Debits and credits are the foundation of double-entry accounting. They indicate an amount of value that is moving into and out of a company’s general-ledger accounts. For every transaction, there must be at least one debit and credit that equal each other. When that occurs, a company’s books are said to be in “balance”. Only then can a company go on to create its accurate income statement, balance sheet and other financial documents.
What Are Debits (DR) and Credits (CR)?
In accounting, the definitions of debit and credit may seem counterintuitive to what they mean in everyday language. These differences are important to grasp from the start. In accounting, a debit (DR) typically records an amount of value flowing into an asset or bank account — unlike, for example, a debit card, where money is taken out of an account. On the flip side, a credit (CR) generally records an amount of value flowing out of an asset account, as opposed to receiving credit in the form of a loan or return, where money flows into an account. Debits and credits are recorded as monetary units, but they’re not always cash and may include gains, losses and depreciation. For this reason, we refer to them as “value.”
Debits and credits underpin a bookkeeping system called double-entry accounting, in which every transaction equally affects two or more separate general-ledger accounts, such as assets and liabilities.
Debits vs. credits: Debits and credits are like the yin and yang of accounting, interconnected and responsible for keeping a business’s bookkeeping entries in balance and harmony. There is no debit without a credit. A debit increases the balance of an asset, expense or loss account and decreases the balance of a liability, equity, revenue or gain account. Debits are recorded on the left side of an accounting journal entry. A credit increases the balance of a liability, equity, gain or revenue account and decreases the balance of an asset, loss or expense account. Credits are recorded on the right side of a journal entry.
|Debits (DR)||Credits (CR)|
|Increase asset, expense and loss accounts.||Increase liability, equity, revenue and gain accounts.|
|Recorded on the left side of an accounting journal entry.||Recorded on the right side of an accounting journal entry.|
- Every transaction in double-entry accounting is recorded with at lease one debit and credit.
- Debits and credits indicate where value is flowing into and out of a business. They must be equal to keep a company’s books in balance.
- Debits increase the value of asset, expense and loss accounts. Credits increase the value of liability, equity, revenue and gain accounts.
- Debit and credit balances are used to prepare a company’s income statement, balance sheet and other financial documents.
Debits and Credits Explained
In double-entry accounting, every transaction is recorded with a debit and credit in two or more accounts, which categorize different types of financial activities in a company’s general ledger. Debits and credits are both opposite and equal (though each line debit/credit doesn’t necessarily have an equal counterpart), occur simultaneously and represent a transfer of value. For example, if a business purchases a new computer for $1,200 on credit, it would record $1,200 as a debit in its account for equipment (an asset) and $1,200 as a credit in its accounts payable account (a liability). If, instead, it pays for the computer with cash at the time of purchase, it would debit and credit two types of asset accounts: debit for equipment and credit for cash.
Drilling down, debits increase asset, loss and expense accounts, while credits decrease them. Conversely, credits increase liability, equity, gains and revenue accounts, while debits decrease them. As such, accounts are said to have a natural, or natural positive credit/debit balance, credit or debit balance based on which one increases the account. For example, assets have a natural debit balance because that type of account increases with a debit.
Why Are Debits and Credits Important?
Debits and credits keep a company’s books in balance. They are recorded in pairs for every transaction — so a debit to one financial account requires a credit or sum of credit of equal value to other financial accounts. This process lies at the heart of double-entry accounting. Accuracy is crucial because accounts “roll up” into specific lines on a company’s balance sheet or income statement, both of which paint a picture of a company’s financial health, value and profitability. They also inform decision-making for internal and external stakeholders, including company management, lenders, investors and tax agencies.
How Are Debits and Credits Used?
Debits and credits indicate value flowing into and out of a business. They are equal but opposite and work hand in hand: For every transaction, an accountant or bookkeeper places a debit in one account and a credit in another account. No matter how many accounts or line items are involved, the total value of debits equals the total value of credits.
How debits and credits affect different types of accounts: An organization’s general ledger is composed of seven types of accounts, which appear on its various financial statements: assets, liabilities, equity, revenue, expenses, gains and losses.
- An asset account reflects the value of resources owned by a company and is expected to provide future economic benefit. Examples include cash, accounts receivable, inventory and property.
- An expense account reflects the costs a company incurs for conducting business and generating revenue. Examples include the cost of goods sold (COGS) or services delivered, employee salaries, travel, advertising and rent.
- A liability account reflects the amount a company owes. Examples include credit card accounts/balances, accounts payable, notes payable, taxes and loans.
- An equity account reflects the shareholders’ interests in the company’s assets. Examples include stocks, distributions, capital contributed, dividends and retained earnings.
- A revenue account reflects the amount of money generated from operating and nonoperating activities. Operating examples include sales and consulting services; nonoperating examples include interest and investment income.
- A gain account reflects an increase in value from activities not related to the core business. Examples include money won from a lawsuit and a gain in value from the sale of an asset or business property.
- A loss account is the opposite of a gain account, reflecting a decrease in value from nonprimary-business events. Examples include money paid for the loss of a lawsuit and a loss in value from the sale of an asset or business property.
For every business transaction — whether a company is receiving payment from a customer, reimbursing a salesperson for travel, purchasing office supplies or taking out a loan — the amount of value changes in at least two accounts. Here’s how debits and credits impact the seven types of accounts:
Debits and Credits T-Chart
A “T chart”, also referred to as a “T-account”, is a two-column chart that shows activity within a general-ledger account. The chart resembles the shape of the letter “t”, where the left column displays debits and the right column displays credits. The name of the account — such as cash, inventory or accounts payable — appears at the top of the chart.
Say, for example, your company buys $10,000 worth of monitors on credit. The purchase translates to a $10,000 increase in equipment (an asset) and a $10,000 increase in accounts payable (a liability) for money owed. The T-charts will look like this:
At the end of the month, you’re ready to pay your bill. The accounts payable account will be debited to remove the liability, and the cash account will be credited to reflect payment (value flowing out). The T-charts will look like this:
Examples of Debits and Credits
Now let’s examine a more complex example of a transaction that calls for debits and credits across multiple accounts. Let’s say your company sells $10,000 worth of monitor stands, and you’re based in Arizona, where the state sales tax is 5.6%. The total charge to the customer is $10,560, which will be the exact amount you will debit (increase) your accounts receivable. You will also debit (increase) your COGS accounts, which we’ll earmark as $5,000. Now we shift to the credit half of the recording process. Your revenue account will be credited (increased by) $10,000 (the purchase price), your liabilities account will be credited (increased by) $560 (for sales tax payable) and your inventory account will be credited (decreased by) $5,000 (the value of the inventory).
The sum of the debits ($10,560 + $5,000) is $15,560. The sum of the credits ($10,000 + $5,000 + $560) is also $15,560. Congratulations! You have mastered double-entry accounting — at least for this transaction.
|Sales Tax Payable||$560|
Manage Debits and Credits With Accounting Software
It’s not difficult to imagine how much time and energy it might take an accountant or bookkeeper (or teams of them) to manually record debits and credits for hundreds or thousands of business transactions and make sure they’re all in balance. All it takes is one error to throw off the books and resulting financial statements. This is why the task is best handled by software, such as NetSuite Cloud Accounting Software, which simplifies and automates many of the processes required by double-entry accounting. That includes recording debits and credits, as well as managing a company’s general ledger and chart of accounts. Once a transaction is created — the software can handle that for certain journal entries, too — debits and credits will be automatically posted to the correct accounts. NetSuite also streamlines accounts receivable, accounts payable and close management processes, boosting efficiency and improving cash flow. All of these capabilities feed into a company’s ability to produce highly accurate financial statements and reports.
The concepts of debits and credits may be clear to accountants and bookkeepers, but they take some getting used to when you’re a business owner who thinks in the everyday terms of credit and debit cards. In the world of double-entry accounting, every transaction impacts two or more financial accounts, whereby a debit indicates value flowing in and a credit indicates value flowing out. The two sides must be equal to balance a company’s books, which are used to prepare financial statements that reflect its health, value and profitability.
Debits and Credits FAQs
What are examples of debits and credits?
Say your company buys $10,000 worth of monitors on credit. The purchase translates to a $10,000 increase in equipment (an asset) and a $10,000 increase in accounts payable (a liability) for money owed. At the end of the month, you’re ready to pay your bill. The accounts payable account will be debited to remove the liability, and the cash account will be credited to reflect payment.
How are accounts affected by debit and credit?
Debits increase asset, loss and expense accounts; credits decrease them. Credits increase liability, equity, gains and revenue accounts; debits decrease them.
What are debits and credits?
Debits and credits are considered the building blocks of bookkeeping. A debit may be referred to as a “DR”. A credit may be referred to as “CR” — these are the shortcut references.