An introduction to debits and credits.
If the words “debits” and “credits” sound like a foreign language to you, you are more perceptive than you realize-“debits” and “credits” are words that have been traced back five hundred years to a document describing today’s double entry accounting system. Don’t worry we have you understanding the rules of debits and credits within minutes. Our easy to use, debit and credit chart, will aid your understanding together with practical, debit and credit examples
What is Double-Entry
Under the double entry system every business transaction is recorded in at least two accounts. One account will receive a “debit” entry, meaning the amount will be entered on the left side of that account. Another account will receive a “credit” entry, meaning the amount will be entered on the right side of that account. The initial challenge with double entry is to know which account should be debited and which account should be credited.
Double-entry bookkeeping system ensures the integrity of the financial values recorded in a financial accounting system. It does this by ensuring that each individual transaction is recorded in at least two different nominal ledgers (sections) of the financial accounting system and so implementing a double checking system for every transaction. It does this by first identifying values as either a Debit or a Credit value. A Debit value will always be recorded on the debit side (left hand side) of a nominal ledger account and the credit value will be recorded on the credit side (right hand side) of a nominal ledger account. A nominal ledger has both a Debit (left) side and a Credit (right) side. If the values on the debit side are greater than the value of the the credit side of the nominal ledger then that nominal ledger is said to have a debit balance.
Each transaction must be recorded on the Debit side of one nominal ledger and that same transaction and value is also recorded on the Credit side of another nominal ledger hence the expression Double-Entry (entered in two locations) one debit and one credit. This ensures that when the nominal ledgers (sometimes known as accounts) are placed in a list which has two columns, the left column for listing nominal ledgers with Debit balances and the right column for ledgers with Credit balances, then the total of all the Debit values will equal the total of all the Credit balances. If this does not happen that may mean that one of the transactions was not recorded twice, i.e. once as a debit and once as a credit as required in the double-entry bookkeeping system.
The double entry system uses nominal ledger accounts. From these nominal ledger accounts a Trial balance can be created. The trial balance lists all the nominal ledger account balances sequentially. The list is split into two columns, with debit balances placed in the left hand column and credit balances placed in the right hand column. Another column will contain the name of the nominal ledger account describing what each value is for. The total of the debit column must equal the total of the credit column.
From the Trial balance the Profit and Loss Statement and the Balance Sheet can then be produced. The Profit and Loss statement will contain nominal ledger accounts that are Income or Expense type nominal ledger accounts. The Balance Sheet will contain nominal ledger accounts that are Asset or Liability accounts.
Double-entry bookkeeping is governed by the accounting equation. If revenue equals expenses, the following (basic) equation must be true:
assets = liabilities + equity
In any period of time, revenue might not actually be equal to expenses. If so, the equation can be further expanded, so that the (extended) equation becomes:
assets = liabilities + equity + (revenue – expenses)
assets = liabilities + (capital – drawings) + (revenue – expenses)
A = L + C – D + R – E
Finally, the equation may be rearranged algebraically as follows:
A + E + D = L + R + C
This equation must be true, for any time period. If it is, then the accounts are said to be in balance. If the accounts are not in balance, an error has occurred.
For the accounts to remain in balance, a change in one account must be matched with a change in another account. These changes are made by debits and credits to the accounts. Note that the usage of these terms in accounting is not identical to their everyday usage. Whether one uses a debit or credit to increase or decrease an account depends on the normal balance of the account. Assets, Expenses, and Drawings accounts (on the left side of the equation) have a normal balance of debit. Liability, Revenue, and Capital accounts (on the right side of the equation) have a normal balance of credit. On a general ledger, debits are recorded on the left side and credits on the right side for each account. Since the accounts must always balance, for each transaction there will be a debit made to one or several accounts and a credit made to one or several accounts. The sum of all debits made in any transaction must equal the sum of all credits made. After a series of transactions, therefore, the sum of all the accounts with a debit balance will equal the sum of all the accounts with a credit balance.
Debits and credits are then defined as follows:
debit: A debit is recorded on the left hand side of a T account
credit: A credit balance is recorded on the right hand side of a ‘T’ account
Debit accounts = Asset and Expenses (also debit money received into bank accounts)
Credit accounts = Gains (income) and Liabilities (also credit money paid out of bank accounts)
The following accounts have a normal balance of debit:
Accounts receivable: debts promised by other entities but not yet paid
Drawings by the owners on equity
The following accounts have a normal balance of credit:
Accounts payable and taxes payable, notes or loans payable: debts promised to outsiders but not yet paid
Credit and debit items are summarized at the end of a recording period in a trial balance which is a list of all the debit and credit balances. The trial balance acts as a self checking mechanism for the correctness of entries in the individual accounts and also as a starting point for the preparation of the Final Account which is made up of the balance sheet and the trading, profit and loss account.
Examples of debits and credits:
Purchase of a new computer system
Debit Computer account (Fixed asset account) is increased.
Credit Creditors account (Liability account) is increased.
This then results in the following transactions:
Paying supplier for the computer
Debit Creditors account (Liability account) is reduced.
Credit Bank account (Asset account) is reduced.