Debits and Credits

Accounting quiz

 

Debits and Credits

Debits and credits form the foundation of the accounting system. The mechanics of the system must be memorized. Once understood, you will be able to properly classify and enter transactions. These entries makeup the data used to prepare financial statements such as the balance sheet and income statement.

Debits and credits system

Accounting equation

Every accounting transaction involves at least one debit and one credit. The sum of debits and the sum of credits for each transaction and the total of all transactions are always equal. A list of all transactions appears in the general ledger. Debits are always presented before credits.

Memorize rule: Debits = Credits

Memorize rule: Debits before credits

 

The double entry system

The process of recording transactions with debits and credits is referred to as double entry accounting because there are always at least two accounts involved. The result of using double entry accounting ensures that every transaction is classified and recorded.

Balance sheet example

The double entry system requires us to pick at least two accounts (places) to record a transaction. Let’s say a business receives $1,000 cash. To record the transaction, the cash account is increased $1,000. As a rule we need another account to record the activity. The other account will help explain the source and purpose of the transaction. Cash can come from revenue (business operations), loans, investments, or cash back from returning an item. In this example, the business was paid cash for services performed. The revenue account therefore also increases $1,000. The combined entry will be to increase cash and increase revenue for the same amount.

The double entry system is used to categorize all transactions in and out of the business. Let’s say $200 cash is paid from the bank. Cash is decreased $200 and another account is required to explain the source and purpose of the transaction. Cash is used for a variety of purposes such as: Equipment, investments, loan payments, expenses, and more. In this example, the business paid a $200 phone bill in cash. The telephone expense account therefore increases $200. The combined entry will be to increase telephone expense and reduce cash for the same amount.

The double entry system categorizes transactions using five account types: Assets, liabilities, equity, income, and expense. The same account may also be used in a two-part transaction if there is an increase and a decrease of the same category. Assets, liabilities, and equity make up the balance sheet and form the equation: A = L + E. Revenue and expenses make up the income statement and can generally be expressed as Revenue – Expenses = Income or Loss.

 

How to increase and decrease different account types

Increases and decreases of the same account type are common with assets. A business may decide to use money to buy equipment. Cash assets will decrease and equipment assets will increase. Transfers from one cash account to another are also recorded in the same category, but in separate sub-accounts.

In accounting, asset increases are recorded with a debit. Asset decreases are recorded with a credit. (Do not confuse this concept with checking accounts that use these terms differently). Asset accounts, especially cash, are constantly moving up and down with debits and credits.

Memorize rule: Debit asset up, credit asset down

In accounting, expense increases are recorded with a debit and decreases are recorded with a credit. This is the same debit and credit rule order as assets. Transactions to the expense account will be mostly debits unless there is a return of an expense or correction of an error.

Memorize rule: Debit expense up, credit expense down

Every account is classified in one of five different classifications: Assets, liabilities, equity,