Bookkeeping 101: Debits vs. Credits

How are Debits and Credits Used in Double-Entry Bookkeeping?

Newton’s Third Law of Motion says that with every action, there is an equal and opposite reaction. Double-entry bookkeeping follows a similar principle—every transaction has an equal and opposite transaction (i.e., counter-transaction).

Because most businesses use double-entry bookkeeping, we’ll dive a bit further into debits and credits using this method. This form of accounting records every business transaction twice: both as a credit and a debit. 

For example, if you decide to open a restaurant, you may have $10,000 in cash saved up to start investing in your business. With this capital, you might buy a professional commercial stove and griddle for $3000. With double-entry bookkeeping, you would credit the cash account $3,000 (decreasing cash) and debit the equipment account that same $3,000 (increasing your equipment asset account).

How Accounts Reflect Debits And Credits

What’s interesting about debits and credits is that they have different effects, depending on the type of account (see table below). For example, the transaction of paying your utility bill will create a credit for your accounts payable account and a debit for your utility expense account. 

As a result, debits (dr) record money coming into an account, while credits (cr) report money leaving an account (to create value elsewhere). For effective bookkeeping, this flow of money is tracked as a journal entry and will indicate an increase or decrease to an account. On your accounting journal, debits will go on the left-hand side and credits the right.

To illustrate debits and credits, we’ll use 2 accounts: Cash and Materials. Let’s say you want to spend $500 on materials for your business. You would take $500 from your Cash account (credit) and put that $500 into your Materials account (debit). The act of crediting and debiting your accounts simply records how money flows within different areas of your business.

The table below demonstrates how the account changes based on whether you are making a debit or credit.

As you can see above, if you increase an asset account, it will require a debit, but if you increase a liability account, it will require a credit. These nuances can be complicated at first. However, as you begin working with your books and consulting others as needed, you’ll gain more confidence and understanding of how to track the flow of money best for your business.  

Debits and Credit Examples

Here are some examples of common transactions that involve debits and credits:

1. Purchase of inventory – When a business purchases inventory, it is recorded as a debit to the inventory account and a credit to the accounts payable account, assuming the business is paying on credit.

2. Sale of goods or services – When a business makes a sale on credit, it is recorded as a debit to the accounts receivable account. A credit is also recorded to the sales or revenue account. This means that the business has increased its assets and its revenue.

3. Payment of expenses – When a business pays for expenses, such as rent or utilities, it is recorded as a debit to the expense account and a credit to the cash account. This means that the business has decreased its assets and its expenses.

4. Loan repayment – When a business makes a loan payment, it is recorded as a debit to the loan account and a credit to the cash account. This means that the business has decreased its liabilities (the amount owed on the loan) and its assets (cash).

These examples illustrate how debits and credits are used to record the financial transactions of a business. Understanding how to correctly record these transactions helps business leaders make informed decisions about their operations. It is important to note the basic principles of debits and credits are universal, but there can be many variations and nuances in how a business records these transactions.