Whether you’re running a sole proprietorship or a public company, debits and credits are the building blocks of accurate accounting for a business. Debits increase asset or expense accounts and decrease liability accounts, while credits do the opposite. As your business grows, recording these transactions can become more complicated, but it is crucial to do it correctly to maintain balanced books and track your company’s growth.
In this article, we break down the basics of recording debit and credit transactions, as well as outline how they function in different types of accounts.
- Debits and credits show the giving and receiving sides of external transactions, providing a full picture of a business’s transactions, ultimately keeping the books balanced. They are crucial to keeping a company’s books balanced using the double-accounting method.
- Debits and credits are best recorded using double-entry accounting, since it allows for complex transactions to be recorded throughout multiple accounts.
- Debits are always recorded on the left and credits are always recorded on the right side of the ledger.
- Debits and credits act differently depending on the type of account, so it’s important to understand how each account works.
Most businesses, including small businesses and sole proprietorships, use the double-entry accounting method. This is because it allows for a more dynamic financial picture, recording every business transaction in at least two accounts.
It works like this: A debit is entered into at least one account, then a corresponding credit of the same amount, but of opposite value, is recorded into at least one account. The two entries are used to show the giving and receiving sides of external transactions. The idea is to get to a net sum of zero, ensuring all dollars are accounted for and the books stay balanced.
The single-entry accounting method uses just one entry with a positive or negative value, similar to balancing a personal checkbook. Since this method only involves one account per transaction, it does not allow for a full picture of the complex transactions common with most businesses, such as inventory changes.
The dual entries of double-entry accounting are what allow a company’s books to be balanced, demonstrating net income, assets, and liabilities. With the single-entry method, the income statement is usually only updated once a year. As a result, you can see net income for a moment in time, but you only receive an annual, static financial picture for your business. With the double-entry method, the books are updated every time a transaction is entered, so the balance sheet is always up to date.
Simply put, the double-entry method is much more effective at keeping track of where money is going and where it’s coming from. Additionally, it is helpful at limiting errors in accounting, or at least allowing them to be easily identified and quickly fixed.
Debits vs. Credits in Accounting
When it comes to debits vs. credits, think of them in unison. There should not be a debit without a credit and vice versa. For every debit (dollar amount) recorded, there must be an equal amount entered as a credit, balancing that transaction.
If you need to purchase a new refrigerator for your restaurant, for example, that would be a credit in your cash account because the money is leaving your business to purchase an item. That item, however, becomes an asset you now own as part of your equipment list. Since that money didn’t simply float into thin air, it is important to record that transaction with the appropriate debit. Although your cash account was credited (decreased), your equipment account was debited (increased) with valuable property. It is now an asset owned by your business, which can be sold or used for collateral for future loans, for instance.
Even in smaller businesses and sole proprietorships, transactions are rarely as simple as shown above. In the case of the refrigerator, other accounts, such as depreciation, would need to be factored into the life of the item as well.
When recording debits and credits, debits are always recorded on the left side and the corresponding credit is entered in the right-hand column.
Debits and Credits With Different Account Types
Even the smallest businesses and sole proprietorships benefit from accurate books. Debits and credits are important to balance the books and keep an accurate balance sheet, which offers an overall picture of assets, liabilities, and owner’s or shareholders' equity. A balance sheet is based on the foundational accounting equation of: Assets = Liabilities + Equity
Depending on the type of account, debits and credits function differently and can be recorded in varying places on a company’s chart of accounts. The equation should still hold, however. This means that if you have a debit in one category, the credit does not have to be in the same exact one. As long as the credit is either under liabilities or equity, the equation should still be balanced. If the equation does not add up, you know there is an error somewhere in the books.
There are five major accounts that make up a company’s chart of accounts, along with many subaccounts that fall under each category. These can be tailored to a business's needs. For example, a restaurant is likely to use accounts payable often, but will probably not have an accounts receivable, since money is collected on the spot for the vast majority of transactions.
A single transaction can have debits and credits in multiple subaccounts across these categories, which is why accurate recording is essential. Below is a breakdown of each type of account.
Double-entry bookkeeping will help your business keep an accurate history of transactions, but it can be complicated. Employ the appropriate tax software, or consider consulting an experienced bookkeeper for assistance.
Assets are items the company owns that can be sold or used to make products. This applies to both physical (tangible) items such as equipment as well as intangible items like patents. Some types of asset accounts are classified as current assets, including cash accounts, accounts receivable, and inventory. Current assets are contrasted to long-term assets. These include things like property, plant, equipment, and holdings of long-term bonds.
Liability accounts make up what the company owes to various creditors. This can include bank loans, taxes, unpaid rent, and money owed for purchases made on credit. Examples of liability subaccounts are bank loans and taxes owed.
Sometimes called “net worth,” the equity account reflects the money that would be left if a company sold all its assets and paid all its liabilities. The leftover money belongs to the owners of the company or shareholders. Many subaccounts in this category might only apply to larger corporations, although some, like retained earnings, can apply for small businesses and sole proprietors. Some examples are stocks and real estate.
Revenue and expense accounts make up the income statement (or profit and loss statement, P&L). As mentioned, debits and credits work differently in these accounts, so refer to the table below.
Revenue accounts record the income to a business and are reported on the income statement. Examples of revenue accounts include sales of goods or services, interest income, and investment income.
Conversely, expense accounts reflect what a company needs to spend in order to do business. Some examples are rent for the physical office or offices, supplies, utilities, and salaries to all employees.
Refer to the below chart to remember how debits and credits work in different accounts. Remember that debits are always entered on the left and credits on the right.
How Do You Tell Whether Something Is a Debit or Credit in Accounting?
Small-business accounting can be confusing when it comes to debits and credits, since some accounts are increased and/or decreased in different measures depending on the transaction. Although complexities exist in every transaction, debits versus credits can be quite simple if you remember the following:
- Debits = more assets (such as cash or utility accounts), less liability, and less equity
- Credits = less assets, more liability, and more equity
Why Should You Use Double-Entry Accounting?
Double-entry accounting allows for a much more complete picture of your business than single-entry accounting does. Single-entry is only a simplistic picture of a single transaction, intended to only show yearly net income. Double-entry, on the other hand, allows you to see how complex transactions are balanced across many different facets of your business, such as inventory, depreciation, sales, expenses etc.
How Do You Identify Debits and Credits in Accounting?
Although debits and credits act differently across various accounts in your books, it is helpful to remember that debits are always entered on the left-hand side of a ledger and credits are always on the right. To know whether you need to add a debit or a credit for a certain account, consult your bookkeeper.