Debits and Credits

Debits and Credits, Oh My!

All of us have heard the terms debits and credits, or debit this and credit that.  But what exactly do those terms mean?

To answer that question, first we need to look at the accounting equation, which forms the basis for our entire accounting system.  It looks like this:

Assets = Liabilities + Owner’s Equity

Assets are the things the company owns, or is owed to the company (Accounts Receivable).  Liabilities are the claims against the assets that other companies or creditors have.  Owner’s Equity is the claim the owner has against the assets of the company and is equal to the Assets - Liabilities.

Accounts on the left side of the equal sign normally have a Debit balance.  In this case it means the number is a positive number.  As an example, one asset account a company has is its bank account.  Because the Bank Account is on the left side of the equation, it should normally have a Debit balance, meaning you have money in the bank.  If the Bank Account ever shows a Credit balance, a negative, your account is over-drawn and it likely means that you’re in trouble.

An example of a liability account would be a bank loan, so your books might have a Bank Loan Account.  Because that would appear on the right side of the equation it would normally have a Credit balance, or a negative number.  A credit balance indicates you owe someone money.

So in general, Debit means positive and Credit means negative or Debit means you have assets and Credit means you owe someone something.

We also say debit an account or credit an account and those phrases refer to recording changes in an account.

When an account has a Debit balance, you debit the account to increase it and credit the account to decrease it.  So for the Bank Account, if you deposit money that would be recorded as a debit, because the deposit increases the Bank Account.  When you take money out, that is recorded as a credit because that decreases the Bank Account.

On the right side of the equation, where the balance is normally a credit, to increase those accounts you credit them and to decrease the account you debit it!  So when you borrow money from the bank, the Bank Loan Account is credited, increasing your liability.  When you make a payment on that loan, Bank Loan Account is debited because that decreases your liability.

We use a double entry accounting system so transactions in the books involve two entries for each transaction.  Let’s use the example of having a bank loan.

In February you borrow $500 from the bank, so that would be recorded like this:

February 2  Bank Account     $500.00
                        Bank Loan                $500.00
  To record a loan from the bank.

We write the date the transaction happened, then the account that gets debited, then the account being credited and then a memo as to why this happened.

In March you make a payment on the loan.

March 2  Bank Loan    $200.00
                  Bank Account      $200.00
  To record making a payment on the bank loan.

This time the Bank Loan gets the debit, to decrease that account and the Bank Account gets the credit to decrease that account.

In modern software we don’t actually write those entries ourselves (although we could if we wanted to).  We simply fill out a form for the amount involved, where it came from, where it’s going and why it happened.  The software then uses that information to create all of the appropriate entries and to adjust the accounts involved.

But, someone says, on my bank statement my deposits are listed as credits and my withdrawals are listed as debits!  You are correct.  

When a financial document is created, it is created from the point of view of the company creating the document.  A bank statement is a financial report, prepared by the bank.  When you deposit money, to the bank that is a liability; they now owe you money.  Look at the equation and you’ll note that Liabilities are on the right and are therefore a credit.  When you take money out, that decreases the bank’s liability to you so it shows as a credit.

Most transactions in accounting involve two parties; it records a shift of money or assets from one party to the other.  What is a debit to one party will be a credit to the other and vice versa.  That’s why for you, a deposit is a debit but to the bank it is a credit.  And because the bank prepares the statement, the debits and credits are opposite to what your books show.  Just in case you’ve ever wondered why they have it backwards.

So now you should better understand what bookkeepers, accountants, bankers and other financial types mean when they talk about debits and credits and how it affects your finances.

Oh my!

© Rigel Chiokis 2012 - 2017