Debit and credit: Explained

Debit and credit play key roles in business financial operations.

In accounting, these two bookkeeping entry types are two sides of the same coin. This means if you debit one account, you need to credit at least one other account to ensure balance.

If you’re using a double-entry accounting system, every debit or credit transaction impacts at least two of your accounts.

Understanding the differences and similarities between debits and credits is critical for your company to stay profitable and ensure that both money in and money out are effectively managed.

Only dealing with one side of the equation—credit or debit—can lead to problems with cash flow or solvency that may impact your operations.

In the best-case scenario, issues with credits and debits require extra work to solve.

In the worst case, your business has to close.

Here’s what you need to know about debit, credit, and keeping your business finances balanced.

Accounting for accounts

Before diving into debits and credits, we need to start with a quick accounting overview. Specifically, we need to talk about accounts.

There are five account types in bookkeeping:

• Assets
• Liabilities
• Equity
• Revenue
• Expenses.

They are all represented in the standard accounting equation:

Assets = liabilities + equity + revenue – expenses.

Your assets, liabilities, and equity are also known as your balance sheet accounts, while your revenue and expenses are known as your income statement accounts.

With each of these larger accounts, you can have smaller account types, such as petty cash, accounts receivable, or accounts payable.

Every transaction in any of these accounts must be entered as either a debit or a credit.

In a double-entry system, any action taken in one account causes a reaction in at least one other.

This means that if you debit one account, at least one other account must have a credit. If you credit an account, another account must have a debit.

Here’s a look at each account type:

Assets

Assets are any items that can help provide future economic benefits for your business.

Some common examples include cash, inventory, equipment, and accounts receivable. Each of these asset types represents its own account under the larger banner of assets.

While you could combine all of these accounts into a single asset record, this would make it almost impossible to track the type and value of specific assets.

Liabilities

Liabilities represent obligations that your business must pay. These may include bank loans, credit card balances, customer credits, and accounts payable.

Equity

Equity includes the money or property that could be returned to owners or shareholders if all business assets were liquidated and all outstanding debts were paid off.

Worth noting? This value can be negative.

For example, if liquidating all assets including cash, equipment, vehicles, and furniture isn’t enough to cover your debts, negative equity is the result.

Revenue

Revenue includes account types such as sales, royalties, and the costs of goods sold (COGS).

The simplest way to think about revenue is as the income earned from the sale of goods and services.

Expenses

Expenses are the costs of operating your business.

Common examples include employee wages, rent on retail spaces, utility bills, and the costs of marketing and advertising.

If you need to pay the cost to stay profitable and it isn’t part of the price of creating your product or service, it’s an expense.

What is debit?

A debit represents an increase in your asset or expense accounts, and a decrease in any of your liability, equity, or revenue accounts.

For example, you take out a bank loan of $1,000 which is deposited into your business bank account, a type of asset account. This means you have debited, or increased, your bank account by $1,000.

This use of the word debit runs counter to its common use in purchasing, where using a debit card to buy an item means money is coming out of your bank account.

Debits, sometimes noted as DR, will appear on the left side of your accounting ledger.

What is credit?

Credits represent an increase in your liability, equity, or revenue accounts, and a decrease in your asset or expense accounts.

For example, if you receive $1,000 in revenue from a customer for services provided, you credit your revenue account by $1,000. In much the same way as debit, credit in accounting does not have the same meaning as credit card—credits represent increases in some cases and decreases in others.

Credits may be noted as CR and appear on the right side of your accounting ledger.

How do credits and debits work in practice?

The most important thing to remember about credits and debits is that they work in tandem.

In other words, if you have a debit, you always have a corresponding credit.

If you have a credit, there must be a debit to balance it out.

If you don’t record both halves of the accounting equation, you’ll quickly have trouble keeping track of your expenses and assets, which can be problematic when it comes time to evaluate your profitability or calculate your taxes.

Consider the two examples above.

In the first, we used the example of a $1,000 bank account deposit, which created a $1,000 debit in your asset account. This same loan, however, also creates a $1,000 credit in your liability account—while the absolute value of this account increases,

it doesn’t represent money you have. Instead, it represents money you owe to the bank.

In our second example, you received $1,000 in revenue from a customer. This creates a $1,000 credit in revenue and a $1,000 debit in assets.

If you only record one half of these transactions, problems start to happen.

Consider the bank loan.

If you record this as a debit to your asset account but don’t record the corresponding credit to liability, your financial records won’t show this debt—and won’t properly balance.

In addition, because this debt isn’t on your books, you may forget to make payments, meaning you could default on the loan and be asked to pay it back in full immediately.

Examples of debits and credits

Let’s look at a few examples of debits and credits in practice.

First up, purchasing equipment.

Let’s say you spend $2,500 on office furniture, and you pay cash. This represents a $2,500 debit to your equipment asset account, and a $2,500 credit to your cash asset account.

Notice that these are both asset accounts—the difference is that in asset accounts, debits are always increases and credits are always decreases.

This means that as your furniture account increases (debits) in value, your cash account must credit (decrease) by a corresponding amount.

Next is a loan payment.

In the example above, you took out a $1,000 bank loan. Now, your business is in a position to repay the loan so you use cash on hand to pay down the full balance of $1,000.

For accounting purposes, you need to debit your loans payable account and credit your cash account.

In other words, you are adding money to your loans payable account (which is subsequently used to pay down your bank debt), and you are removing money from your cash account to pay down the loan.

It’s also possible to have multiple debits and credits from the same transaction.

Consider the payment of employee wages.

In this case, you debit wage expense and payroll tax accounts, and you credit cash accounts.

On the debit side, you’re increasing wage expenses and tax accounts because both of these go up when you pay employees. Cash naturally decreases by the same amount, which means you credit this account.

Let’s say you pay an employee $2,000 for their recent work, and hold back $300 in taxes. This means you debit your wage expense account for $1700 and debit your payroll tax account for $300.

You then credit your cash account for the full amount of $2,000.

Final thoughts on debit and credit

Debit and credit are two sides of the same accounting coin—you can’t have one without the other.

Every time a debit occurs, there’s a corresponding credit. Each time you enter a credit, there must be an equal debit.

What’s important to remember is that debits and credits have opposite effects depending on the type of account they impact.

Debits always increase asset or expense accounts, and decrease liability, equity, or revenue accounts. Credits always increase liability, equity, or revenue accounts, and decrease asset or expense accounts.

While the math can get complicated if you’re crediting or debiting multiple accounts simultaneously, the single biggest key to bookkeeping success can be summed up in a single word: balance.

If your financial records aren’t balanced, don’t go looking for a complicated cause or a mysterious factor. Instead, look for debits without corresponding credits or credits without companion debits.

Find those and you’re well on your way to fixing the problem.