Your online business is getting ready to prepare its annual financial statements. Before you do this, you must check all accounts to see that the books balance. This process takes account of debits and credits—accounting terms used to describe all of a business’s transactions. Learn more about what they are and the role they play in double-entry accounting.
What is double-entry accounting?
Double-entry accounting is a system for recording transactions that involves debiting one account and crediting another account. The double-entry system typically displays two side-by-side columns with debits on the left and credits on the right. The document listing the entries is called a ledger.
The key feature of double-entry accounting (also known as double-entry bookkeeping) is the two columns of debits and credits balancing. Each transaction has a debit and credit entry, and the sum of debits on the left must equal the sum of credits on the right. Using debits and credits in this way allows a business to track money coming in and going out. Through a periodic review of the ledger called a trial balance, a business ensures its accounts are accurate, which is essential because the accounts figure in the preparation of financial statements.
The double-entry method often seems puzzling to newcomers. First, you must match transactions to the appropriate accounts for debit and credit entries. Second, the terms “debit” and “credit” are not always as simple as “add” and “subtract.” Although a debit typically decreases an account while a credit increases it, in some cases, as described below, the reverse is true.
The goal of double-entry accounting is to balance debits and credits to properly track the flow of money into and out of the business. Much of the work of double-entry accounting is automated by business software programs.
What is the accounting equation?
Before we can get into the details of how debits and credits work, it’s important to understand a fundamental concept of finance called the accounting equation. It looks like this:
Assets = Liabilities + Equity
This equation also can take the following form:
Assets - Liabilities = Equity
These two forms of the equation sum up a business’s balance sheet, one of three essential financial statements, along with the income statement and cash-flow statement. It’s called a balance sheet because the business’s assets must equal, or balance, the liabilities and equity.
What is a debit in accounting?
A debit signifies either an increase in an asset account or a decrease in a liability or equity account on the balance sheet. It also shows a decrease in a revenue account or an increase in an expense account on the income statement. Debits always are entered on the left side of a ledger.
For example, suppose a camping-gear business purchased a $10,000 computer system to improve its inventory control. It enters $10,000 as a debit to the equipment asset account.
What is a credit in accounting?
A credit has the opposite effect on the ledger: It signifies a decrease in assets or an increase in liabilities or equity on the balance sheet. It can also signify an increase in revenue or decrease in expenses on the income statement. Credits are entered on the right side of the ledger.
Using the example above, if the camping-gear business paid cash for the computer system, it enters $10,000 as a credit to the cash account, which is an asset account, to balance the $10,000 debit to the equipment asset account. On the other hand, if it purchased the computer with a payment due in 60 days, it would instead credit $10,000 to the accounts payable account, a liability account, to balance the $10,000 debit to the equipment asset account.
How to use debits and credits in accounting
Accounting based on the double entry system involves the following five types of accounts. The first three appear on a business’s balance sheet, and the latter two are found on the income statement.
Assets
Asset accounts include any resources owned or controlled by a business producing an economic benefit. Tangible assets include cash, property, factories, equipment, inventory, and accounts receivable, while intangible assets include patents, trademarks, and other intellectual property. A debit increases the value of assets, while a credit results in a decrease.
Liabilities
Liability accounts reflect a business’s payment obligations, including loans, bonds, accounts payable, and property and income taxes. A debit decreases a liability account; a credit increases it.
Equity
Equity includes contributions of money from owners, funds raised from selling stock to shareholders, and retained earnings, which are the profits not distributed to owners or paid to shareholders as dividends. A debit decreases an equity account, while a credit increases it.
Revenue
Revenue accounts, also called income accounts, are for money generated from all business operating and non-operating activities. This includes sales of goods and services, as well as royalties, interest payments, investment income, and rent. A debit decreases a revenue account; a credit increases it.
Expense
Expense accounts include cost of goods sold (COGS); selling, general, and administrative (SG&A) costs; and other operating or non-operating costs. Among COGS are raw materials and wages for production workers; SG&A expenses include rent, utilities, and staff salaries. Like assets, an expense account is increased by debits, and decreased by credits.
The charts below can help keep things straight. They show the five key account types on the balance sheet and income statement, with examples of how debits and credits impact each type of account.
| BALANCE SHEET | |||
| Assets | Liabilities | Equity | |
| Debit | INCREASE | DECREASE | DECREASE |
| Credit | DECREASE | INCREASE | INCREASE |
| INCOME STATEMENT | ||
| Revenue | Expenses | |
| Debit | DECREASE | INCREASE |
| Credit | INCREASE | DECREASE |
Debit vs. credit accounting examples
Here’s an example of debit vs. credit accounting on a balance sheet.
Imagine a camping-gear retailer buys $100,000 of tents and sleeping bags from manufacturers on credit, payable in 60 days. Here is how a debit and credit entry might look in double-entry accounting with the account types shown in parentheses:
| DATE | ACCOUNT | DEBIT | CREDIT |
| XX/XX/XXX | Inventory (asset) | $100,000 | |
| Accounts payable (liability) | $100,000 |
Separately, the business sells $50,000 of camping and hiking gear, giving customers 30 days to pay. The sales tax in the company’s state is 5%, or $2,500, so the total sale is $52,500. Here is how debit and credit entries might look:
| DATE | ACCOUNT | DEBIT | CREDIT |
| XX/XX/XXX | Accounts receivable (asset) | $52,500 | |
| Product sales (revenue) | $50,000 | ||
| Sales tax (accounts payable - liability) | $2,500 |
Note the above is an example of two credit entries balancing a single debit entry. The important point is the sum of debits always equals the sum of credits.
Once customers pay for the gear later in the month, the ledger is updated with the following debit and credits:
| DATE | ACCOUNT | DEBIT | CREDIT |
| XX/XX/XXX | Cash (asset) | $52,500 | |
| Accounts receivable (asset) | $50,000 | ||
| Sales tax remitted (cash/asset) | $2,500 |
In the final example, let’s say the camping-gear business wants to expand and needs $200,000. It obtains a $100,000 loan from a bank, and it raises another $100,000 by selling shares to investors. This is how the transaction might appear in the ledger:
| DATE | ACCOUNT | DEBIT | CREDIT |
| XX/XX/XXX | Cash (asset) | $200,000 | |
| Loan payable (liability) | $100,000 | ||
| Common stock (equity) | $100,000 |
Similar to the customer sale, this transaction has a debit matched by an equal credit that’s in two parts. The important point in double-entry accounting is the left-side value—$200,000—is equal to the two $100,000 entries on the right-side value.
Debit and credit accounting FAQ
Is a credit positive or negative?
A credit can be positive or negative, depending on the type of account affected. For liability, equity, and revenue accounts, a credit increases the account’s value. For assets and expenses, a credit is negative, decreasing the account value.
Does a debit always mean an increase?
A debit can increase or decrease an account. Debit entries increase asset and expense accounts, while they decrease liability, equity, and revenue accounts.
What is the accounting equation?
The accounting equation is the foundation for double-entry accounting using debits and credits. It is represented as follows: Assets = Liabilities + Equity. In other words, the value of the business’s assets always equals all the claims on those assets by creditors (liabilities) and the owners (equity).
