The fundamentals of accounting rely on two things: debits and credits.
For those who are new to accounting, getting your head around debits and credits can be confusing and may take a bit of time, but they really are important in everything that we do as accountants.
So What are Debits and Credits?
Trying to understand what a debit or a credit actually is can make it even more tricky. This is because they are not physical items: you can’t see them and you can’t touch them. Instead, they are a concept which need to be explained through the use of examples.
At a very basic level, debits and credits represent increases and decreases within the accounts of a business. The fundamental of EVERYTHING within accounting is that for every debit entry into the books, there MUST be an an equal credit entry.
The basic rule is that debits represent increases in assets and credits represent increases in liabilities. Let’s look at an example:
Example
If a business buys a vehicle for £500 cash then how do we record this as accountants?
Firstly, we need to understand what the business has actually done: by buying the vehicle, they have increased the amount of vehicles they hold on their books (vehicles are assets). They have also paid for the vehicle in cash and have therefore reduced the amount of cash they hold (cash is also an asset)
To show this increase in assets we must debit the motor vehicles account and credit the bank account, both by £500. This can be shown in a journal format:
- Dr Motor Vehicles £500
- Cr Bank £500
That is how we would record and enter this transaction into a company’s accounting system. This is an easy example because the entry only affects the assets of the business. If the business was to buy the vehicle on credit (i.e. they agree to pay the seller at a later date), this would represent an increase in assets and an increase in liabilities, which as mentioned earlier would be shown as a credit.
The journal for this would be:
- Dr Motor Vehicles £500
- Cr Trade Payables £500
These examples make it a bit easier to see how debits and credits affect assets and liabilities. From here it becomes a lot easier as most transactions will involve a movement in assets or liabilities. If you pay for an expense (heating, lighting etc.) then you will probably pay for it in cash and therefore will decrease your cash (asset). Therefore this would credit your cash (decrease in assets) and debit your expense account.
There is no easy way to explain how debits and credits affect the other types of accounts – reserves and expenses for example. Instead, you must always think of the other side of these transactions first. As we did above, if you pay for an expense you credit your cash and therefore will debit your expense. If you issue shares you will most likely receive cash for them and thus, debit your cash (asset) and credit your share capital (reserves).
Here is a summary of what an increase to each of the main accounts will be in terms of debits and credits:
- Assets: increase = debit
- Liabilities: increase = credit
- Expenses: increase = debit
- Reserves/equity: increase = credit
- Purchases: increase = debit
- Revenues: increase = credit
Again, for purchases and revenues, think about the other side first. If you receive cash or a promise to pay for a sale then you increase your assets (debit) and therefore credit your sales account. The opposite is true for purchases.
For more information surrounding how the double entry system works on this post surrounding The Accounting Equation but for now, this should help to get you started.
