A Beginner’s Guide to Debits and Credits
Background
Accounting is essential for the functioning of an enterprise. It allows you to receive income from the work of the company, to record all receipts of funds, expenses. Accounting data is constantly changing with the business activity. The debits and credits can be said to be one of the main concepts in accounting. Both terms denote the sum of monetary and material values, however, their meanings are opposite of each other.
The ancestors of the foundations of accounting are considered to be the ancient Egyptians (they developed the basics of inventory) and the Incas (they developed the basics of double-entry system described below). In Eurasia, but already in this millennium, Korea and Italy (more precisely, the countries of the Italian peninsula, which later united into one country) made a tangible contribution to the formation of accounting and applied its foundations in practice. It was the Italian peninsula that gave the first accounting training materials:
- a treatise by the monk Luca Pacioli from 1494 describing and systematizing the principle of double-entry;
- later works of mathematician Gerolamo Cardano, mechanic Simon Stevin.
Therefore, the emergence of the first society of accountants in Italy (Venice), in 1591, can be called natural.
Double Entry
It so happened historically that all business transactions are typically reflected using a double-entry system. This is done in order to understand what assets the entity has and how they were obtained. Thus, you can assess the effectiveness of doing business and make the right strategic decisions.
Any action carried out by a business entity is written down in a bookkeeping log using an account it corresponds to in the so-called chart of accounts, which orders bookkeeping accounts where transactions are recorded depending on the type of the transaction.
For example, if your business wrote checks to pay wages from your business bank account, then at the same time this fact is reflected in two accounts at once, where settlements with personnel are reflected on a debit side of an account typically named Wages Expense and the credit (right) side of Cash reflects where these funds were deducted from. As a result, this gives an understanding of where the funds came from and where they went.
What are debit and credit?
As already described above, a double-entry system is needed in order to understand the origin of assets and the appropriateness of their use. This system was first described in the Latin language. Thus by looking at the meanings of the Latin words credere and debere, we may get a clue as to why Luca Pacioli has chosen these words in particular. Credere in Latin means to entrust something, while debere means to owe to someone. When a bank loaned or entrusted money to a business, the Latin word debere would have been used. The term credere would have been used to describe the fact that the business now owes the money of equal value back to the banks. In a way, each of these terms describes a different side of the same transaction.
Simply put, a debit represents an increase on the left side of any particular account involved in a transaction. Credit is the right column of the account. At the same time, can you say that a debit entry makes the balance of an account go up or down? The answer depends on what account you are looking at. To increase some accounts, you need to create a debit entry. For other accounts, a debit entry will mean that their balance is decreasing.
This all might sound very confusing, however, there is a set of simple rules that you should use to get everything right. To know whether you should write the amount in the debit column or the credit column of a particular account, you need to know its normal balance. What does it mean?
The topic of debits and credits is closely intertwined with the concept of normal balance. By this term, it is meant that every account type is increased only with a debit or only with a credit, while an opposed entry will decrease the balance. You can see the rules presented in the table above.
Once again, due to the fact that when calculating the financial result, the double-entry recordkeeping of the operation is used, you can easily say which direction the funds went. For example, if we withdraw money from the Cash account and send it to some type of liability account (e.g. paying off debt), then in the accounting language write off these funds from the credit side of Cash and write them down to a debit side of liability.
Examples
To help you better grasp this whole topic, let’s go over different scenarios and determine with accounts were affected and how. The first transaction we are going to look at is a purchase of a new computer for your small business, which cost you $980. You exchange your cash for the computer. In this case, both accounts affected (Cash and Equipment) are asset accounts, with Cash going down and Equipment increasing. Accordingly, you will debit the Equipment account and credit the Cash account.
You also had someone invest $15,000 into your business. The investor exchanged cash for shares in your business. Thus, you have more Cash and the Shareholder’s equity also increased. You will make a debit entry under Cash and credit entry under Shareholder’s equity.
Later on, your business paid some dividends to the shareholders. In this case, you had cash going out of your business, so to decrease the balance in this account, you will need to credit it. Simultaneously, you will need to decrease the Shareholder’s equity account (Dividends) to reflect that the shareholder no longer owns as much in your company with a debit entry.