Debits and credits are undoubtedly the most commonly used terms in accounting. But before we go into the details of debits and credits, let’s briefly discuss the double-entry accounting system, as it will help us in understanding debits and credits.
As the name suggests, double-entry accounting system is a method of accounting which is based on the principle that every business transaction has two aspects. For recording each business transaction, there is always a corresponding effect on one or more accounts that needs to be recorded as well. For example, if an entity has paid USD 100 as rent expense, it should be recorded as follows:
- USD 100 is recorded as rent expense; and
- USD 100 is recorded as reduction in cash.
We’ll discuss this double-entry accounting system in detail, but for now, it must be kept in mind that this is the system that is being used all over the world, and it uses debits and credits to record the business transactions. Therefore, to be a good accountant, understanding the basics of double-entry accounting system is particularly important.
What are debits and credits?
Like in mathematics, “Plus (+)” is used to add something and “Minus (-)” is used to subtract something, similarly in accounting, debits and credits are used to record the transactions either adding or subtracting amounts in relevant accounts. BUT THERE IS A CATCH!
It is not completely like mathematics. In accounting, nature of all five (5) types of accounts is predefined. These accounts are either debit or credit in nature. Accordingly, if a transaction to be recorded involves an account whose nature is debit, then a debit entry will be used to increase the balance and a credit entry will be used to reduce the balance of that account. Similarly, if a transaction to be recorded involves an account whose nature is credit, then a credit entry will be used to increase the balance and a debit entry will be used to reduce the balance of that account.
Let’s take a look at the nature of all five types of accounts and then we’ll go through some examples.
|Debit in Nature||Credit in Nature|
|Income or revenues|
To make it clearer, Let’s look at debits and credits in another way along with an illustration.
Accounts are often represented as T-accounts which have two sides. Left side is called debit side whereas right side is called credit side. For illustrative purposes, we’ll post the following transactions into relevant T-accounts for better understanding:
- Purchase of goods worth USD 50 on credit.
- Sale of goods to customers worth USD 65 on credit.
- Payment of USD 50 made to supplier.
- Receipt of USD 65 from customer.
- Receipt of USD 25 from opening receivables balance.
The above transactions are related to following accounts:
- Cash account (an asset account)
- Trade receivables account (an asset account)
- Trade payable account (a liability account)
- Sales account (an income account)
- Cost of sales account (an expense account)
Let’s make T-accounts of above-mentioned accounts and record the illustrative transactions.
* Dr. is the abbreviation of debit, whereas Cr. is the abbreviation of credit.