The most basic accounting concept is often the most misunderstood and easily confused. As the language of business, accounting is utilized in virtually every company or organization to help keep track of transactions and “balance the books”. So, to shed some on the difference between debits and credits, as well as fundamental principles of accounting, I’ve put together this article. Let’s begin from the bottom-up, the accounting equation.
The Accounting Equation
To understand the basics of accounting principles, the most important concept to keep in mind is the accounting equation. Balancing this formula is the primary aim of accounting processes. Being aware of it will be critical in knowing the “why” behind virtually everything else in accounting. The equation is as follows:
Assets = Liabilities + Shareholders’ Equity
An asset is “an economic resource that is expected to generate future benefits for a business” (Simko, Farris, & Wallace, 2017). Typically, assets include any property (tangible and intangible), plant (buildings, land, etc.), and equipment that is owned by a company.
A liability is “simply an obligation to make future payments” (Simko, Farris, & Wallace, 2017). Some typical liabilities include loans, lease agreements, contracts, and accounts payable.
Shareholders’ equity is “the residual value of a business – that is, the value of any assets remaining after all liabilities have been satisfied” (Simko, Farris, & Wallace, 2017). Shareholders’ equity frequently shows up on financial statements of publicly traded companies as two parts, common stock and retained earnings. Common stock is investors’ claim or shares in a business and retained earnings is the amount of profit kept in the company to fund future operations.
Now that we have an idea of the basic formula for accounting let’s take a look at what goes into keeping the math balanced.
When a business transaction occurs, there will always be one party trading something with another party in exchange for something else. A straightforward example is when you buy food from a grocery store. You’re paying money in exchange for receiving food from the grocery store.
Let’s say you pay for the groceries from your checking account. Your bank account decreases by the purchase amount, and the grocery store’s bank account increases by the same amount. In accounting terms, we say that your bank account records a debit, and the grocery store’s bank account records a credit.
What’s a Debit?
A debit either increases an asset or expense account or decreases a liability or shareholders’ equity account. In our example above, the grocery store is receiving an asset (cash), so it’s going to increase the cash balance in its bank account by recording a debit. On our bank account, we debit our grocery expense account to record the proper cash flow from the transaction.
What’s a Credit?
A credit either decreases an asset or expense account or increases a liability or shareholders’ equity account. From our example, our checking account is going to go down, because we paid the grocery store with an asset (cash). The transaction posts as a credit to our cash balance. At the same time, the grocery store will record a credit to its revenue balance, which is an equity account. The accounting equation is thus balanced.
Let’s take a look at how each account would be reflected in a journal entry. Debits appear on top and to the left, while credits appear on the bottom and are indented to the right. This concept is referred to as double-entry accounting and has been used for hundreds of years to help balance recorded sales.
Grocery Store’s Journal Entry:
| Cash | $$$ |
| Revenue | $$$ |
Our Journal Entry:
| Grocery Expense | $$$ |
| Cash | $$$ |
How to Know the Difference
As explained above, the cash transaction is both a debit and a credit, depending on which party’s account is recording the transaction. This is an important difference to understand.
Both the grocery store and you have bank accounts that record the flow of money in and out of the respective accounts. A debit to one is a credit to the other and vice-versa. Here lies the rub. To understand the difference, you must first identify which account is reflecting the transaction.
Does the account represent an asset or expense to you? If so, then a debit will mean it is increasing, and a credit will indicate it is decreasing.
Does the account represent a liability or shareholders’ equity to you? If so, then a credit will symbolize an increase in it and a debit will indicate a decrease.
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Sources
Simko, P., Farris, K., & Wallace, J. (2017). Financial Accounting for Executives & MBAs. Cambridge Business Publishers.