Debits and Credits
Debits and credits are the fundamental concepts in the double-entry bookkeeping system, which is the basis for nearly all modern accounting systems.
In this system:
- Debit (Dr): A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is positioned on the left side in an accounting entry.
- Credit (Cr): A credit is an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is positioned on the right side in an accounting entry.
The use of debits and credits allows the accounting system to maintain balance, reflected in the equation: Assets = Liabilities + Equity.
The rules can be summarized as follows:
- Assets: Debit to increase, Credit to decrease.
- Liabilities: Credit to increase, Debit to decrease.
- Equity: Credit to increase, Debit to decrease.
- Revenue: Credit to increase, Debit to decrease.
- Expenses: Debit to increase, Credit to decrease.
Every financial transaction affects at least two accounts; one must be debited and the other credited by an equal amount. This is known as the principle of “double-entry” and it enables the accounting equation to always remain in balance.
It’s important to note that in accounting, the terms “debit” and “credit” do not have the same connotations as they do in everyday language. They are not synonymous with “increase” and “decrease” nor do they mean “good” or “bad.” They are simply terms used to describe the two sides of a transaction in double-entry bookkeeping.
Example of Debits and Credits
Let’s go through an example of a simple business transaction and see how debits and credits apply:
Scenario: Let’s say a business, named Best Bakery, decides to buy a new oven for their kitchen. The oven costs $2,000 and they decide to purchase it outright using the business’s cash.
Here’s how the transaction would be recorded in the company’s accounting system:
- Best Bakery’s cash account (an asset account) would decrease by $2,000. To record a decrease in an asset account, you would credit the account. So, you’d credit Cash for $2,000.
- Best Bakery’s equipment account (another asset account) would increase by $2,000 because they now have a new asset: the oven. To record an increase in an asset account, you would debit the account. So, you’d debit Equipment for $2,000.
The journal entry for this transaction would look like this:
So, in this example, Best Bakery debited (increased) the Equipment account and credited (decreased) the Cash account. This keeps the accounting equation in balance: Assets (Cash + Equipment) = Liabilities + Equity. Even though the cash decreased, the total assets remain the same because the value of equipment increased.