The Different Between Debits and Credits
Every accounting system, whether you utilize a cash or accrual accounting method must utilize debits and credits. Debits and credits must also offset each other or be equal. Money Instructor defines the difference between the two this way:
- Debits decrease liabilities and equity. They also increase assets.
- Credits increase liabilities and equity and decrease assets.
While that’s a pretty clear definition, if you’re new to business that doesn’t really tell you how to use debits and credits. To further understand how debits and credits work, consider your general ledger and the journal entries that need to be made. Ultimately, the purpose of your general ledger is to have accurate balance sheets and income statements.
The General Ledger
Before we learn how to use debits and credit, do you know what the purpose of your general ledger is? A general ledger is an accounting form that bookkeepers utilize to maintain an accurate accounting of every transaction that takes place in the day to day operations of a business. The ledger contains a chart of accounts designed for a particular business and when a journal entry is made into the ledger, the entry must have both a credit and a debit.
A chart of accounts represents your business. For example, you have asset accounts such as cash in bank, accounts receivables, and fixed assets like equipment. It also contains liability and equity accounts such as accounts payables, loans payable, and owner equity.
Using Debits and Credits
Knowing upfront that debits and credits must be equal, lets look at some examples of debits and credits in financial accounting.
If you purchase inventory at $1,000, your journal entry would look like this:
- Debit to your inventory account of $1,000
- Credit to your cash in bank account of $1,000
If you pay all your utility bills that total $1,000, you journal entry would look like this:
- Credit to your cash in bank for $1,000 to pay the utility bills
- Debit your utility expense accounts: $500 to telephone, $250 to water, $250 to gas and electricity. Here the debits and credits still equal.
Companies that buy on credit will have to make journal entries for accounts payables that will look like this if say $1,000 is charged:
- Credit accounts payables $1,000
- Debit the expense account(s) $1,000
When it’s time to pay for the items you purchased on credit your journal entry would be this:
- Debit accounts payable $1,000 to clear the outstanding debt
- Credit your cash in bank once the $1,000 check is written, it’s not necessary to deal with the expense account; you did that first as shown above.
If you allow people to open charge accounts with your business, you to enter that into your general ledger this way:
- Debit your accounts receivable account for the amount the customer charged, say $1,000.
- Credit the appropriate sales account depending upon what was charged by the customer for $1,000
Once the customer pays you, your entry would become this:
- Credit your accounts receivable account to clear out the charge due for $1,000
- Debit the sales account utilized when you set up the receivable.
Debits and Credits: Simple Yet Challenging
The world of debits and credits can be simple and a challenge to master especially if you have a large chart of accounts. Once you master the task of understanding how debits and credit work in financial accounting, at tax time, you should be able to print your general ledger and all the debits should equal the credits to ensure balanced books.
If you’re new to using general ledgers, making journal entries, and using debits and credits, some software programs like Quickbooks and Peachtree Complete will help you set up your chart of accounts based on the type of business your own. Each time you record cash out or cash in, the guided set up tutorials in these two software systems will automatically debit and credit the appropriate accounts.
Learn the basics of using debits and credits by enrolling in a basic accounting class at your community college or speak with your tax professional to help you understand the reason they are used to ensure an accurate accounting of your financial records.