really important for credit and debit entries.

For example, a contra asset account would be connected to the liabilities side, and a contra liabilities account would be connected to the asset side. An increase or decrease in one side of the accounts causes an increase or decrease in another side of the contra account.

The debit and credit sides are also connected through the same contra accounts. When the credit side increases, the contra account decreases the amount on the debit side for a similar amount. In a similar way, the increase on the debit side causes an equal decrease on the credit side of the T-Balance sheet.

Balancing Transaction

This is the final and most rules of the debits and credits in accounting. The credit side must equal the balance side for each and every transaction. This is the basic rule of a double-entry bookkeeping method.

The increase on the credit side of the T-accounts balance sheet must be matched by an equal decrease on the debit side of the T-accounts balance sheet, and vice versa.

If both sides do not match, it means that the books are not balanced, which means either an error occurred in the noting of transactions in the accounting books or a financial mismatch exists in the accounting books. So, it is extremely important that the transactions are balanced.

Conclusion

There are four simple rules of debits and credits in accounting. It is extremely important that all four of these rules are followed when entering a transaction in accounting books. If these rules are not followed, then multiple issues could occur which would cause financial problems for the company in the future.

Debits and credits play an integral part in the double entry bookkeeping system which requires each business transaction to be entered twice into the records.

. once as a debit in one ledger account and once as a credit in another ledger account.*

The bookkeeping journals show which two (or more) accounts are affected.

Their values must equal each other, which is where the term ‘balancing the books’ stems from.

*That is, a minimum of once into each account.

The value of a transaction can be entered once as a credit, but split into 3 different debits on 3 different accounts as long as the 3 when added up equal the one credit.

See the example near the bottom of this page showing the split between stationery, office equipment and drawings all debited, but the bank account credited once.

How to do debits and credits

Debits and credits format

They are displayed in a simple ‘T’ format.

Debits are on the left side of the ‘T’ ledger.

Credits are displayed on the right side.

If you have trouble remembering which goes on the left and which on the right, one trick you can do is to think of the letter r for r ight.

The word debit does not have an r in it. C r edit does have an r in it. C r edits go on the r ight.

How do we know which account to debit and which one to credit?

Keeping in mind the accounting equation, below is a list that shows you what happens to each account when it is debited and when it is credited.

Get the debits and credits ‘cheat’ sheet.

Effect on values in the debit or credit columns

How to do debits and credits

If a value is placed into the credit column of the assets account, it will decrease the total value of that account.

If a value is placed into the debit column of the expenses account the total of that account will increase.

. you get the idea!

Let’s use a simple business transaction to see this in action:

On 4 April Mr Jones bought a box of copy paper for the office costing $15.00 using a business check/cheque.

Following the double entry rules, two bookkeeping ledger accounts will be affected:-

  1. the bank account – in the books we want to show that money has gone out of the bank account thus decreasing the bank balance.
  2. the stationery account – the money has been used to buy a stationery item thus increasing the expenses balance.

How to do debits and credits

t ledger example

How to do debits and credits

Can you see the T!

From this illustration you will observe that the $15.00 has been placed on the left side of the stationery ledger account and on the right side of the bank ledger account.

How to do debits and credits

t ledger Opening Balances

All asset, liability and equity accounts will have an opening balance at the beginning of a new financial year.

These balances are the closing balances brought forward from the previous financial year.

The balances in the asset accounts are usually debits.

The liabilities and equity balances are usually credits.

In the above ledger illustration, the bank ledger has an opening balance of $1,050.00.

This means that at the end of the previous financial year this business had that much money in their bank account.

The revenue and expenses accounts are always cleared at the end of a financial year so they start the new year with a zero balance.

Now, say if Mr Jones used the same check/cheque to buy several different items such as:

  • $15.00 for paper
  • $200.00 for a printer and
  • $28.00 for a book for personal use

What would the debits and credits look like? See below.

t ledger example for Expense purchases

How to do debits and credits

  • The stationery ledger is being increased with a debit which adds to the overall total of business expenses.
  • The office equipment ledger is being increased with a debit which adds to the value of the assets.
  • The drawings ledger is being increased with a debit which adds to the amount of personal money the owner takes/spends.
  • The bank account is being decreased because, obviously, the money has been spent!

Note that the debits of the first three ledgers add up to the total credit in the bank ledger.

There is no need to split the credits out.

Go here to learn more about bookkeeping ledgers.

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How to do debits and credits

Debits and credits are an important part of organized bookkeeping. The two concepts work together so that bookkeepers can better manage their financial transactions. If you’re not accurately tracking your debits and credits, your accounting could get extremely messy and chaotic.

Some differences between the two can affect how your small business conducts its bookkeeping. Here is what you should know about debits and credits.

What are Debits and Credits?

Debit and credit are terms for transaction entries used in bookkeeping that track your business’s cash flow. You’ll use both terms when you use double-entry accounting.

Every transaction that your business makes is either a debit or a credit. Debits are money that comes out of your account, and credits are money that will go into your account.

What are the Rules of Debit and Credit?

Debits and credits have several rules for bookkeeping. Debits:

  • Decrease liabilities and owner’s equity (on a balance sheet)
  • Increase assets (on a balance sheet)
  • Increase expense accounts (on an income statement)
  • Decrease assets (on a balance sheet)
  • Increase liabilities and owner’s equity (on a balance sheet)
  • Increase revenue (on an income statement)

The essential bottom line is that for every transaction that your business makes, there must be at least one debit and one credit. If you don’t follow this rule, your books will turn out unbalanced.

In the accounting journal, you’ll write debits first on the left-hand side of your journal entry. You’ll also record your entries with debits first.

Next, you’ll record credits on the right-hand side of your journal entry. You’ll write credits below debits in the register. You’ll do this so you know where the money that you’ll spend will come from.

How Do Debits and Credits Work?

Debits and credits work whenever a transaction occurs. When one account decreases in value as a debit, the other account must increase in value as a credit.

In your chart of accounts, you’ll use these 5 categories to record your financial transactions:

  • Assets
  • Liabilities
  • Owner’s equity
  • Revenue
  • Expenses

A list of how debits or credits work within the chart of accounts is below:

  • Assets: Increase debit; Decrease credit
  • Liabilities: Increase credit; Decrease debit
  • Equity: Increase credit; Decrease debit
  • Revenue: Increase credit, Decrease debit
  • Expenses: Increase debit, increase credit

Examples of Debit and Credit

An example of both a debit and a credit can help illustrate the process. If your business spends $1,000 in office supplies purchased in cash, you’ll need to record both the item and how you purchased it.

Within the expense account of your small business’ income statement, you’ll provide:

  • The date of the entry (on the left-most portion of the entry)
  • The account name (the name you’ll record the transaction as)
  • Debit (the amount paid for the office supplies)
  • Credit (the amount used to purchase the office supplies)

Since cash is an asset, and assets increase credits, you’ll use the same $1,000 as both a debit and a credit. This will let you know that you’ll use the $1,000 in cash to purchase the office supplies.

Work with the Pros

Debits and credits are the centerpieces of bookkeeping. However, it’s easy to overlook the importance of carefully tracking your bookkeeping entries when you’re busy running your business.

To save time and money, opt to work with a professional bookkeeper who can skillfully and efficiently manage your books for you. Work with the bookkeeping pros today at 1-800Accountant for your bookkeeping needs.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.

Introduction

Debit and credit are the opposite sides of the same coin in accounting terms. When an entry is done, at one side it is entered as debit, while on the other side of the accounts book, it is entered as a credit.

This is known as the double-entry bookkeeping method. It is the standard across every financial industry. The history of double-entry bookkeeping goes back to almost a thousand years!

The debit and credit entries create double entries for every single transaction. This makes it easy to track any issues, financial imbalances, or any other problem by checking both the debit and credit entry.

For an accounts book to balance, the credit side of the accounts book must be equal to the debit side of the accounts book. The debit goes to the left side of a T-accounts book, whereas on the right side is where the credit is entered.

Example

Consider, for example, a Business called company A, which receives orders worth ten thousand dollars from one of its suppliers. Company A is expected to pay for that product after three months, but it has already received the products. Now, to accounts, the company has ten thousand dollars worth of products which it is not expected to pay for after three months.

How would this order of ten thousand dollars worth of product go into the accounts book of company A? Ten thousand dollars would be entered as both a credit and debit? It would be entered as an increase on the debit side because the company has received products worth ten thousand dollars, while at the same time, the ten thousand dollars would also be taken out of the credit side, but after three months, because the company is expected to pay for it after three months.

The increase in ten thousand dollars on the debit side is equal to the decrease of ten thousand dollars on the credit side. As a result, the accounts book of Company A is balance. This is the advantage of double-entry bookkeeping.

Rules of debits and credits in accounting

There are four simple rules to remember when doing entries in an accounts book regarding debits and credits in accounting. The four rules are visualized in figure 1 below:

Figure 1: The four rules of Debit and credit in accounting

The four rules shown in figure one for debit and credit in accounting are when does credit side increases, when do debit side increases, what are contra accounts, and it is extremely important to balance the credit and debit side.

When does credit side increase?

This is the very first rule in debit and credit in accounting. The credit side, which is on the left side of the T-Balance sheet, increases when credit is added to it. The credit side only decreases when the debt is added to it. This is because the debt is on the opposite side of the balance sheet.

The addition of the debit means, either the suppliers have received payments, or if your company is the one which is supplying, it has supplied products to the other company. The credit side of the balance sheet includes liabilities, revenues, and equity.

A simple example of this can be seen when you take out money from your bank account, you would receive a message from your bank that one hundred dollars have been debited from your account. The bank transaction follows the same logic.

When does the debit side increase?

It follows the same principle as when the credit side increases. But, in this case, the debit side increases when debt is added to the left side of the T-account balance sheet and decreases when credit is added to the right side of the T-account balance sheet.

This happens because in the double-entry bookkeeping both sides of the accounts balance sheet must balance. The increase in credit must be balanced by an equal decrease in debit. The debit side includes assets, dividends, and expenses.

Keep in mind above stated example of the bank transaction. The other side of it would your credit side of the bank would decrease, as you have debited your account for one hundred dollars.

Contra Accounts

A contra account is a connected account that offsets the balance in another account, related to that account. Contra accounts are really important for credit and debit entries.

For example, a contra asset account would be connected to the liabilities side, and a contra liabilities account would be connected to the asset side. An increase or decrease in one side of the accounts causes an increase or decrease in another side of the contra account.

The debit and credit sides are also connected through the same contra accounts. When the credit side increases, the contra account decreases the amount on the debit side for a similar amount. In a similar way, the increase on the debit side causes an equal decrease on the credit side of the T-Balance sheet.

Balancing Transaction

This is the final and most rules of the debits and credits in accounting. The credit side must equal the balance side for each and every transaction. This is the basic rule of a double-entry bookkeeping method.

The increase on the credit side of the T-accounts balance sheet must be matched by an equal decrease on the debit side of the T-accounts balance sheet, and vice versa.

If both sides do not match, it means that the books are not balanced, which means either an error occurred in the noting of transactions in the accounting books or a financial mismatch exists in the accounting books. So, it is extremely important that the transactions are balanced.

Conclusion

There are four simple rules of debits and credits in accounting. It is extremely important that all four of these rules are followed when entering a transaction in accounting books. If these rules are not followed, then multiple issues could occur which would cause financial problems for the company in the future.

One of the first steps in analyzing a business transaction is deciding if the accounts involved increase or decrease. However, we do not use the concept of increase or decrease in accounting. We use the words “debit” and “credit” instead of increase or decrease. The meaning of debit and credit will change depending on the account type. Debit simply means left side; credit means right side. Remember the accounting equation? ASSETS = LIABILITIES + EQUITY The accounting equation must always be in balance and the rules of debit and credit enforce this balance.

In each business transaction we record, the total dollar amount of debits must equal the total dollar amount of credits. When we debit one account (or accounts) for $100, we must credit another account (or accounts) for a total of $100. The accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure, or duality. Watch this video to help you remember this concept:

Review this quick guide to recording debits and credits. It will be necessary for you to commit the rules for debits and credits to memory before you move forward in this course. Note: This are general guidelines and we will have exceptions to these rules.

How to do debits and credits

Click Image to Enlarge

After recognizing a business event as a business transaction, we analyze it to determine its increase or decrease effects on the assets, liabilities, stockholders’ equity items, dividends, revenues, or expenses of the business. Then we translate these increase or decrease effects into debits and credits.

Recording Changes in Balance Sheet Accounts

Balance Sheet accounts are assets, liabilities and equity. The balance sheet proves the accounting equation. Recording transactions into journal entries is easier when you focus on the equal sign in the accounting equation. Assets, which are on the left of the equal sign, increase on the left side or DEBIT side. Liabilities and stockholders’ equity, to the right of the equal sign, increase on the right or CREDIT side.

Assets Liabilities & Equity
DEBIT increases CREDIT increases
CREDIT decreases DEBIT decreases

There is an exception to this rule: Dividends (or withdrawals for a non-corporation) is an equity account but it reduces equity since the owner is taking equity from the company. This is called a contra-account because it works opposite the way the account normally works. For Dividends, it would be an equity account but have a normal DEBIT balance (meaning, debit will increase and credit will decrease).

Recording changes in Income Statement Accounts

We learned that net income is added to equity. We also learned that net income is revenues – expenses and calculated on the income statement. The recording rules for revenues and expenses are:

Revenues Expenses
CREDIT increases DEBIT increases
DEBIT decreases CREDIT decreases

The reasoning behind this rule is that revenues increase retained earnings, and increases in retained earnings are recorded on the right side. Expenses decrease retained earnings, and decreases in retained earnings are recorded on the left side.

The side that increases (debit or credit) is referred to as an account’s normal balance. Remember, any account can have both debits and credits. Here is another summary chart of each account type and the normal balances.

Account Type Normal Balance
Asset DEBIT
Liability CREDIT
Equity CREDIT
Revenue CREDIT
Expense DEBIT
Exception:
Dividends DEBIT

Regardless of what elements are present in the business transaction, a journal entry will always have AT least one debit and one credit. You should be able to complete the debit/credit columns of your chart of accounts spreadsheet (click Chart of Accounts).

Next we look at how to apply this concept in journal entries.