In this article, we break down the basics of recording debit and credit transactions, as well as outline how they function in different types of accounts.
Double-Entry Accounting
Most businesses, including small businesses and sole proprietorships, use the double-entry accounting method. This is because it allows for a more dynamic financial picture, recording every business transaction in at least two accounts. It works like this: A debit is entered into at least one account, then a corresponding credit of the same amount, but of opposite value, is recorded into at least one account. The two entries are used to show the giving and receiving sides of external transactions. The idea is to get to a net sum of zero, ensuring all dollars are accounted for and the books stay balanced. The dual entries of double-entry accounting are what allow a company’s books to be balanced, demonstrating net income, assets, and liabilities. With the single-entry method, the income statement is usually only updated once a year. As a result, you can see net income for a moment in time, but you only receive an annual, static financial picture for your business. With the double-entry method, the books are updated every time a transaction is entered, so the balance sheet is always up to date. Simply put, the double-entry method is much more effective at keeping track of where money is going and where it’s coming from. Additionally, it is helpful at limiting errors in accounting, or at least allowing them to be easily identified and quickly fixed.
Debits vs. Credits in Accounting
When it comes to debits vs. credits, think of them in unison. There should not be a debit without a credit and vice versa. For every debit (dollar amount) recorded, there must be an equal amount entered as a credit, balancing that transaction. If you need to purchase a new refrigerator for your restaurant, for example, that would be a credit in your cash account because the money is leaving your business to purchase an item. That item, however, becomes an asset you now own as part of your equipment list. Since that money didn’t simply float into thin air, it is important to record that transaction with the appropriate debit. Although your cash account was credited (decreased), your equipment account was debited (increased) with valuable property. It is now an asset owned by your business, which can be sold or used for collateral for future loans, for instance.
Debits and Credits With Different Account Types
Even the smallest businesses and sole proprietorships benefit from accurate books. Debits and credits are important to balance the books and keep an accurate balance sheet, which offers an overall picture of assets, liabilities, and owner’s or shareholders’ equity. A balance sheet is based on the foundational accounting equation of: Assets = Liabilities + Equity Depending on the type of account, debits and credits function differently and can be recorded in varying places on a company’s chart of accounts. The equation should still hold, however. This means that if you have a debit in one category, the credit does not have to be in the same exact one. As long as the credit is either under liabilities or equity, the equation should still be balanced. If the equation does not add up, you know there is an error somewhere in the books. There are five major accounts that make up a company’s chart of accounts, along with many subaccounts that fall under each category. These can be tailored to a business’s needs. For example, a restaurant is likely to use accounts payable often, but will probably not have an accounts receivable, since money is collected on the spot for the vast majority of transactions. A single transaction can have debits and credits in multiple subaccounts across these categories, which is why accurate recording is essential. Below is a breakdown of each type of account.
Assets
Assets are items the company owns that can be sold or used to make products. This applies to both physical (tangible) items such as equipment as well as intangible items like patents. Some types of asset accounts are classified as current assets, including cash accounts, accounts receivable, and inventory. Current assets are contrasted to long-term assets. These include things like property, plant, equipment, and holdings of long-term bonds.
Liability
Liability accounts make up what the company owes to various creditors. This can include bank loans, taxes, unpaid rent, and money owed for purchases made on credit. Examples of liability subaccounts are bank loans and taxes owed.
Equity
Sometimes called “net worth,” the equity account reflects the money that would be left if a company sold all its assets and paid all its liabilities. The leftover money belongs to the owners of the company or shareholders. Many subaccounts in this category might only apply to larger corporations, although some, like retained earnings, can apply for small businesses and sole proprietors. Some examples are stocks and real estate.
Revenue
Revenue accounts record the income to a business and are reported on the income statement. Examples of revenue accounts include sales of goods or services, interest income, and investment income.
Expense
Conversely, expense accounts reflect what a company needs to spend in order to do business. Some examples are rent for the physical office or offices, supplies, utilities, and salaries to all employees. Refer to the below chart to remember how debits and credits work in different accounts. Remember that debits are always entered on the left and credits on the right.
Debits = more assets (such as cash or utility accounts), less liability, and less equityCredits = less assets, more liability, and more equity
