Debits and credits are major players in the accounting world. In this lesson, you will learn just what debits and credits are and why they are important to accounting.
Newton and Accounting
'For every action there is an equal and opposite reaction.' Have you ever heard that phrase? A couple of hundred years ago, that phrase was uttered by a man named Sir Isaac Newton, a world renowned mathematician and physicist. Newton made that statement when he was discussing the laws of motion in physics. Isn't it amazing that here we are, hundreds of years later, and that one statement can be used to explain debits and credits in accounting?
Before we get too involved in the discussion of debits and credits, let's learn a few basics. Every business has various transactions that occur each day. Each of these transactions are examined by accountants and recorded in the accounts that they affect.
In the first steps of accounting, accounts are broken down into T-accounts. T-accounts are simply visuals to help accounting professionals see the effects of transactions on accounts individually. The accounting system that is used most often in this day and time is called double-entry accounting. Double-entry accounting requires that every business transaction be recorded in at least two accounts. One account will be debited, and one account will credited.
What Are Debits and Credits?
So, now that you have the basics down, let's talk a little about what debits and credits are. Debits and credits are both forms of notation that are used in accounting to keep the balance in accounts. A debit is an entry on the left side of the T-account that increases asset and prepaid expense balances and decreases liability and equity account balances. A credit, the opposite of a debit, is an entry on the right side of the T-account. It increases liability, expense, and owner's equity accounts and decreases asset and prepaid expense accounts. It can seem a little confusing to understand debits and credits, so let's look at an example.
Peggy owns a dress making shop. It's taken her two months, but she's just finished an elegant wedding dress for a customer. The customer paid a $200.00 deposit on the dress before Peggy made it. She comes in and picks up her dress and pays Peggy the $400.00 that she still owes on the dress. The total cost of the dress is $600.00.
Using this example, you can see that Peggy was given $400.00 today for a balance due on a dress. That $400.00 is a debit to the cash account. This debit increases the cash balance by the $400.00. Cash is an asset account. Since a deposit was made on the dress, it was sold on account, meaning that it is an accounts receivable. Since Peggy uses a double-entry accounting system, she must have a credit that equals that debit. For this instance, the credit, which is $400.00, will go to the accounts receivable.
What's the Purpose of Debits and Credits?
Remember Newton's comment from the beginning of this lesson? 'For every action there is an equal and opposite reaction.' That's exactly what happens with debits and credits. For every debit, there is a credit, and for every credit there is a debit. One entry increases the value of an account, while another decreases the value of an account. This keeps accounts balanced, which is what the main purpose of accounting is - to balance!
Look at Peggy's dress shop. For one transaction, there were two entries made to accounts. One entry added $400.00 to an account balance, and one entry subtracted $400.00 from an account balance. In this example, $400.00 - $400.00 = 0. The transaction, once zeroed out, is considered balanced.
Debits and credits are fundamental parts of the double-entry accounting system. The double-entry accounting system requires that every business transaction be recorded in at least two accounts. One account will have a debit entry, and one account will have a credit entry. A debit is an entry that increases the asset and prepaid expense account balances and decreases a liability, expense, or equity account balance. Just the opposite, a credit is an entry that increases the balance in a liability, expense, or equity account balance and decreases the balance in an asset or prepaid expense account.
The easiest way for accounting professionals to see the results of each transaction is to create T-accounts. T-accounts are visuals that accounting professionals use to see how accounts are affected by the debits and credits of business transactions. Debits are recorded on the left side of the T-accounts, while credits are recorded on the right side of the T-accounts. When the total debits of a transaction is added to the total credits of the same transaction, the ending result should be zero. This means that the transaction is balanced.
The best way to remember the purpose of debits and credits is to remember that age-old saying that is accredited to Newton: 'For every action there is an equal and opposite reaction.' Remembering that will help you to effectively use debits and credits to achieve the one thing accounting is famous for: balance!
Following this lesson, you should be able to:
- Summarize what a double-entry accounting system is
- Describe what a T-account is
- Explain how and why credits and debits should balance out to zero in accounting