Accounting 101: Debit and Credit Explained

Introduction

Debits and credits are two accounting basics that often stump new business owners. No business owner wants their books to be sloppy and out of balance, so it is imperative to have firm knowledge about debits and credits. With a clear picture of your cash flow and comprehensive financial records, you can track your earnings, create strategic growth plans, and budget more effectively.

What do the terms debit and credit mean? Why do debits increase certain accounts but make others go down? Furthermore, how does any of this impact your company?

Continue reading to gain a fair idea regarding debits and credits.

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Debits and Credits Explained

First, Let's dispel a common myth about properly comprehending debit and credit.

There is no right or wrong with debits and credits. And they are not the same as adding and subtracting.

Accountants use the terms debits and credits to represent the duality of commercial transactions. They allow you to track the origin and destination of funds. Debits are noted on the left side of an entry, and credits are entered on the right side.

The double-entry accounting system is built on debits and credits. A company's general ledger accounts show the value coming in and out of them. Remember,  for every debit, there has to be an equal and corresponding credit. A company's books are said to be in "balance" when that happens.

The terminology of debit and credit in accounting may contradict their ordinary meanings. For example, in banking parlance, debit denotes a withdrawal, and credit denotes an addition to your account. However, depending on the type and form of the account, this is quite the reverse in accounting, which is why one has to be careful when preparing bank reconciliation statements. These differences are essential to grasp from the get-go. 

Debits and credits are recorded in monetary units. However, they’re not tangible cash transactions and may include gains, losses, and depreciation. That's precisely why we refer to them as “value.”

Luca Pacioli, a Franciscan monk, created the double-entry accounting method. This method that he developed now serves as the foundation for modern-day accounting, and owing to that, he is titled the father of accounting. Pacioli advised that one should only end his workday once the debits equal the credits. 

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Debit and Credit Rules

The basic rules of debits and credits are:

• When a debit (left-hand side) is added, the balance of all accounts that typically have a debit balance goes up; when a credit (right-hand side) is added, the balance goes down. Dividends (draw), expenses, and assets are all included in debit accounts.
• When a credit (right-hand side) is added, the balance of all accounts that typically have a credit balance goes up; when a debit (left-hand side) is added, the balance goes down. Revenue, equity, and liabilities are all included in credit accounts.
• The credit and debit sides of a transaction must be equal. If not, your accounting software will throw an error that needs to be corrected because the transaction is imbalanced.
  

The Three Golden Rules Of Accounting

Debit the receiver, credit the giver.

Regarding personal accounts, the giver is credited, and the recipient is debited. A general ledger account that belongs to a person or an organisation is called a personal account. If something is received, debit the account.

Debit what comes in and credit what goes out

Use the second golden rule for honest accounts, also known as permanent accounts. Real accounts don't end with the year; their balances are carried over to the following accounting period.

An asset account, a liability account, or an equity account can all be considered real accounts. Contra assets, liability, and equity accounts are also considered real accounts.

When an asset, for example, enters your business, debit the account. This is the process for real accounts. When an asset leaves your business, credit the account. 

Debit all expenses and losses, credit all income and gains

The last accounting golden rule covers nominal accounts. An account closed at the end of each accounting period is known as a notional account. Temporary accounts are another name for nominal accounts. Revenue, expense, and gain and loss accounts are examples of temporary or nominal accounts.

When using nominal accounts, debit the account whenever your company has a loss or expense. If your company has gains or revenue to record, credit the account.

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How Does Debit and Credit Impact Your Accounts

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Having said that, the five types of accounts that firms use most frequently are revenue, costs, liabilities, owner's equity, and assets.

The treatment of each kind of account, in terms of debit and credit changes, is shown in the table below:

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Final Take

"Credit" is denoted by CR in double-entry accounting, and debit is denoted by DR. The definition of credit is "what is owed," while the definition of debt is "what is due." Gaining helpful insight into the rises and falls of essential accounts and making sense of a company's balance sheet can be achieved by learning how to use CR and DR.

Accountants and bookkeepers may understand the principles of debits and credits, but as a business owner, it might take some time to get used to them. Anyone handling their finances has to know the difference between credit and debit. Learning the distinction between credit and debit can help you manage your money and make wiser decisions.

Gaining a better understanding of debits and credits will help you record company transactions more accurately. Improving bookkeeping accuracy is crucial to creating trustworthy financial statements for your government, interested parties, and all stakeholders—particularly for tax purposes.

If you're new to small business accounting, it can be challenging to understand the distinctions between debits and credits and how they impact account balances. However, much of the struggle is eliminated if you use Inkle Books to make invoices and manage to spend.

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