What are Debits and Credits?
Double-entry accounting forms the basis for recording the financial transactions of an enterprise. The double-entry system of accounting uses Entries to record those transactions. Those entries have two principal parts “Debit” and “Credit.”
A practical understanding of this debit and credit is essential for maintaining the books of accounts. The Debits and Credits indicate the financial position of an enterprise.
Every monetary transaction has two parties associated with them, namely the Receiver and the Giver or in simple terms, the Buyer and the Seller. But first, we need to know the effect of the debit and credits in the double-entry accounting system.
What is Debit?
A debit is an accounting entry that increases the asset account and the expenses account. It also decreases the liability and the equity account.
What is Credit?
Credit is an accounting entry that increases the liabilities and the equity account and decreases the asset and expense account.
The position of debit and credit:
Debits and Credits in the Double-entry system of accounting are recorded in a “T” format of the ledger.
The Debits come on the left side of the “T.”
The Credits come on the right side of the “T.”
Once you get this formation, the next step is to classify the transaction into debit and credit aspects. The real challenge is in knowing what part of the transaction is debit or credit.
The format for recording debit and credit in Journal Entry:
The double entry system uses Journal Entries, which is also known as the “Chronological Entry” to record the transactions. The journal entry is the first step of recording in the system of Double entry. The format for a journal entry is:
Debit A/c Dr (where the debit aspect of the transaction is recorded)
To Credit A/c (where the credit aspect of the transaction is recorded)
The Debit entry is next to the margin, and the credit entry is few spaces away from the margin.
The types of accounts in the Double-entry system:
The accounting transactions are classified in the following heads:
1. Equity accounts
2. Asset accounts
3. Liabilities account
4. Expenses account
5. Income account.
The method of recording debit and credit varies for each of the accounting heads.
Recording of debits and credits in equity and liabilities account:
The Liabilities account indicates the enterprise’s debt to other vendors and financial institutions. The liabilities are classified as Long-term liabilities and Short-term or current liabilities. Examples of long-term liabilities are bank loans, mortgage repayment, and so on. The examples of current liabilities are accounts payable, outstanding payments, and so on. The owner or the proprietor’s investment in the business is also a liability to the enterprise.
The equity account is the summation of the owner’s assets in the business, like stock and retained earnings.
The liability and the equity accounts are recorded in the same manner in the double-entry system of accounting. The increase in equity and liabilities are credits recorded on the right side of the “T” format of the ledger, and the decrease in equity and liabilities are debits recorded on the left side of the “T” format of the ledger.
A transaction involving the liabilities account:
The enterprise has accounts payable of $5000, which is accounts payable and current liability. When paying, the journal entry will be
Accounts Payable A/C Dr $5000
To Cash A/C $5000
As the liability of the accounts payable has decreased, it will be debited, and the balance of cash has also reduced as cash has been used to make payment.
A transaction involving the equities account:
If the owner brings an additional capital $25,000 to the business, the journal entry would be as follows:
Cash A/C dr $25,000
To owner’s equity A/C $25,000
There is an inflow of cash, which is an asset account. The balance of the owner’s equity account also has increased and therefore credited.
Recording of debits and credits in the assets account:
The assets account indicates the value of the assets owned by the business. Just like liabilities, assets are also differentiated as Current assets and Long-term assets. The examples of current assets are stock, inventory, and so on. The instance of long-term assets, island, machinery, building, and so on. The assets are displayed on the right side of the Balance sheet.
One has to remember that the debits are recorded on the left side of the “T” account, and the credits are displayed on the right side.
As per the golden rules of accounting, an increase in assets are debited, and a decrease in assets are credited. So if there is an increase in an asset, it is a debit, and a reduction in asset means credit.
Example of asset account:
The business sells its warehouse at $40,000, and the cash was received. The journal entry for this transaction would be:
Cash A/C dr $40,000
To warehouse A/c $40,000
There is an increase in cash, which is a current asset, so it is debited, and there is a decrease in fixed assets, which is credited.
A business purchased $10,000 worth of inventory for its production. The journal entry for this transaction is:
Inventory A/C dr $10,000
To Cash A/C $10,000
As there is an increase in the inventory A/C, it will be a debit entry, and the decrease in the Cash A/C will be credit entry.
Recording of Debits and Credits in expenses account:
The expenses accounts are a part of the profit and loss statement, also known as the income statement. The expenses account to cover the whole operating costs of the business, which includes many types of accounts. When recording expenses account, the increases in expenses is debit, and the decrease in expenses is credit.
When recording in the ledger, the debits on the left side feature the increase in the expense account, and the credits on the right side highlight the decrease in the expense account.
Examples of expense account:
The business purchased stationery worth $1000 and the journal entry for this transaction would be:
Stationery A/C Dr $1000
To Cash A/C $1000
The purchase of stationery is an expense, and Stationery A/C is an expense account in the income statement. The Cash account is an asset. An increase in the stationery account is debit, and a decrease in the cash balance is credit.
Recording of debits and credits in Income account:
Income account features the revenue received from the operations of the business. The income includes both cash and credit sales. The other sources of income can also be from investments. The income accounts reduction is debit and an increase in credit.
In the “T” format, the increases of the income account are recorded in the credit side or the right side, and the decreases in the income account are credited in the debit side or the left side.
Example of income accounts:
A cash sale of $10,000 has taken place in the course of business. The journal entry for this transaction would be:
Cash A/C Dr $10,000
To Sales A/C $10,000
There is an increase in the asset account viz Cash so, it is a debit, and there is an increase in sales revenue, so it a credit.
These are the rules for applying debit and credit to the transactions of a business. These five accounts are part of the expanded accounting equation. These simple rules help the accountant to analyze the transactions’ debit and credit aspect and record them effectively.