Introduction
One of the primary difficulties that can be faced by a beginner in accounting is to understand the concept of debits and credits. It is often assumed that if the transaction is a debit, it is an inflow of money and if it is a credit, it is an outflow of money, but this is not the case in accounting. Rather, debits and credits are merely the two facets of each financial transaction. They ensure that the accounting equation is always balanced and that each and every transaction is accurately recorded. With this knowledge of how the various types of accounts are affected by debits and credits, bookkeeping should not be so daunting or mysterious.
Debits and credits is a crucial skill to learn, whether you’re a student, entrepreneur, accountant or someone just learning bookkeeping for the first time. All accounting systems, financial statements and bookkeeping software are based on these principles. This guide will explain the debits and credits rules, introduce the three golden rules of accounting, give you some memorable examples and gives you a chart to remember which accounts are debited or credited with which operation. At the end, you will have a simple framework which will make it much simpler to record transactions.
It’s useful to get a grip on the rules of debits and credits before getting into the journal entries and ledgers, because it helps you to understand how each of these kinds of accounts works, and why every transaction must have an equal credit and debit entry.
What are Debits and Credits?
Debits and credits are the two basic aspects of each accounting transaction. They are able to calculate how much to increase or decrease the value of various accounts and make the accounting equation balance. Financial transactions impact on at least 2 accounts due to the double-entry bookkeeping system for accounting. A debit entry is made to one account and a credit entry of equal amount is made to another account. Such equality helps in maintaining accurate financial records and enables accountants to create a sound financial statement. Debits and credits do not show positive or negative numbers, but only which side of an account is to be debited or credited in the transaction. It is better to know this concept so as to remove one of the most common misconceptions for the beginners: they may think that debits are gains and credits are losses.
The other is that the effect of a debit on the account depends on the account in question. For instance, if cash is debited, cash is increased and if a liability account is debited, that amount is reduced. Similarly, if you credit revenue, you make the income go up and if you credit an expense, you reduce the expenses. It can be difficult for the learner to distinguish this, until he/she realizes how each account type works. As you see that each account maintains its own pattern, the whole system of accounting starts to make sense and journal entries and financial reporting get a lot easier.
Why do all Transactions contain both a Credit and a Debit?
Under the double-entry bookkeeping system, each financial transaction must impact on two accounts. This concept is used to assure that the accounting equation (Assets = Liabilities + Owner’s Equity) is always true. When a business acquires equipment using cash, one asset account will be increased and the other asset account will be decreased. When a company takes out a loan from the bank, cash comes in and so do the liabilities. The equality of the accounting equation is maintained in that every transaction will result in the total amount of the debits being equal to the total amount of the credits. It is the first step towards the right bookkeeping and can help accountants identify errors in the books by using trial balances and reconciliation protocols.
Let’s say a business has received a payment of N500, 000 from a customer, for services rendered. The cash account will be increased because the company now has more money in the account. Meanwhile, there is also an increase in revenue, as the business has generated income. An increase in cash is a debit and an increase in revenue is a credit. The total of the debit ₦500,000 is balanced with the total of the credit ₦500,000 in the book keeping. The same rule is true with any business dealings no matter how big or complex they may be. Once you grasp this relationship, you can make your journal entries correctly.
Three Golden Rules of Accounting
The three golden rules of accounting were originally created for traditional bookkeeping with personal, real and nominal accounts. Today’s accounting system divides accounts into five groups: assets, liabilities, equity, revenue and expenses, but these rules are a great way to teach the basics of the debit/credit side of the ledger.
Rule One: Debit the Receiver, Credit the Giver
This is applicable to the personal account of individuals, companies, customers, suppliers or organizations. An account is debited whenever a person or a business receives value from the business. If a value to business is given, the account is credited. If for instance the goods is supplied on credit it is credited to the supplier as the supplier has given value to the business. If the payment is ever made, the supplier’s account is debited since cash is paid to the supplier. Many transactions with customers, vendors and customers outside the system can be understood by using this simple rule.
Rule Two: Debit What Comes In, Credit What Goes Out
This is the case with real accounts, assets of the business that have a tangible and intangible character. An asset account is debited whenever an asset is added to a business. When an asset is removed from the business, a credit is made on the asset account. Assume that a firm buys the office furniture using cash. The furniture account is debited when new furniture enters the business thus increasing the furniture account. The cash account is credited with cash leaving the business to pay for the purchase. The rule helps one to easily remember the way in which physical and non-physical assets are recorded.
Rule Three: Debit Expenses and Losses, Credit Income and Gains
Revenue, expenses, gains, losses are the examples of nominal accounts. Expenses are reducing the profitability of the business so the relevant account is debited whenever the business has expenses or loss. Any income or gain of the business will be credited to the appropriate account as these will add to the profits of the business. For example, if electricity is paid the electricity expense account is debited and cash is credited. Debit cash and credit consulting revenue for consulting income. This rule is directly related to a proper accounting of business performance in the preparation of the Income statement.
Debit and Credit Chart you should Memorize.
Newcomers can learn the debit and credit rules of the five major account types instead of having to memorize hundreds of accounting entries. This is used in almost all accounting systems and helps to prepare journal entries correctly.
Debits will be used to increase assets, and credits will be used to decrease assets. Some examples of this are cash, equipment, inventory, vehicles, land, buildings, and accounts receivable. Debit an asset account when a business buys more assets. When assets are sold, used, or removed from the business the account will be credited. If assets are being increased, then they are a resource that the company has, so it is expected that there will be a debit entry.
The number of credits is added to liabilities and the number of debits is subtracted from liabilities. Loans Payable, Accounts Payable, Salaries Payable and Taxes Payable are all included in these accounts. When the business takes on debt or incurs a debt or obligation, the credit will increase liabilities. Decreased when debts are repaid or obligations paid off. This inverse relationship of assets vs liabilities is helpful in avoiding a number of bookkeeping mistakes.
Credits also increase owner’s equity and debits decrease it as they are the owner’s claim on business assets after removal of liabilities. Cr (credit) entries will add equity, and debits (credit) entries will decrease equity. Revenue are the same, as the income would increase the owner’s equity. Expense accounts are similar to assets as debits increase them and credits decrease them, as expenses reduce the owner’s equity by decreasing the profits.
Simple Illustration of Debits and Credits
It is easier to learn accounting if it’s linked to real-life situations. Assume a business owner begins a business with an initial capital of ₦1,000,000.Assume that a business owner invests money of ₦1,000,000 in the business. The cash account will need to be debited by N3, 000,000 to increase the cash account. Capital is credited by ₦1,000,000 because owner’s investment will increase owner’s equity. The two entries are perfectly balanced, and illustrate exactly the double entry principle, in addition to adding to overall business resources.
Now, if the business buys office equipment worth ₦300,000 using cash, what happens? Now, if the business buys office equipment for ₦300,000 using cash, what will happen? Equipment is brought into the business, the equipment account gets a debit of ₦300,000. Money is dispensed from the business, thus cash is given a credit of ₦300,000. One asset may gain in value while another loses value, but, total assets are not affected because what has changed is how they are distributed among the assets. This example illustrates that debts do not always lead to a decline in overall wealth and credits do not always lead to a loss of wealth.
Let’s take another case where the company rendered consulting services and was paid immediately in cash, ₦200,000. Cash is debited when it is gained, which means that the company has more money. Consulting revenue is added to the business’s revenue through a credit. The transaction not only increases the cash flow and profitability, but also balances the debits and credits. One of the most frequently used journal entries in service companies is this type of journal entry.
Lastly, assume that the business’s electricity expenses are ₦50,000 per month. The electric company used the electricity, and their cost is added to the electricity expense account, so the cost account is debited. The cash account will be reduced by the amount of cash that was received, so there will be a credit entry to the cash account. A double entry will allow the costs to be recorded in the accounts correctly and ensure that the cash accounts are kept correct.
Common Mistakes Beginners Make
A common error is using the terms debit “good” and credit “bad.” This confusion can be compounded by the fact that bank statements are not the same as business accounting statements and use banking terminology. Debit and credit in bookkeeping are the left and right hand sides of an account and they have no inherent meaning. If they are increasing or decreasing in an account is entirely dependent on the account category. It is important to keep in mind this difference to avoid mix-ups in journal entries and financial statements.
A common error is making a journal entry for only one side of the transaction. All legitimate accounting transactions involve at least two accounts and need to be reported on both sides as well to ensure the accounting books are balanced. An incorrect trial balance will arise if one side is omitted and this will result in difficulties when reporting the financial statements. Many novices also make the wrong choice of account category, such as logging the purchases of recording equipment as an expense and not as an asset. These errors can be avoided if you know the function of each account.
Some people also attempt to memorize sentences/individual entries in the journal rather than comprehending the reasoning behind them. Memorization can be helpful in the short term, but is more challenging once new transaction types are introduced. By instead concentrating on what happens to each account when it is debited and credited, building stronger accounting skills will be acquired that can be utilized in virtually any financial transaction that is undertaken in practice.
Some Tips for Remembering Debits and Credits
A simple way to learn debits and credits is to use the accounting equation, as well as some memory tricks. Prior to recording any transaction, determine the accounts that will be affected and look at each account and ask, is it going up or down? Remember the characteristics of that particular account category. Debits increase assets and expenses; credits increase liabilities, owner’s equity and income/revenue. This should be repeated regularly to establish confidence and eventually reduce uncertainty when doing journal entries.
You can also go through some basic transactions in business. Record cash sales, inventory purchases, repayments of loans, payment of salary and collections from customers. The same Flow of Debit and Credit repeats itself a number of times, reinforcing the concepts naturally. In addition, the use of visual aids can enhance learning, such as using T-accounts to clearly distinguish debit and credit entries on the left and right sides. As your experience increases, making the correct debit/credit entries becomes automatic; and you can concentrate on what is happening in your business rather than what the rules of accounting are.
Conclusion
Financial transactions are expressed in debits and credits. They may seem confusing at first, but they’re simple once you learn how each account to particularize responds to a particular entry. Each financial transaction involves at least two accounts; total debits are equal to total credits and the accounting equation is always in balance. The three golden rules of accounting are a great way to understand personal, real and nominal accounts and the five major account categories are a contemporary way to record transactions with accuracy.
The trick in accounting is not to memorize these tons of journal entries, but to understand what’s going on for each transaction. You will understand how Assets, Liabilities, Equity, Revenue and Expense are affected by debit and credit, and build a solid system that will work for most bookkeeping situations. So, if you practice these and understand them, even accounting concepts that you thought were confusing will turn into second nature, transactions will be recorded with increased accuracy and financial statements will be easier to prepare.
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