Introduction
Many often find debits and credits to be the most difficult concept to come to terms with in accounting. Many think accounting is hard because of the inability to remember the increase and decrease side of an account. The reality is that debits and credits are based on a logical system that is merely easy to learn once known. Each financial transaction an Accounting will record will impact at least two accounts; the debit and credit will always make the accounting equation equal. If you’re taking accounting courses in school, studying for professional exams, or bookkeeping for your business, you’ll find it easier to learn this and less daunting to make journal entries that will help build your confidence. This tutorial covers what debits and credits mean, which accounts have which normal balances, examples and tips to remember what to write on the debit and credit sides of the account and make it easier for you to get used to keeping accounting records.
Debits and Credits in Accounting: What are they?
Debits and Credits are the basic of the Double Entry Accounting System of business that is followed by all businesses around the world. Debit means an entry on the left side of an account, credit means an entry on the right side of an account. Debit doesn’t necessarily mean loss and credit doesn’t necessarily mean gain. While in day-to-day parlance, a debit card will take money out of your bank account, a credit card will add a debt to your financial burden, in accounting terms it is quite the opposite. Whether an account will increase or decrease is dependent upon the type of account that the transaction will deal with in accounting. All transactions must include one debit and one credit with the amount of the debit equal to the credit. This equality is crucial to maintain accounting records and create reliable financial statements. When you’re trying to figure out what debits and credits are, the first step is to learn the positive or negative balance of an account, and how this relates to the meaning of debits and credits.
Why Accounting Uses Debits and Credits
The debit and credit system was developed due to the principle of duality in accounting, every transaction occurs in two ways to a business. If a company were to purchase equipment by paying cash, the company would acquire equipment and the company’s cash reserves would be reduced or depleted. A sale on credit means that the revenue is added to and the amount owed by the customers also rises. It would be extremely misleading and incomplete if only one side of these transactions was recorded. Debits and credits offer a logical method for recording both sides of each transaction, and make sure that the accounting equation remains balanced. This also aids accountants in detecting clerical mistakes as one of the conditions is that total debits should be equal to the total credits, if not, there must be a clerical error in the recording. While it’s a function of modern accounting software, accountants and students should still grasp the logic behind the entries since software can’t make all the decisions about which accounts should be involved in a transaction for a given transaction.
The Accounting Equation behind Debits and Credits
Before understanding the debits and credits, it is important to understand the Accounting Equation: Assets = Liabilities + Owner’s Equity. All business transactions will impact one of these components of the equation and the debit credit rules make sure that the equation will always be balanced. For instance, when the owner gives some cash to the business as capital, the businesses ‘cash’ asset account will be increased by the same amount of the owner’s ‘capital’ account will be increased by the same amount. If the business pays rent in cash, cash will be a subtraction from the assets of the business, and expenses will be a addition to the owner’s equity, because the profit will be less. Each debit must have a credit; therefore, the equation will not be out of balance. When you look at transactions from the accounting equation perspective, you will be able to make journal entries much easier as you will know what the business gained, what it gave up and which account categories were involved in the transaction.
The Five Main Types of Accounts
Accounting groups all accounts into five headings: assets, liabilities, equity, revenue and expenses. Assets are the resources that are owned by the business; for example cash, inventory, vehicles, equipment, etc. and the accounts receivable. Liabilities are what is due to outside parties, such as loans, accounts payable and wages payable. Equity is the owner’s net position in the business once all the business liabilities have been subtracted from the assets. Revenue is the money received for the selling of goods or services, and expenses are the costs that have to be incurred to produce the revenue, such as salaries, rent and utilities. It’s very significant to comprehend these categories as debit and credit guidelines are completely dependent on the account type involved. Students that memorize account classifications first, and then do journal entries, typically have a much easier time learning accounting than students that just dive in to journal entries without understanding the accounts they are dealing with.
Normal balances of Different Account Types
All accounts are kept with a normal balance, the sides where the increases are made in the account are the most frequent. Typically, assets and expenses have a debit balance that is they are increased by a debit and reduced by a credit. Liabilities, equity and revenue generally have credit balances and are increased by a credit and decreased by a debit. This is the Rule of all the Journal entries you will ever make in Accounting! For instance, cash is an asset and will therefore increase on a debit and a bank loan is a liability and will therefore increase on a credit. A credit is added to the sales revenue account since it is a revenue account, and a debit is added to the rent account, since it is an expense account. After learning the normal balances of the five categories of accounts, journal entries don’t seem so confusing anymore; you can tell the direction that each account should move.
The Golden Rule to Remember Debits and Credits
Remembering the acronym DEAD CLIC is one of the easiest ways to remember the steps in accounting. DEAD is used to remember that Expenses, Assets and Drawings increase when debited; while CLIC is used to remember that Liabilities, Income and Capital increase when credited. Money that the owner of the business removes from the business for his/her own personal use is drawn out of the business, and money that the owner invests in the business is capital. This memory aid helps students to easily identify whether an account is increasing or decreasing to determine the appropriate debit/credit. The other trick is to visualize an enormous T-account, assets and expenses on the left and claims (liabilities, equity and revenue) on the right. This graphical representation provides a reminder of the relationship of account categories and their normal balances: always debs on the left and always credits on the right. These easy methods can prevent students from making mistakes while taking an exam or bookkeeping practical.
Understanding T-Accounts and their Function
T-accounts are graphic representations of ledger accounts which help to clarify debit and credit transactions. The title of the account is at the top and the left side of the page will be used for debits and the right side of the page will be used for credits. When a firm receives cash from a customer, a debit entry is made in the Cash account because cash is an asset which increases. When the same business pays the electricity bill, the cash account will be credited, as the amount of cash will be getting reduced. The students can clearly understand how the balances of various accounts will change from one transaction to another, and why the balance of some accounts will increase with a debit while others will increase with a credit by using T-accounts. Many accounting teachers require students to draw T-accounts before they make journal entries as it makes things easier to understand and will minimize confusion. While most of this activity is concealed in a computerized accounting system, the principle is the exact same in any accounting package that businesses use today.
Debit and Credit Examples
Examples are the quickest method of comprehending accounting concepts. It can be assumed that the owner of a business makes an investment of ₦500,000 in his business. It is a credit to owner’s equity for cash when the cash increases, but when the capital increases, then cash is debited by ₦500,000. When the business purchases furniture for ₦100,000 in cash, business’ assets (furniture) will be increased and credited, while the business’ cash will be decreased and credited. When service revenue is provided to a customer for a service of the value of N50,000, the company’s cash will increase with a debit and the service revenue will increase with a credit. When workmen are paid salaries of ₦20,000, it means that salaries are increased (debited) and cash is reduced (credited). Students will notice patterns and become more confident in creating journal entries with repetition from examples such as these rather than solely with memorization techniques.
Common Errors Student Make
Debit equals increase and credit equals decrease is not always true, and is the source of many accounting student errors. Others have rules in their heads, but do not know the different type of accounts, and therefore cannot deal with new transactions. A second frequent mistake is to overlook that, for each transaction, at least two accounts will be involved and that total debits will always equal total credits. Personal banking terminology is sometimes mixed up with accounting terminology, particularly in the case of bank statements and cash account. The easiest approach to prevent these errors is to recognize the type of account, its normal balance direction, and then apply the normal balance rules. The regular practice of journal entries is also very important since accounting is a skill that needs to be practiced and applied over time, it is not something that can be memorized.
Simple Steps for Recording Journal Entries
There are four simple steps to make journal entries.
The first step is to identify all the accounts that have been impacted by this transaction. Second, determine if each of these accounts represents an asset, a liability, equity, revenue or an expense. Third, identify the direction of change (up or down) for each account due to the transaction. Fourth, use the debit/credit rules according to the type of account and direction of flow. By doing this, it can help to avoid confusion and uniformity in solving accounting problems. This process will over time become automatic and students will be able to analyze transactions in a quick and accurate manner. Even after many years of practice, professional accountants tend to think in a similar fashion; it is a systematic process that reduces error and enhances the accuracy of financial information that is used to make decisions.
Why Debits and Credits are Important.
Debits and credits are not only subjects of exams and textbook examples, but a means of communication for businesses to share financial information. The debit/credit system is used in all financial statements, accounting systems, payroll systems, and bookkeeping practices, and was created centuries ago. Students who are familiar with these concepts can easily learn advanced concepts like adjustments, financial statements, cost accounting and auditing as these concepts are built on these concepts. Debits and credits are not so complex and should be viewed as a logical way of recording economic events in a consistent and balanced manner rather than as rules to be memorized. After you master the concepts, accounting is not so much a game of guesswork as a game of applying a set of reliable rules that is a true representation of a business’ financial activities.
Conclusion
Debits and credits are the lifeblood of accounting, and the base of all journal entries. While these can be a bit confusing at first, an understanding of what types of accounts they are and what their normal balance should be makes the subject logical and predictable. Be sure to remember that debits to assets and expenses increase the amounts, and credits to liabilities, equity and revenue do the same. Increase understanding with the help of memory aids like DEAD CLIC, regular practice with T-accounts and transaction examples. The more that you practice, the more that you will be able to know the proper entries and how to keep the books balanced. These basic accounting principles will help you gain confidence and develop your skills to handle more complex accounting concepts and accurately and professionally record business transactions.
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