Last updated by
Charles Hall
on
June 10, 2022
Even those with limited accounting experience likely know that debits and credits are fundamental elements of accounting and make up the double-entry accounting method. What they are less likely to know is the specific rules of how to correctly record debits and credits.
Even those with limited accounting experience likely know that debits and credits are fundamental elements of accounting and make up the double-entry accounting method. What they are less likely to know is the specific rules of how to correctly record debits and credits.
Debits and credits are a way of representing financial transactions between two accounts. Understanding the rules of debits and credits begins with a basic understanding of double-entry accounting and normal balances.
This article will tell you all you need to know about the rules of debits and credits.
This article may contain affiliate links where we earn a commission from qualifying purchases.
Table of contents
Debits and credits exist within the context of the double-entry accounting method. This method is one of the most common in accounting and stipulates that every financial transaction affects two accounts simultaneously.
To account for these transactions, the double-entry method treats every account as what is called a "T-account." This term, a synonym for ledger account, reflects the literal appearance of each account. These accounts have a single vertical line dividing the left and right sides.
For every transaction, the accountant records an increase in the debits column or the credits column in two or more accounts. Creating entries in multiple accounts for every transaction is a vital tool for balancing a business's books. But to use this system, you first need to understand one of the foundational principles of the double-entry accounting method.
Every business has multiple accounts to manage. These typically include accounts like inventory, accounts payable, and much more. When using the double-entry accounting method, you need to record some account increases as debits while increases in other accounts are credit entries.
Knowing whether an increase in an account should be treated as a debit or credit is critical to using t-accounts correctly. In this method, the normal balance of accounts determines whether an increase in that account should fall on the left or right side of the ledger.
Regarding normal balance, every account will fall into one of two categories. Either their normal balance is as a debit. Or their normal balance is a credit. This relates to expectations regarding the balance of each account.
If an account's normal balance is debit, then increases to that account belong as entries in the debit column. When there is a decrease in an account with a normal debit balance, that decrease gets recorded as a credit. The opposite is true for accounts with a normal credit balance.
At this point, it would help to have some examples to illustrate the normal balance classification system. There are several standard accounts within an organization's general ledger. Traditionally, every one of those accounts belongs to one of the following groups:
There can be numerous accounts within each category. But all accounts within a single category receive the same treatment in the double-entry accounting method. That's because each class has an established normal balance of accounts. Below is a chart showing where each of these account types belongs in the double-entry method:
To add clarity to this concept, let's look at some typical accounts that an average business or organization might have on its general ledger. As mentioned in the previous section, each of these individual accounts will be an asset, or liability, or equity, etc. Below is a chart showing where some standard accounts belong according to this classification:
Let's look at assets for an example. All asset accounts have a normal debit balance. Since cash is an asset, any increase in cash should appear as an entry on the left side of the cash account ledger. The same is true of inventory or any other type of asset account. When inventory decreases, an entry noting that decrease should appear in the credits column on the right side of the inventory ledger.
Conversely, sales are a form of revenue, and all revenue accounts have a normal credit balance. When a sale takes place, the dollar value of that sale will appear in the credit column of the sales ledger.
Before we go any further in our exploration of debit and credit rules, there is another type of account that we should mention. Contra accounts are a type of account that has an association with another account.
In this relationship, a contra account is essentially the opposite of the primary account. For example, while an asset account has a normal debit balance, a contra account associated with an asset account will have a normal credit balance.
Businesses use contra accounts to reduce the value of the accounts with which they are associated. There are many reasons why a company might choose to do this.
That reasoning is a topic for a different time. In the context of double-entry accounting, all you need to know is that a contra account gets the opposite treatment of its partner account. In other words, while asset accounts show increases in the debit column, a contra asset account shows increases in the credit column.
Now that you have a firm grasp of how debits and credits fit within the double-entry accounting method, you are ready to see the process in action. In the following sections, we will look at a few examples of using the double-entry method in recording some hypothetical business transactions.
In these examples, we'll imagine a business owner as they carry out some financial transactions. After each transaction, we'll show you how each relevant account might look after adding the entries that correspond to the transaction.
For the sake of our example, let's consider that a business owner is opening an ice cream shop. This will serve as the context for the transactions we will study. One of the first tasks of any business is initial funding. Let's imagine the owner of this ice cream shop invested $10,000 upfront upon opening the business.
According to the double-entry method, that transaction needs to appear on two account ledgers. The cash account, having a normal debit balance, would show an increase of $10,000 in its debit column. The capital account, which has a normal credit balance, would display a credit of $10,000. Below is a sample of how both those accounts would look after accounting for the initial investment transaction:
At times, the owner's contribution to a company may not be enough to cover the startup costs for their business. In that case, it is common practice to seek outside investors who are willing to back that business venture in the form of a loan.
For our ice cream shop owner, let's assume that they convinced a friend to invest $5,000 into the business. Again, the transaction needs to appear in two different accounts.
As was the case in the last transaction, the cash account will show an increase in the debit column of $5,000. But that $5,000 will also appear in an account likely called notes payable. Notes payable accounts typically represent the amount of money that a business has yet to pay back to a lender.
Here is how these two ledgers should look after this outside investment takes place:
Now that our ice cream shop owner has a reasonable amount of funds, it is time to begin building their business. To do this, the owner decides to purchase inventory in the form of sundae dishes, ice cream scoops, and disposable spoons.
After making those purchases, the total cash the owner spend totaled $3,000. Those funds came directly from the cash account that the owner funded using their own investment and their friend's loan. The $3,000 will now appear as an entry in the credits column since the cash account is an asset with a normal debit balance.
Inventory is also an asset. So any inventory ledger will have a normal balance as a debit. Below are those updated ledgers after the inventory purchase:
With the ice cream shop open, new customers are flocking to the counter. Naturally, this leads to sales. And sales, like any other transaction, influence multiple ledgers in the double-entry system.
In our scenario, the ice cream shop owner made a total of $6,000 in their first month of business. As with the acquisition of inventory, those sales will impact the cash account and the inventory account, both of which are assets:
After recognizing the success of their first month of business, the ice cream shop owner decides to put that cash to use. They consider loan repayment to be their priority. The owner uses the proceeds from the ice cream sales to cover the loan they received from their fried upon opening the business.
Recall that this initial loan was for an amount of $5,000. To keep matters simple, we will ignore any interest on that amount. When out business owner pays back the full $5,000, here is how their cash and notes payable ledgers should look:
The above example could go on without end to express every business transaction that takes place for that ice cream shop. In real life, that is the role an accountant plays when balancing a company's books.
The ice cream example reveals how effective the double-entry method is for keeping track of all transactions in an organized way. But that example alone does not fully explain why double-entry accounting is so effective and widespread in the accounting world. To gain a comprehensive knowledge of this efficacy, you need to familiarize yourself with one of the underlying elements of the double-entry method.
The accounting equation is a centuries-old formula that describes a business's financial state. Below is the equation in its most basic form:
Assets = Liabilities + Equity
This simple equation is the backbone of double-entry accounting and all other modern forms of accounting. Below are some standard definitions for those different components of the equation:
In studying the accounting equation, you will notice that balance is always the desired outcome. As with many equations, that which lies on the left sign of the equal sign is equivalent to the terms on the right side. In that light, the accounting equation mandates that a company's assets must be equal to a combination of what they owe and what others have invested into the company.
It is through adherence to this principle that companies are able to create balance sheets. The balance sheet shows the current condition of a company from a broad perspective. This perspective serves as a general indication of the company's success.
If a company can achieve balance, that means they are financially viable. In other words, they have successfully accrued enough assets to match the total values of their liabilities and shareholder stakes. Failure to reach this balance indicates that a business may fail in general, as the value they acquire in their business pursuits does not equal what they owe and what others have invested.
The reason why the double-entry method is so useful is that it respects the need for balance in every transaction. Through this method, no account can change without affecting another account. This gives a real-time indication of how a business will need to alter its transactions to remain afloat.
By recording debits and credits accurately as they occur, a business owner can have a clearer idea of how well the business is performing. The debits and credits method results in a well-organized general ledger that makes financial reporting as easy as it can be.
The double accounting method calls for balance at all times. By making entries in two accounts for every transaction, you are contributing to your company's overall financial balance.
As we noted earlier, the double-entry method is the most popular method among accountants. But it is not the only method in existence. To round out your double-entry accounting know-how, compare this system to one of its main alternatives.
The primary counterpart to the double-entry method is single-entry accounting. Single entry accounting is a simple but less comprehensive system.
Single entry accounting records look a lot like the transaction record for a typical checking account. These ledgers will show basic details for a financial transaction, and the single-entry method does not require the accountant to make entries in multiple account ledgers.
We have already extolled the benefits of a double-entry accounting method. So, what would motivate someone to forgo that system in favor of single-entry? There are a few reasons why someone might make this choice:
There may be more reasons that exist for a business to chose single entry accounting. But the three listed above are often the strongest motivations.
Still, a small business with limited transactions may want to consider the double-entry system. While a bit more complex, the double-entry method has proven its usefulness in recording financial transactions.
The double-entry accounting method is one of the best accounting systems that the world has ever known. But to use this system correctly, you need to know about the rules of debits and credits. This requires that you know about normal account balance and how to set up a general ledger. Armed with those skills, you can use debits and credits to ensure that your books remain balanced at all times.
Kaysville, UT 84037
AccountingSmarts.com participates in the Amazon Services LLC Associates Program, which is an affiliate advertising program created to provide a means for websites like ours to earn commission by advertising and linking to Amazon. This site also chooses to participate in other affiliate programs such as ShareASale, CommissionJunction, ClickBank and more, and is compensated for referring our audience to these companies.
© 2024 Accounting Smarts
You can email us at [email protected]