Debits and Credits!

Ok, enough talk about economic doom and gloom. Today we are going back to this Blog’s roots (Accounting – in case you couldn’t guess it from the title) and talk about the very foundation of all modern accounting practices: Debits and Credits!

Remember how your business is made up of Assets, Liabilities and Equity? Remember how Assets equals Liabilities plus Equity? Remember Income, Expenses and profits? If you don’t remember them, I strongly suggest you go back and read up on them!

If you have a good handle on these things already, I would like you to imagine your business (or any business) to be a balancing scale. One side of the scale is called debit, the other side is called credit. Every transaction that enters into a business has to be recorded with debit entry and a credit entry. In other words:

FOR EVERY DEBIT THERE IS A CREDIT AND FOR EVERY CREDIT THERE IS A DEBIT

Repeat this mantra as many times as necessary to get it into your head.

*Legend has it that if you repeat the debit credit mantra three times at precisely 11:11 pm, The Comic Accountant will mysteriously appear and clean up all your messy accounts for you…*

What this means is that debits and credits represent different things for the different types of transactions we have.

For the balance sheet items (Assets, Liabilities and Equity):

*Debits increase Assets and Credits decrease them. For Liabilities and Equity, Credits increase them and Credits decrease them.*

For the profit and loss items (Income and expenses):

*Income are always Credit and Expenses are always Debit*

The only time the above is not true is when you either give/receive a refund to/from your customer/supplier.

Let’s take a look at some examples:

Buying a new car for $1,000 using cash from your bank account:

*The motor vehicle account will be debited since it has increased by $1,000 (the value of the car); the bank account will be credited because it has decreased by $1,000* (cash used to pay for the car)

Taking a loan of $2,000

*The bank account will be debited because it has increased by $2,000 (the money from the loan); The loan account is credited because it too has increased by $2,000 (to record the money that you owe)*

Bringing in personal money to start the business of $1,000

The bank account will be debited because it has increased by $1,000 (the money you bring into the business); The Owner’s Equity account is credited because it too has increased by $2,000 (to record the value of your share in the business)

Making a cash sale of $100

Your customer pays you in cash, increasing your bank account by $100, which is a debit entry because your asset increases; your sales account increases by $100 which is a credit entry – because income is always credit

Buying stuff from the supplier on credit (which means on loan) worth $300

You buy stuff on credit, which means your purchase account increases by $300 which is a debit entry – because expense is always debit; your accounts payable (which is what accountants call the account used to record what you owe your suppliers) increases by $300 which is a credit entry because your liability increases.

It is important to note that in business talk, credits are often used to describe situations which are related to loans, borrowing and any purchases that involve paying later. Debits are used to refer to using money you already have (as opposed to borrowing it), like debit cards which are tied to your bank accounts.

Quick note on bank accounts – often when banks put money into your account they will say that they have ‘credited’ your account. This may seem strange as an increase in assets should be a debit right? But if you will recall our lesson on interest rates, any money you deposit with a bank is treated as a loan to them – hence when the money in your account increases, from the bank’s point of view, their liability increases, hence they record it as a credit.

“Ohoho thank you for depositing your money with us. Now excuse me while I lend out this money at crazy high interest rates and pay you back almost nothing for letting me use your money to make money! Cheerio!”

That’s debits and credits in a nutshell! If you are a small business owner, chances are that you will never hear your accountant mention debits and credits in front of you. You won’t even find debits and credits displayed in most accounting software (In Xero, for example, unless you are looking to do manual journals, you won’t find any reference to debits and credits). The reason is that accountants like to think that debits and credits are far too complicated for non-accountants to understand. But hey, if you’ve read this far, you now know more about debits and credits than the average small business owner. Good job!

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