If you are trying to do your small business books, you have probably encountered the terms, “debit” and “credit”. This is one of the first things accountants learned in college and is really the bread and butter of moving around all of those financial statements, equations, and general ledgers. So understanding the basics of debits & credits can make understanding your finances so much easier.
Whether you use Quickbooks, Xero, or just plain old Excel, it is important to understand how debits and credits work. In this guide, we will explain what a debit and credit is and how it works with the various accounts.
Note, this is a basic guide. Accountants spend years understanding how debits and credits work in various situations. So don’t be too hard on yourself if you don’t pick it up quickly - that is what we are here for!
Debits and Credits Definition
AccountingTools.com defines Debit as an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is positioned to the left of an accounting entry.
AccountingTools.com defines a Credit as an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is positioned to the right in an accounting entry.
Based on these two definitions, you may begin to start developing an understanding of what debits and credits mean. To put it simply, they help direct you whether an account should increase or decrease. As we go through each of the accounts, you will understand how they work together.
How Debits and Credits Affect Various Accounts
There are a couple of ways to look at this. If you refer to the chart above, you get a quick overview of whether a debit or credit will increase or decrease an account. Now let’s go into detail and consider a few examples.
Assets: When a business obtains assets, you debit this account. When a business loses an asset, you will credit this account. When a company obtains a patent, that would be an asset and you would debit the appropriate account. When a company sells inventory, which is an asset, you would credit the account.
Wait, but aren’t you making money off that sale? That’s an asset right! Yes, but you are going to credit revenue. If you notice, these are opposites and balance out the transaction!
Liabilities: Liabilities are the opposite of assets and treat debits and credits as such. Liabilities can be anything from a long-term loan, bill you need to pay, or employee work that has been performed but not yet paid.
You will want to credit this account when you want the corresponding balance to increase. This can sometimes be an adjustment to wrap your head around since many of us traditionally think of “in the red” or negative numbers as liabilities. Avoid that thinking and simply see an increase in liabilities as a credit.
Revenue: Remember that example from the asset section where to record revenue, you need to credit the account? This is where that comes in. When you look at your Income Statement your sales, other income, interest income, etc. are all included in this revenue section.
Expense: Expense accounts record money that has left the business. They may be tied to assets, liabilities, or even equity, but we want to understand what money we have spent that will give us our gross profit. Expenses work opposite of revenue in that you debit to increase, credit to decrease.
Equity: This account is representative of ownership within the business. It may have owners contributions, different kinds of stock, and retained earnings. The debits and credits of this account work just like the liabilities accounts in that they increase with credits and decrease with debits.
Ok, that was a lot to take in! It is important to know accountants spend years studying this information and how it relates to everything from buying the office stapler to recording employee pensions. What you have just learned is no small defeat! This complex knowledge is the cornerstone for building out your financial statements and can even help you understand them a bit better.
If you are struggling to understand debits, credits, and what all of these accounts mean - we have ProAdvisor’s standing by ready to help you get the most out of your financial statements.