Debit vs Credit Accounting Explained
Understanding debit vs credit accounting is one of the crucial steps in learning the fundamentals of bookkeeping and accounting. Knowing the difference will help you record business transactions correctly, avoid costly mistakes, and decrease your risk of an IRS audit.
Solid record-keeping shapes every financial move your business makes by influencing how you track cash, measure performance, and understand your business's financial health. That's why most businesses entrust their books to accounting experts who work to keep them compliant and offer invaluable insights into their business activity.
What Are Debits and Credits?
Debits and credits represent the two sides of every accounting entry in your business. Debits increase assets and expense accounts, while credits increase liabilities, revenue, and equity accounts. They work together to keep your financial records balanced by showing how each financial transaction impacts different accounts.
When an asset account like equipment, inventory, or cash goes up, you record a debit. When a liability or revenue account goes up, you record a credit. This rule applies consistently across all business transactions.
A Common Misconception About Debits and Credits
A common misconception among beginners to accounting is that debits always signify money coming in and credits always show money going out. In reality, it depends entirely on the type of account.
A debit simply means you're adding value to asset accounts, like cash or equipment. A credit means you're adding value to liability accounts, such as accounts payable. These terms don't describe cash flow. Rather, they describe how different accounts are affected by each transaction.
Debits and credits are one of the fundamental principles behind bookkeeping for beginners that small business owners must master if they want to take care of their own books. Alternatively, working with an expert in small business accounting ensures mistakes, such as misclassifying debits and credits, don't slip through the net and become more serious problems down the line.
The Role of Debits and Credits in Double-Entry Accounting
Every transaction your business makes impacts at least two accounts. This is where double-entry bookkeeping comes in. Nearly all businesses use double-entry bookkeeping to record transactions. It’s also required by the Generally Accepted Accounting Principles (GAAP).
Total debits must equal the total credits for the books to be balanced in this system. Imbalances help businesses and tax authorities detect discrepancies and fraud. This is because any imbalance signals that something has gone wrong.
Most accounting and bookkeeping professionals use the double-entry system. It's also the standard system on accounting software platforms. The basis of this system is sorting your business transactions into a chart of accounts.
Common business accounts include:
Asset Accounts
Asset accounts track resources that businesses own that will provide future benefits. Assets include cash, inventory, equipment, and furniture.
Liability Accounts
Liability accounts track what your business owes. Common liabilities include credit cards, bank loans, unpaid taxes, and money owed by the business to employees and suppliers.
Equity Accounts
Equity accounts show the owners' financial interest in the business. This includes their capital, any withdrawals they've made, and retained earnings.
Revenue Accounts
Revenue accounts record what the business earns. Revenue includes income from sales, interest, rent, and other miscellaneous earnings.
Expense Accounts
Expense accounts track the costs needed to run a business. This account covers expenses like rent, utilities, salaries, marketing costs, insurance, and depreciation.
Understanding how these accounts behave makes the concept of debits and credits much easier to grasp. However, a rudimentary understanding isn't enough for most business owners. These changes must also be entered meticulously to maintain accurate records, remain compliant, and for business owners to really understand where their business earns and loses money.
Pro tip: Your trial balance will help you check that your books balance and that debits equal credits in your ledger. Your accountant will help you understand your books and use them as a basis to make strategic business decisions that contribute to growth.
The Normal Balance Rule
A "normal balance" is an important term in accounting as it tells you which side of an account (debit or credit) increases it. Every account has a "normal" side. You need to know whether each account increases with a debit or a credit when you record a transaction.
Accounts that normally have debit balances include:
Asset accounts
Expenses accounts
Accounts that normally have credit balances include:
Liability accounts
Equity accounts
Revenue accounts
Debits and Credits in Practice
Let's imagine a hairdressing salon in Jacksonville, Florida. The salon's bookkeeper records every business transaction and reflects the changes each transaction has on different accounts:
Situation 1: The salon receives a utility bill for $150, which they must now pay. This bill is an expense covering electricity for the month.
Journal entry:
Debit utilities expense $150 (expense increases)
Credit accounts payable $150 (liability account increases)
In this case, no money came into the business. However, the expense account increased with a debit because you're recognizing the cost for the month.
Situation 2: A client receives a $100 haircut but will pay next week
Journal entry:
Debit accounts receivable $100 (assets increase as the client owes money)
Credit service revenue $100 (revenue account increases)
No money left the business in this case. However, the credit represents earned income. This is an example of when revenue increases with a credit, but no money actually leaves the business.
Situation 3: Liability increases with a credit. The salon signs for $2,000 worth of hair styling products that will be delivered later in the week.
Journal entry:
Debit inventory account $2,000 (asset account increases)
Credit accounts payable $2,000 (liability increases)
The salon didn't spend cash today. However, its liability account increased with a credit because the company owes its supplier money.
The Role of the General Ledger and Sub-Ledger
Every debit and credit recorded in your bookkeeping flows into a structured system of ledgers, which includes the sub-ledger and general ledger. The general ledger acts as the master record, summarizing all account activity across assets, liabilities, equity, revenue, and expenses.
Sub-ledgers track the detailed transactions behind specific accounts, such as individual customer invoices in accounts receivable or supplier bills in accounts payable. Together, these ledgers ensure your books stay balanced, provide clarity on each transaction, and form the foundation for accurate financial statements. Your accountant will handle your business’s ledgers and use them to flag inconsistencies and offer insights into your business’s performance.
The Role of Debits and Credits in Financial Statements
Debits and credits work as a bridge between everyday bookkeeping and the meaningful financial reporting that shapes your business strategy. Every transaction you record flows into one or more accounts that ultimately make up the balance sheet and income statement. Together, these give you a full financial snapshot of your business.
Debits increase asset accounts, and credits increase liability and equity accounts on the balance sheet. Everyday updates to cash, inventory, or owner's equity accounts influence the numbers that appear on the balance sheet.
Debits increase expenses, and credits increase revenue on the income statement. Every transaction contributes to the final profit or loss shown on the income statement.
Accurate Bookkeeping Improves Your Financial Health
Mastering debits and credits is one of the most important parts of understanding your business's finances. Your entire accounting system becomes much easier to navigate when you understand how each account behaves and which side increases it.
Accounting software automates much of the behind-the-scenes work. However, partnering with an expert accountant ensures your records stay accurate, and helps you improve your business's finances going forward.
