I completely get the mix-up between debits and credits in accounting—it’s a common headache. These two little words, debit and credit, have been confusing accounting students, investors, and business owners for centuries. But, once you understand it, you will agree it is an ingenious record-keeping method created centuries ago. In this article, I’ll break down these concepts with some clear examples that make sense to everyone.
Get ready for some lightbulb moments.
Essential Points
- Every financial transaction has two sides in the double-entry accounting system: a debit and a credit.
- Debits increase asset or expense accounts, while credits increase liability, equity, or revenue accounts.
- Tools like the expanded accounting equation (DEALER) help sort transactions correctly.
- Debits on the left and credits on the right
- The total value of Debits must always equal the total value of Credits
What are Debits and Credits in Accounting?
Debits and credits in accounting are the foundation of the double-entry accounting system. They represent the two sides of every business transaction. The concept is that every transaction has two sides: a debit and a credit. For every transaction something is given and something is received. In accounting, these two sides of every transaction are recorded in the General Ledger, in separate accounts with one being a debit and one being a credit. The dollar amount for the debit and the credit must also be equal.
This double-entry system ensures that the accounting equation remains balanced:
Assets = Liabilities + Owner’s Equity
To maintain this balance, the double-entry accounting system requires every transaction to have two parts, a debit and credit. If an account is debited, another must be credited for the same amount. The total dollar value of debits must always equal the total value of credits.
Debits and Credits in Accounts
Debits and credits are not inherently about increase or decrease but rather about the side of the account, they are entered on. To make things easier, think of debits and credits as the “left” and “right” sides of an account. Debits go on the left and Credits go on the right-hand side of an account.
I find that a practical way for me to explain debits and credits and how they each affect an account is to refer to the basic accounting equation:
Assets = Liabilities + Equity
Debits and credits either increase or decrease an account depending on which side of the accounting equation the account is in. For example, all asset accounts are on the left-hand side of the accounting equation and liabilities and equity are on the right-hand side of the accounting equation.
Furthermore, on the left-hand side of the accounting equations are all the asset accounts, and all asset accounts are increased by debits and decreased by credits. The opposite holds true for the right-hand side of the accounting equation. On the right-hand side of the accounting equation, we have the liabilities and equity accounts. These accounts are increased by credits and decreased by debits. This is the opposite of how debits and credits affect asset accounts.
In summary
- Assets Accounts: Debits on the left and Credit on the right. Debits increase the accounts, credits decrease the account.
- Liability and Equity Accounts: Debits on the left and Credit on the right. Credits increase the accounts, Debits decrease the account.
Graphical Representation of Debits and Credits in Accounts
If you are a visual learner like me, nothing is more helpful than the image below, especially when trying to understand different types of accounts. This is how I learned the concept more than 20 years ago and it still pops up on my mind automatically when I think of any accounting transaction.
The graphic starts with the accounting equation: Assets = Liabilities + Equity. There is a T account under assets which shows the debits are on the left and the credits are on the right. The plus sign shows that debits increase the asset accounts and the minus sign shows that credits decrease the asset accounts.
Moving on to the right-hand side of the equal sign, you see the T account below liabilities and Equity. Again, the debit is on the left-hand side, and the credit is on the right-hand side. This is always true. Debits are always on the left and credits are always on the right. But, notice the location of the plus and minus signs. They are opposite for Assets, on the left-hand side of the accounting equation.
Once you cross over the equal sign to the liabilities and equity side, the plus and minus sign reverse. Now you have a minus under debits and a plus sign under credits. This means that for liabilities and equity, debits decrease the account and credits increase the account.
Debits and Credits in the Expanded Accounting Equation
One very helpful trick is extremely helpful to remember if a debit increases or decreases an account. This trick works for all accounts, but first, I need to explain to you what the expanded accounting equation is.
The expanded accounting equation is an extension of the basic accounting equation, which is:
Assets = Liabilities + Owner’s Equity
The expanded equation provides a more detailed understanding of a company’s equity and how it is affected by various transactions.
The expanded accounting equation is:
Assets = Liabilities + Equity + Revenue − Expenses – Dividend
if we use some basic math and move things around, we get the rearranged expanded accounting equation
Dividends + Expenses + Assets = Liabilities + Equity + Revenue
You can now use the mnemonic DEALER to help you remember. Now the same rules of debits and credits in accounting apply. Debits on the left and credits on the right. Also, notice the plus and minus signs on the DEA side and the LER side.
DEA = LER
debit | Credit debit | Credit
+ – – +
Memorize these rules:
Dividends, Expenses, and Assets are increased by Debits.
Liabilities, Equity, and Revenue are increased by Credits.
How Debits and Credits Affect Asset Accounts
Debits increase asset accounts, while credits decrease them. For example, if a business purchases equipment for $10,000 in cash, the asset account “Equipment” is debited $10,000 to increase its balance, and the asset account “Cash” is credited $10,000 to decrease its balance.
Similarly, if a business receives $5,000 in cash from a customer for services rendered, the asset account “Cash” is debited $5,000 to increase its balance, and the revenue account “Service Revenue” is credited $5,000. The accounting equation (Assets = Liabilities + Owners’ Equity) must always remain in balance.
When an asset account increases with a debit, there must be an offsetting credit to another account, either decreasing another asset, increasing a liability, or increasing owners’ equity. Conversely, when an asset account decreases with a credit, there must be an offsetting debit to another account. This double-entry system ensures that the accounting records remain accurate and balanced.
How Debits and Credits Affect Liability Accounts
Debits decrease liability accounts, while credits increase them.
For example, if a company takes out a $20,000 loan, the liability account “Loans Payable” is credited $20,000 to increase its balance, reflecting the amount owed. When the company makes a payment of $5,000 towards that loan, the “Loans Payable” account is debited $5,000 to decrease the balance, and the asset account “Cash” is credited $5,000 to reduce the company’s cash position.
The accounting equation (Assets = Liabilities + Owners’ Equity) must remain balanced. When a liability account increases with a credit, there must be an offsetting debit to another account, either increasing another liability, decreasing an asset, or decreasing owners’ equity. Conversely, when a liability account decreases with a debit, there must be an offsetting credit to another account. This double-entry system ensures that the financial records accurately reflect the company’s obligations and maintain the fundamental accounting equation.
How Debits and Credits Affect Equity Accounts
Debits decrease equity accounts, while credits increase them.
For example, if an owner invests an additional $25,000 of their personal cash into the business, the equity account “Owner’s Capital” or “Common Stock” is credited $25,000 to increase the owner’s stake in the company. The offsetting debit of $25,000 would go to the asset account “Cash” to reflect the increase in cash from the owner’s investment.
Conversely, if the owner withdraws $10,000 from the business for personal use, the equity account “Owner’s Drawings” or “Dividends” is debited $10,000 to decrease owner’s equity. The offsetting credit of $10,000 would go to the asset account “Cash” to show the outflow of cash to the owner.
So in summary, transactions that increase owners’/shareholders’ equity are credited to equity accounts like Retained Earnings, Common Stock, and Paid-in Capital. Transactions that decrease equity are debited to equity accounts like Owner’s Drawings and Dividends Paid.
How Debits and Credits Affect Expense Accounts
In accounting, expense accounts track business costs and expenditures. Debits increase the balance of an expense account, while credits decrease it. When a company incurs an expense, such as paying for utilities or salaries, the expense account is debited, reflecting the increase in expenses Conversely, when an expense is reduced or reversed, the expense account is credited, decreasing its balance.
For example, if a company pays $2,000 in rent for the month, the expense account “Rent Expense” is debited $2,000 to increase its balance, and the asset account “Cash” is credited $2,000 to decrease the cash balance.
Similarly, if a company incurs $5,000 in utility expenses, the expense account “Utility Expense” is debited $5,000 to increase the expense, while the liability account “Accounts Payable” is credited $5,000 to increase the amount owed to the utility company.
The accounting principles of debits and credits ensure that the company’s financial statements accurately reflect the expenses incurred during a given period.
How Debits and Credits Affect Dividend Accounts
In accounting, dividends represent the distribution of a portion of a company’s earnings to its shareholders, and they have a unique interaction with debits and credits. Unlike most equity accounts, which are increased by credits, dividend accounts typically have a normal debit balance and are increased by debits. This means that when a company declares dividends, it records a debit to the dividends account. This debit entry in the dividend account reflects a decrease in retained earnings, as it represents earnings being returned to shareholders rather than being retained within the company for growth or debt payment.
For example, if a company declares a cash dividend of $10,000 to its shareholders, the dividend account “Dividends” is debited $10,000 to increase its balance, and the asset account “Cash” is credited $10,000 to decrease the company’s cash position.
Accounting 101 Debits and Credits in a Journal Entry
In accounting debits and credits are entered into the ledger with a journal entry. The total of debits must equal the total of credits ensuring the accounting equation remains balanced. This is known as double-entry bookkeeping. Each journal entry affects at least two accounts. For every debit entry, there must be a corresponding credit entry of equal amount, and vice versa.
In a journal entry, the debit is listed first and it is on the left side, then the credits on the right, following the fundamental principles of credit and debit.
Journal Entries Debits and Credits Examples
To illustrate journal entries, let’s consider a few examples:
- Purchasing Inventory on Credit
If a business purchases $5,000 worth of inventory on credit, the journal entry would be:
Debit: Inventory (Asset) $5,000
Credit: Accounts Payable (Liability) $5,000
This increases the Inventory asset while also increasing the Accounts Payable liability.
- Paying Salary to Employees
If a company pays $10,000 in salaries to employees, the journal entry would be:
Debit: Salary Expense $10,000
Credit: Cash (Asset) $10,000
This increases the Salary Expense account while decreasing the Cash asset account.
- Recording Revenue from Sales
If a business makes a $2,500 cash sale, the journal entry would be:
Debit: Cash (Asset) $2,500
Credit: Revenue $2,500
Accounting 101 FAQs
What are credits and debits in accounting?
Credits and debits are the two sides of a transaction in accounting. In every financial transaction, there is an equal amount recorded as a credit and a debit. This system is known as double-entry bookkeeping and helps to ensure accuracy and balance in financial records.
Explain the concept of double-entry accounting.
Double-entry accounting is a system of recording financial transactions where every transaction affects at least two accounts. For every debit entry, there must be a corresponding credit entry.
What is the accounting equation?
The accounting equation states that Assets = Liabilities + Equity. It shows the relationship between a company’s assets, liabilities, and owner’s equity.
What is accounting?
Accounting is the process of recording and summarizing financial transactions of a business or organization. It involves analyzing, interpreting, and presenting financial information.
What is bookkeeping?
Bookkeeping is the process of recording the daily financial transactions of a business. It includes tasks such as recording sales, purchases, receipts, and payments.
What is the role of an accountant?
An accountant is a professional who is responsible for preparing and analyzing financial records, ensuring compliance with tax laws, and providing financial advice to businesses and individuals.
