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double entry accoutning

Understanding Debits and Credits

by Sanjeev Archak Sanjeev Archak No Comments

Every industry runs on jargon. These jargon often trip people. In the accounting world the tripwires are “Debit” and “Credit”. There is no doubt that Debit and Credit are the cornerstones of the accounting block. Understanding debits and credits will help a business owner read financial statements better than before.

What are Debits and Credits?

In a nutshell, debit represents all the money flowing into business and credit represents all the money flowing out of business. Most businesses these days use double-entry system of accounting. Under this system, every transaction has two legs i.e, a debit and a credit leg.The entire business is organised into individual accounts. For ease of understanding lets call these accounts as buckets

For example:

  • the cash in your bank account will be the  “Cash” bucket
  • the value of your  furniture will be the “Furniture” bucket
  • the bank loan taken by your  business will  be the “Loan” bucket

Whenever your business purchases furniture or repays or avails a loan the balances in these buckets changes. Recording the changes in these buckets requires a language other than English. That is where debits and credits come in. Often, accountants abbreviate debits and credits to dr and cr.

How do debits and credits operate?

In a business money doesn’t appear or disappear out of nowhere. Debits and credits are designed to track where money is coming from and where to it goes.

Let’s take an example where you decide to buy a piece of furniture for Rs 50,000, here is how it will look like in our bucket system:

  • Firstly, money will move out of the cash bucket, cash bucket stands credited for Rs 50,000
  • Secondly, the furniture bucket will increase by Rs 50,000

As mentioned earlier, in the double entry system every debit has a corresponding credit. Here is how the entry will look like:

Account Debit Credit
Furniture          50,000
Cash          50,000

An accountant would say that we are crediting the bank account for Rs 50,000 and debiting furniture for Rs 50,000.

How do debits and credits operate in liability accounts?

The cash and furniture buckets are “asset” buckets. There are “liability” buckets as well. Examples of liability bucket are business loans, share capital. Yes, your own share capital is a liability for the business. We will get to that later in this post. Let’s see how debit credit and operate when you borrow a loan of Rs 50,000:

  • Firstly, money will move into the cash bucket, cash bucket stands debited for Rs 50,000
  • Secondly, money will move into the loan bucket, loan bucket stands credited for Rs 50,000

This transaction has increased the cash and loan balances. Cash balance denotes what you have and the loan balance denotes what you owe. Here is how the entry will look like:

Account Debit Credit
Cash          50,000
Loan          50,000

How do debits and credits operate in equity accounts?

Let’s take a situation where you invest Rs 50,000 as equity share capital in the business, debit and credit will operate as under:

  • Firstly, money will move into the cash bucket, cash bucket stands debited for Rs 50,000
  • Secondly, money will move into the equity bucket, equity bucket stands credited for Rs 50,000

Why is it that crediting an equity account makes it go up, rather than down? That’s because equity accounts don’t measure how much your business has. Rather, they measure all of the claims that investors have against your business. Here is how the entry will look like:

Account Debit Credit
Cash          50,000
Equity          50,000

The Debit and Credit Thumb Rule

Here is a simple way to remember debits and credits in accounting:

Debit Credit
Increases an asset account Decreases an asset account
Increases an expense account Decreases an expense account
Decreases a liability account Increases a liability account
Decreases an equity account Increases an equity account
Decreases revenue Increases revenue
Always recorded on the left Always recorded on the right

If you’d rather not deal with debits and credits at all, try Integra. We’ll do your double-entry bookkeeping for you, all online, no matter where you are in world.