Debits and credits refer to the fundamental characteristics, and the fundamental mathematics, of all transactions recorded in a business’s general ledger.
All financial transactions for the business are recorded in the general ledger as journal entries. They are recorded into specific accounts, which represent various aspects of the business’s financial activity, such as accounts receivable, cash, prepaid assets, or sales.
All journal entries will be recorded as either a debit or a credit. Whether a journal entry is a debit or a credit depends on the basic nature of the transaction and the account in which it is entered. A debit means what is due or owed—it refers to money going out. Credit means to entrust or loan—it refers to money coming in.
However, even with these definitions, the use of debit and credit in the context of business accounting is not entirely intuitive or obvious. This is because the use of the terms has a different meaning from how they might be used in other contexts.
For example, debit in reference to a bank statement or a debit card has a different meaning than it does in the context of business accounting. Similarly, credit in reference to a credit card, credit score, or line of credit is also different from a credit in the general ledger.
Another way to understand debits and credits in business accounting is to look at them mathematically. A simple way to distinguish between the two is to know that a debit entry always adds a positive number to the ledger, and a credit entry always adds a negative number. Even though positives and negatives are not used in the actual journal entries, the mathematics of how they are used leads to either a positive or negative result.
The process is further explained by the nature of the account in which debits and credits are used. To elaborate, some accounts carry a debit, or positive balance, while others carry a credit, or negative balance. The effect of the debit and credit journal entries will depend on which type of the two accounts they are entered.
A debit entry in a debit balance account will increase the account balance because adding two positives always results in a positive. A credit entry in a credit balance account will also increase the balance because adding two negatives always results in a negative. Finally, a debit entry in a credit balance account, or vice versa, will lower the account balance because negatives and positives always negate each other’s value mathematically.
To fully understand the logic of debits and credits, it is essential to know which accounts carry a debit or credit balance.
Accounts that carry a debit balance are assets, expenses, and dividends. Accounts that carry a credit balance are liabilities, revenues, and equity.
Following this basic logic, a debit entry in any of the three debit balance accounts will increase the balance of that account.
Similarly, a credit entry into any of the credit balance will increase the (negative) balance.
Finally, a debit entry in any of the credit balance accounts, or a credit entry into any of the three debit balance accounts, will effectively lower the balance of the account.
The use of debits and credits is defined by the system of accounting in which they are used. Debits and credits are an element of the double-entry accounting system.
The basic premise of the double-entry system holds that every transaction has an equal and opposite effect in at least two different places. That is to say, the transaction will impact at least two accounts, and the two entries will balance out.
This is logic is expressed in the form of an equation that informs all accounting records, which is: Assets = Liability + Equity. All double entries can be inputted into this equation.
Based on this logic, a journal entry will always have a debit and a credit in the respective accounts where they are recorded. The two entries will also balance out.
To help maintain this logic of journal entries, debits are always recorded in the left-hand column of the general ledger and credits are always recorded in the right-hand column.
Because of the way this looks on paper, the double-entry system is also referred to as a T-account. The term describes the appearance of the bookkeeping entries, which resembles a large “T.” The title of the account appears above the top horizontal line of the “T” and debits and credits are listed on the left and right side of the vertical line.
If a manufacturing company takes out a loan for $1,000 to purchase machinery, the loan will be posted as a $1,000 credit in accounts payable, and the machinery will be recorded as a $1,000 debit in the appropriate asset account.
As the loan is paid down, payments will be recorded as debits in accounts payable until the loan is completely paid off.
In another example, if a furniture store sells a $500 sofa to a customer on credit, its accountants will post a $500 transaction in the credit column of the sales account and a $500 debit in the accounts receivable. As the customer makes payments on the credit, the business will record the payments as credits in the accounts payable and as debits in the cash account. When the customer has completely paid off the sofa, the accounts payable item will be zero.
While the use of debits and credits in the double-entry accounting system is not always intuitive, the system helps businesses accurately record all transactions and the effect they have on financial performance.
The proper use of debits and credits ensures that revenue and other forms of monetary value are never overstated and that they are appropriately offset by their corresponding costs and underlying expenses. In this way, the system provides for maximum accuracy and consistency in the business’s accounting records.