In accounting, the terms “debits” and “credits” might get confusing at times. This gets even trickier if you are a small business owner with no prior accounting experience and are tasked with managing your books as well. Even if you have an in-house bookkeeper, it is important to understand the basics of accounting so that you know what goes behind the numbers. As debit and credit are at the core of bookkeeping, this is the first thing you must become familiar with.
So, what exactly do “debit” and “credit” mean? Why do they exist together for every transaction made in the books? What is the difference between debit and credit?
Before we go on exploring the differences between debit and credit, let’s discuss the five major types of accounts that form the structure for your chart of accounts.
There are three kinds of balance sheet accounts:
Asset accounts record the resources your company owns that provide monetary value to your business. They can be physical assets like land, building equipment, vehicle, cash, or intangible assets like patents, trademarks, and software.
Liability accounts are the debts your company owes. This includes payables like accounts payable, wages payable, invoices payable, taxes, etc.
Equity accounts represent what’s left of the business after subtracting all your company’s liabilities from its assets. They measure a company’s worth to its owner or shareholders.
These are the accounts that form an income statement:
Revenue accounts represent the income your business brings in from the sale of goods or services.
Expense accounts refer to the money and resources you spend in the process of running your business for generating revenues, i.e., utilities, wages, office supplies, and office rent.
Business transactions revolve around these five major accounts, and the way balance sheet and income statement accounts interact with each other in a transaction results in a change in their values, such that:
And to record changes in their value resulting from the transactions, we use two types of entries in account ledgers – debits and credits.
Now the question that pops up is – what is the difference between debit and credit?
Here, you need to understand a little about double-entry accounting to grasp the differences between debit and credit.
Under the double bookkeeping system, you record two or more entries for every transaction, which means every transaction would have two accounts – one would be debit, and another would be credit. For example, if Company A withdraws cash of $20,000 from the bank, this transaction will involve two accounts under the double-entry system. One would be cash, and another would be a bank.
When there is an increase in the value of assets/expenses, the change in the account is a debit denoting a transfer of value to that account. Conversely, an increase in liabilities/income is a credit representing a transfer from the account (the cause of the corresponding debit in the assets account). When debit increases the account, the credit decreases the account and vice versa. So, we debit the account when the asset/expenses account increases and the liability/income account decreases. We credit the account when the asset/expenses account decreases and the liability/income account increases.
To understand the difference between debit and credit better, let’s look at a few examples.
1. Company XYZ sells a product to a customer for $1500 in cash. This would result in $1500 of revenue and cash of $1500. This would be recorded as an increase of cash (asset account) with a debit and an increase of revenue (revenue account) with a credit.
2. Company XYZ purchases computers for its office use for $10,000. So you would record the cost of the computers, which is a fixed asset, as a debit of $10,000 to your fixed asset account. The corresponding credit for the purchase of the computer will be recorded by crediting your expense account with $10,000.
The above example sums up the difference between credits and debit.
Debit and credit exist like twins in accounting. Debit alone cannot balance the whole transaction. Similarly, credit also cannot do the balancing act without the assistance of a debit account. Debits and credits are equal but opposite entries in your books. If a debit increases an account, you will decrease the opposite account with a credit. That signifies the fundamental difference between debit and credit.
For example, a company that issues an invoice to its client would record the invoice amount by entering a debit for the accounts receivable account in the balance sheet and credit of the same amount in the revenue account in the income statement. Similarly, after paying the invoice to that company, the client would enter a credit in the accounts receivable section and a debit in the cash section.
This is how debits and credits balance the books in double-entry bookkeeping.
The difference between debit and credit is also reflected in the way they are placed in the books. Debits and credits are traditionally placed in a T format in a journal. Listed in two separate columns, a debit entry is made on the left side of an account, and a credit entry is made on the right side of an account. Debit is indicated with the suffix “DR,” and credit is denoted with the suffix “CR” or a minus sign.
This is a basic template of how debits and credits are recorded as a journal entry.
The difference between debit and credit is evident from this T chart.
Let’s summarize the key points discussed regarding the difference between debits and credits.
By now, you may have grasped the basic differences between debit and credit and how they work to keep your books accurate while giving you a comprehensive picture of your business’s financial health.
Financial management experts at Monily have helped several small and medium-sized businesses to not only understand the difference between debit and credit but have also enabled them to gain access to timely and accurate books with appropriate reporting and streamlined financial processes.