Credit and debit are the terms used by accountants and shopkeepers when the transactions are to be recorded. The transaction amount which is entered on the left side is debit and credit is entered on the right side. This method of accounting is called a double-entry system – since the transactions on the right and left hand should be balanced. It provides accuracy in financial statements. The first challenge is to understand which part of the statement will have credit and which one will have debit.
Debit: It is an accounting entry which increases an expense account or asset, or reduces an equity account or liability. Debit is placed on the left side of the accounting entry. Generally, Dividends, Expenses, Assets and Losses are increased with a debit.
Credit: Credit is an accounting entry that increases a liability or an equity account or reduces an expense account or assets. Credit is placed on the right side of the accounting entry system — generally, credit increases the following accounts: Gains, Income, Revenue, Liability, and Stockholders Equity.
Debit and credit are distinguished by mentioning the amounts in separate columns. A different way to write debit and credit is to use the suffix ‘Dr’ for debit and the suffix ‘CR’ for credit. Alternatively ( + ) also can be depicted ( – ) for credit. Although there is a minus sign, the debit and credit do not directly correspond to negative or positive numbers. When the total debt exceeds the total credits in an account, then the account is said to have a net debit balance which is equal to the difference, and when the opposite is true, then the account is said to have a net credit balance.
Usage of Debit vs Credit
Whenever the transaction is credited, at least two accounts are impacted. A debit entry is recorded against one account; on the other hand, a credit entry is recorded against the second account. There is no maximum limit to the number of accounts that are present in the transaction, but the minimum should not be less than two accounts.
The total of credit and debit transactions for every balance sheet should equal each other so that the transaction is said to be in balance. If the transactions are not in balance, then it would not be possible to create a proper and standardized financial statement. This is why the use of credit and debit in the format of two columns transactions recording is one of the crucial of all controls for accounting accuracy.
There can be a lot of confusion about the inherent meaning of debit and credit. For example, if a cash account is debited, that means the cash in hand increases, but if accounts payable account is debited, then the amount of accounts payable liability reduces. These differences arise because credit and debit have different impact across different types of large accounts which are:
- Liability account: Balance is increased because of credit and balance is decreased because of debit.
- Asset account: the balance is decreased because of credit and balances increased because of debit.
- Equity account: balance is increased because of credit and balance is decreased because of debit.
This reverse use of credit and debit is because of the accounting equation. Accounting equation is something on which the entire structure of accounting transactions is built.
The accounting structure is represented as:
Assets = Liability + Equity
Therefore, you can have assets if you have paid for them in terms of equity or a liability so that you must have one so that you can have another. Consequently, to see if a transaction of debit and credit is created, then you are increasing an asset and increasing a liability also. There are few exceptions like increasing one as it accounts and decreasing another asset account.
Rules of debit vs credit
Following are a few of the rules regarding usage of debit and credit, which are as follows:
- All accounts usually have a debit balance which increases when the debit is added to them and decreases when credit is added to them. This rule applies to assets, expenses and dividends.
- All the accounts which usually have a credit balance will increase when the credit is added to them and reduce when a debit is added to them. This applies to revenues, abilities and equity.
- The sum of debit should be equal to the sum of credit in a transaction. If such a thing happens then, the accounting transaction becomes unbalanced and will not be accepted by the accounting software.
Credit and debit in common accounting transactions
The following are essential points for the use of credit and debit in everyday business transactions:
- Sale against Cash: Credit the revenue account and Debit the cash account
- Credit Sale: Credit the revenue account and debit the account of accounts receivable
- Cash payment of account receivable: credit the account of accounts receivables and debit the cash account
- Purchase supplies on credit: credit the account is payable and debit the supplier expense account
- Purchase supplies on cash: The cash account is credited, and supplies expense account is debited
- Purchase inventory for cash: The cash account to be credited and inventory accounts to be debited
- Purchase inventory for credit: The accounts payable account is to be credited, and the supplies expense account is to be debited.
- Employee payments: Cash account is credited while wage expenses and payroll tax accounts are debited
- Take a loan: loans payable account is credited while cash account is debited
- Repay a loan: cash account is credited while loans payable account is debited.
To determine whether a specific account should be credited or debited, the accounting equation is used, which consists of five rules of accounting. They are also known as classical approaches and which is based on three rows for a nominal account, personal accounts and real account. This is to determine whether an account is to be debited or credited.
- Nominal account: these relate to losses, expenses, gains or income.
- Personal account: Personal accounts related to banks, individuals, creditors, companies, etc.
- Real accounts: real accounts are the assets of a company which may be tangible or intangible like buildings, machinery, patents, goodwill, etc.
Whether debt increases or decreases in an account is dependent on the kind of account. The basic principle is that the account that receives the benefit is debited and the account that gives the benefit is credited. For example, an increase in the asset is debited, and an increase in liability is credited.
The following are the Golden rules of accounting. These rules are as follows for every type of account:
- Real accounts: whatever goes out is credited and whatever comes in is debited
- Nominal account: all incomes and gains are credited, and losses or expenses are debited.
- Personal account: Givers account is credited, and the receiver’s account is debited.
The modern approach is used for a complete accounting equation, and it is straightforward to remember if you focus on dividends, costs, assets, and expenses. All those types of accounts increase with a debit or because of the entries on the left side. Alternatively, a reduction in any of those accounts is an entry on the right side, which is credited. On the other hand, a rise in revenue, equity accounts or liability are depicted with the right-side entries and decreases are depicted by the outside entries.
Credit and debit occur at the same time in every financial transaction. Assets = Equity + Liabilities Therefore if there is an increase in asset account then either there should be a decrease in another asset account, or a liability account should increase.
For example, if an organization provides services to the consumer who does not pay immediately, then the company records that transaction as an increase in the asset. Accounts receivable is debited, and revenue is increased with a credit entry. When the customer makes payment to the company, then both accounts change again. The cash account is debited, and there is a decrease in accounts receivable. When the company deposits that cash of a customer in the bank account, then two things change. Bank records show cash accounts are debited, and records show a rise in liability to the customer. A credit is recorded in the account of the customer.
When new accounting is to be set up for new business, multiple accounts are to be established which record all the transactions which are expected to occur. Cash accounts receivable, Accounts Payable, inventory and retained earnings are typical accounts which are present in every business. Every account can be broken down further so that it can provide additional details as required. For example, the accounts receivable can be broken down to show that every customer who owes the money to the company.
All the accounts should be first classified into one of the five major types of accounts which are income, assets, ability, equity, and expense. The account should be fully understood so that it can be appropriately classified into one of those five accounts.
On the other hand, liabilities are the items that are part of the obligations of the organization. These include mortgages, Accounts Payable, loans, debits, etc.
The equity shows the value of outstanding shares which have been company issued. All the expenses and incomes are summarised in the section of equity in one line, which is called retained earnings. Cumulative profit is affected by this account.
The expansion of the retained earnings account is Profit and Loss statement. All the income and expenses are broken down, which were summarised in the retained earnings. Details of sales, expenses, cost of sales and profitability of the company is shown in the profit and loss report. Many companies depend heavily on the profit and loss statement and review it regularly to help them to make strategic decisions.