Let’s ask the most basic question that you might have an answer for but it’s the most important one: What exactly does it mean to “debit” and “credit” an account? Why is it important to know the difference between such a basic concept?
Trust us when we say this, what you might think is “basic” information, in reality, is the most important one. Do you know why? It’s the foundation of double-entry accounting. They indicate the amount of money moving in and out of the company’s general ledger accounts. For every transaction that must have happened till date, there must be at least one debit and credit that equal each other. When it does occur, the books are said to be in balance. Once it’s in balance, the company can go ahead and create an accurate income statement, balance sheet, and other financial-related documents.
This all then translates to how you generate invoices, compensate your staff, pay your bills, and measure your business’s overall success and financial health.
See, we told you that it’s important. We usually shrug off the “debited” and “credited” notifications but by the end of this blog, you will start to pay attention to it more than ever. That’s the magic book’s guarantee.
So, what is Debit and Credit in accounting?
What is Debit and Credit?
It might seem quite self-explanatory, debit means money going out of the account and credit means money coming in. Just like a coin, every credit must have a corresponding debit for the same dollar amount and vice versa. But if you start digging even deeper, you will discover that to increase an asset account, you record a debut and to increase a revenue account, you need to record a credit. In banking terminology, the generic definition works but for accounting records it’s a different ballgame altogether.
Let us dig even deeper into the generic so you will have a clear understanding,
When there is money deposited in your checking account, it is a debit to you because your assets increase and it’s the credit to the bank because it’s not their money, it’s yours. In the books, it’s a liability. To put it mildly, an increase in a liability account is credit, debit is the bank’s credibility.
Now coming back to the accounting part of this,
Debits are usually recorded on the left side of a journal entry to increase the balance of an asset or expense account and decrease the balance of a liability, equity, and revenue account. On the flip side of this, however, credits are recorded on the right side. They usually increase the liability, equity ,and revenue. This decreases the balance of assets or expenses.
Journal Entry:
| Account | Debit | Credit |
| Office Equipment | $1,000 | |
| Cash | $1,000 |
In this scenario:
- The debit reflects an increase in assets (equipment added).
- The credit reflects a decrease in assets (cash spent).
Why is this confusing?
According to Newton’s third law, every action has an equal and opposite reaction. The system of debit and credit is designed to make sure that the accounting equation stays true to that:
Equity= Assets – Liabilities+ Revenue – Expenses
When you are dealing with multiple accounts like this, it’s not always obvious whether an account increases with debit or credit. As we have mentioned, assets and expenses increase with debits, whereas liabilities, equity, and revenue increase with credits.
For example, you have received a $2000 payment from a client for the service you have provided. How will you actually record it?
In this case, Debit your cash account, which is an asset, to show the increase in the revenue. Credit your revenue account to reflect the income earned.
This is just one single example but when you start managing multiple accounts and multiple “in and outs” of the revenue, it gets a bit complex and hard to handle.
Note: In such situations, good accounting software does wonders.
When debits and credits start to feel really overwhelming and you don’t have the resources to get accounting software, you can always rely on a T-account.
What is a T account?
A T account, as the name suggests, is the T-shaped visual representation of an account in your ledger. At the top other T, you will write the name of the account, which can be Cash, Revenue, or Utilities, on the left side of the T will be for your debits, and on the right side of the T is for the credits. This helps you answer the most important question “What is happening to this account?” With this practice, you will see exactly how a transaction affects your accounts and helps you stay balanced and accurate.
This is the most useful technique because when multiple accounts are involved, a T account helps you break down each step. This also helps you see the increase and decrease of the revenue side by side to make you understand your account better. When there is an imbalance, a T account will help you spot the problem and you can rectify it immediately.
Here is a simple example:
Let’s say you are paying $5000 for office rent. What you need to do is record this in two accounts:
1: Rent expense
2: Cash
What is happening is:
You are increasing your rent expense by $5000 which means it’s a debit. You are also decreasing your cash by $5000 which means a credit.
This is how it looks:
| Rent Expense | Debit | Credit |
| $5,000 |
| Cash | Debit | Credit |
| $5,000 |
Now it’s well balanced.
For the last minute, we have been throwing around the word “Balanced”. What does it mean though? Let’s take a look at it
What does “Balance” Mean in Debit and Credit?
Let’s say you are running a business as a collection of buckets, each of them serving a specific purpose in tracking your financial health. As you know, every transaction gets sorted into one of five main categories.
Those categories are:
1: Asset Accounts:
These are the resources that your business owns and relies on to generate income. This can include cash, inventory, and accounts receivable.
Let’s say your company sells handmade furniture for a very select market. Then the woods and tools you buy are part of your asset because they generate your revenue.
2: Expense Accounts:
Running a business always comes with a cost and to track those costs, expense accounts comes in handy. They can usually include the cost of running an advertisement, your labor or employees, delivery cost (If it’s a service or B2C physical products), and materials. These accounts reflect what it takes to keep your business running.
Let us give you a small example:
If you pay $650 for social media ads to promote handmade furniture that payment is usually categorized as an advertising expense.
3: Liability Accounts:
It’s never easy to run a business on your own money. You might end up borrowing some money to keep the lights on or expand into different markets. To track that, we use the Liability account, which usually includes loans, accounts payable, or taxes owed.
For example: If you borrow $10,000 to buy advanced tools or get a kickass marketing team, that amount goes into your liability account as money owed to the lender.
4: Equity Accounts:
Usually, this represents your stake in the business, which could be the initial money you invested or stock holdings if your business has shareholders.
Let’s say, you started your business with $20,000 of your own money, then that amount will be recorded as your share of ownership in the company.
5: Revenue Accounts:
All the money you are making in your business is where it is all stored. This account captures the financial wins you had throughout the business.
In your handmade furniture company, when you sell a table for $1000, that amount is recorded as revenue in your income account.
Now let’s talk about how you record them. There are two main approaches to recording transactions:
Single Vs Double Entry Accounting:
Single: This simple method usually records only the revenue and expenses which is often used by very small businesses or freelancers. Let’s say you have received $2000 in cash and you have spent $550 on supplies. In such a case, a single entry would be simply noting down these two transactions without connecting them to other accounts.
Double: In our industry, we call it the “Gold Standard” because it provides a comprehensive view of finances. In this system, every transaction that happens impacts at least 2 accounts, one as a debit and other as a credit. For example, if you buy office furniture for $1000, you would debit it as an asset account and credit your cash account by the same amount. If you receive $500 from a client, you would debit your cash account and credit your revenue account.
Why are we emphasizing so much on the accuracy of balanced entry?
Here is why:
Importance of Accuracy:
1: When debits and credits are recorded correctly, the balance sheet clearly shows you whether the company’s assets are sufficient to cover the liabilities or not. For example: You are running a huge manufacturing company that has $500,000 in total assets and $400,000 in total liabilities. Now there is $100,000 of equity that is recorded as equity and if errors were made in recording the purchase of machinery, which is an asset, or a loan, which is a liability, then the calculation could be misleading and can jeopardize the critical financial decisions, which in many cases can be securing additional funding.
2: The accuracy can ensure that the revenues are correctly credited to income accounts and expenses are properly debited from expense accounts. Let’s say you have a retail store that has earned $200000 in revenue and has incurred $150000 in expenses in Q2. If we accurately enter the data, the net profit is $50,000. But, if you have spent $10,000 for advertising expenses and for some reason, are omitted during the entry. This will lead to misconceptions about the cash flow and you might overspend on inventory or expansion.
3: Whether you are a bootstrap company or an investor-backed company, the balance sheet and income statement are highly critical tools to evaluate a company’s value and financial stability for the future. Accuracy in entering debit and credit can build a sense of confidence and from the stakeholder’s point of view, it will foster trust and transparency. For example: A SaaS product seeking funding has reported assets of $1 million with liabilities of $600,000 and equity of $400,000. The income statement shows annual revenue of $800,000 and a profit margin of around 20%. If these figures are backed by proper data input of debit and credit from the start, it increases the likelihood of attracting investors.
Accountants and bookkeepers understand the ideas of debits and credits, but it takes some time to adjust when you’re a business owner who thinks in terms of credit and debit cards daily. In double-entry accounting, every transaction affects two or more financial accounts, with a debit indicating value coming in and a credit indicating value going out.
A company’s books must always be balanced in order to create financial statements that represent its health, value, and profitability.
