What are debits and credits, and why is it important to know for bookkeeping? Accounting uses a double-entry system, which means that debits (left-side entry) and credits (right-side entry) must match.
First, let’s talk about the following different account types: assets, liabilities, equity, revenue, and expenses.
An asset is anything that holds value for the company. A liability is any financial obligation that the company owes, whether to a person or another company. Equity is the owners’ stake in the company. Revenue is the income that the company made. Expenses are costs incurred to earn that revenue.
Assets, liabilities, and equity are on the balance sheet, while revenue and expenses are on the income statement.
The equation below must be balanced for every transaction.
Assets = Liabilities + Equity
An easy way to think about debits and credits on a balance sheet is like a debit and credit card.
Assets are the debit card, and liabilities and equity are the credit cards.
A debit card is linked to money you own in your bank, so debiting it means that you are increasing the amount in your bank account and crediting it means you are decreasing the amount in your bank account.
So, debiting increases an asset account, while crediting decreases an asset account.
A credit card is money you borrowed from the bank, so it is the opposite of a debit card. Crediting on a credit card means that you’re increasing the credit owed to the borrower, while debiting it means that you are decreasing the account owed to the borrower.
So, crediting increases liability and equity accounts, while debiting decreases liability and equity accounts.
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Example 1: Company A buys new equipment using $5,000 in cash.
Using the equation:
Cash (asset) decreases by $5,000, and equipment (assets) increases by $5,000.
The entry will be a debit to equipment for $5,000 and credit to cash for $5,000.
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Example 2: Company B buys new equipment on account for $5,000.
Using the equation:
Equipment (asset) increases by $5,000, and accounts payable (liability) increases by $5,000.
The entry will be a debit to equipment for $5,000 and credit to accounts payable for $5,000.
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Example 3: Company C buys new equipment for $7,000. The company pays $1,000 in cash and $6,000 on account.
Using the equation:
Cash decreases by $1,000, accounts payable (liability) increases by $6,000, and equipment (assets) increases by $7,000.
The entry will be a debit to equipment for $7,000, credit to cash for $1,000, and credit to accounts payable for $6,000.
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Now, let’s expand the equation to include revenue and expenses.
Assets = Liabilities + Equity + (Revenue – Expenses) [Current year]
Revenue increases the owner’s equity, so crediting increases the revenue account and debiting decreases the revenue account.
Expenses are the opposite of revenue, so debiting increases the expense account and crediting decreases the expense account.
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Example 1: Company B receives $3,000 of rental income.
Using the equation:
Rental income (revenue) increases by $3,000, and cash (asset) increases by $3,000.
The entry will be a debit to cash for $3,000 and credit to rental income for $3,000.
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Example 2: Customer returns $600 item due to a malfunction.
Using the equation:
Cash (asset) decreases by $600, and sales revenue (revenue) decreases by $600.
The entry will be a debit to sales revenue for $600 and credit to cash for $600.
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Example 3: Company C purchases a $200 saw needed to complete a job for a client.
Using the equation:
Cash (asset) decreases by $200, and small tools (expense) increase by $200.
The entry will be a debit to small tools for $200 and credit to cash for $200.