If you need to balance your business’s books, understanding debits and credits is key.
In very simple terms, debits decrease liability and increase assets and expense accounts, and credits do the opposite. When debits are equal to credits, your books are balanced, so it’s important to ensure that every debit has a matching credit to keep things in check.
Debits and Credits – What’s the Difference?
Debits and credits are the backbone of good bookkeeping, so it’s important to understand how they operate together. To put them in familiar terms, you can think of credits as adding a positive number, while debits add a negative. To complicate things somewhat, the terms “positive” and “negative” aren’t actually applied in bookkeeping – but keep them in mind as a reference point.
The reason we talk in terms of “balancing” accounts is that debits and credits are literally entered on opposite sides of a table: debits to the left and credits to the right. Just like a pair of weighing scales, every entry on the left should have an equal (but opposite) entry on the right.
Debits and Credits – What are they for?
The primary purpose of debits and credits is to track a business’s transactions. Income and outgoings are recorded as credits and debits against an account. A business’s accounts will be broken down into five main categories, as follows:
EXPENSE ACCOUNT
This is a record of the costs that are incurred in running a typical business, and might include expenses such as salaries, utilities, rent and rates, as well as costs like advertising and travel.
ASSET ACCOUNT
If something has a potential financial benefit to the business, it is considered an asset.
Cash, stock, property, vehicles and money owed to the company are all recorded as assets.
LIABILITY ACCOUNT
When there are costs a business is obliged to meet, they are entered into the liability account.
Common business liabilities include loans, bank fees, taxes and supplier payments.
REVENUE ACCOUNT
The revenue account records income, such as sales of goods and services. Other sources of business income might include interest income and revenue from investments.
EQUITY ACCOUNT
Equity is quite simply the value remaining when a business’s liabilities are deducted from its assets. It is the residual value of the owners interest in the business. This equity can be in the form of stocks and bonds, real estate, pension plans and debt security, for example.
We’ll look again at the fictitious Bob’s Hardware Store to put some debits and credits into context:
In the morning, Bob sells no less than five of his new line of ladders to one of his favorite clients, who pays him on the spot in cash. At lunch, Bob pays the money into the bank and sits down to update his accounts.
Bob now has $500 more cash in the bank, and $500 less stock in his store. Under his Revenue Account he credits his cash $500. In his Assets Account, he enters a debit of $500.
Feeling bright about the future with sales going so well, Bob decides to invest in a flash commercial on his local TV station to attract even more clients. The bank happily loans Bob $2,500 to pay for the commercial.
The next time Bob updates his account (which he always does promptly!) he credits his Liabilities Account to the value of the loan – $2,500. At the same time, he enters a debit of $2,500 to his Assets Account for the cash. Of course, when Bob pays the TV station, he’ll have to update his accounts again!
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