Debits and Credits(Additional Explanation Part 1)

Introduction

For 25 years I observed college students struggling with the bookkeeping and accounting terms “debit” and “credit”. They easily memorized that asset accounts should normally have debit balances, and those debit balances will increase with a debit entry and will decrease with a credit entry. They also memorized that liability and owner’s (or stockholders’) equity accounts normally have credit balances that increase with a credit entry and decrease with a debit entry. It was easy to accept that every transaction will affect a minimum of two accounts and that every transaction’s debit amounts must be equal to the credit amounts.

Things got a little shaky when they were told to credit a revenue account when a company has earned fees or sold products. (After all, they had memorized that credits reduce asset account balances and increase the credit balances in the liability accounts.) A similar problem occurred when they were told to debit an expense account when a company incurs an expense. (After all, a debit increases the balance in an asset account and decreases the credit balance in a liability account.)

After reviewing the feedback we received from our Explanation of Debits and Credits, I decided to prepare this Additional Explanation of Debits and Credits. In it I use the accounting equation (which is also the format of the balance sheet) to provide the reasoning why accountants credit revenue accounts and debit expense accounts.

Hopefully this will give you a deeper understanding of the terms debit and credit which are central to the 500-year-old, double-entry accounting and bookkeeping system. Since this system is included in today’s accounting software, the better you understand it the more confident and effective you will be in your tasks and in your communication with superiors, peers, clients, and others you want to help.

Pertinent Facts Relating to Debits and Credits

To get started, let’s review some facts that you should already be aware of as a bookkeeper, accountant, small business owner, or student.

Debits, Credits, Double-Entry, Accounts

Debit means left side. Its abbreviation is dr. (Apparently the Italian or Latin word from which debit was derived included an “r”). Do not think of debit as good, bad, or anything else.

Credit means right side. Its abbreviation is cr. Do not think of credit as good, bad, or anything else.

Double-entry means an accounting system in which every transaction is recorded with amounts entered in two or more accounts. Further, the amounts entered as debits must be equal to the amounts entered as credits. If this is done for every transaction and without errors, then all the amounts appearing in the accounts will have the total amount of debits equal to the total amount of credits.

Accounts are the bookkeeping or accounting records used to sort and store a company’s transactions. Some of the accounts will have titles such as Cash, Accounts Receivable, Inventory, Equipment, Accounts Payable, Common Stock, Sales, Wages Expense, Rent Expense, Interest Expense, and perhaps hundreds more. The accounts can be found in the company’s general ledger. Hence, these accounts are also known as general ledger accounts.

T-accounts are a sketch or visual aid (outside of the general ledger) that are used by accountants in order to see the effects of the debit and credit components of a transaction. The left-side of the “T” is used for the debit amounts, while the right side is used for the credit amounts. Hence, if a company pays $500 for equipment, the two relevant T-accounts will look like this:

The accounts are usually arranged in the general ledger according to the following classifications:

• Assets
• Liabilities
• Owner’s (stockholders’) equity
• Revenues
• Expenses
• Gains
• Losses

The balance sheet accounts consist of these account classifications:

• Assets
• Liabilities
• Owner’s (stockholders’) equity

The income statement accounts consist of these account classifications:

• Revenues
• Expenses
• Gains
• Losses

Formats of the Balance Sheet and Accounting Equation

One of the main financial statements is the balance sheet (also known as the statement of financial position).

The format of the balance sheet for a sole proprietorship is:

The format of the balance sheet for a corporation is:

The format of the accounting equation (or basic accounting equation or bookkeeping equation) is identical to the format of the balance sheet.

Balance Sheet Accounts are Permanent Accounts

A company’s general ledger accounts can also be viewed as one of two types:

• permanent accounts
• temporary accounts

The permanent accounts are the balance sheet accounts. In other words, the permanent accounts are the accounts used to record and store a company’s amounts from transactions involving assets, liabilities, and owner’s (stockholders’) equity.

The balance sheet accounts are referred to as permanent because their end-of-year balances will be carried forward to the next accounting year. The permanent accounts are sometimes described as real accounts.

Recap: The asset, liability and owner’s (stockholders’) equity accounts are known as balance sheet accounts, permanent accounts, and real accounts.

Income Statement Accounts are Temporary Accounts

The general ledger accounts that are not permanent accounts are referred to as temporary accounts.

Temporary accounts are generally the income statement accounts. In other words, the temporary accounts are the accounts used for recording and storing a company’s revenues, expenses, gains, and losses for the current accounting year.

The income statement accounts are temporary because their balances are not carried forward to the next accounting year. Instead, the balances in the income statement accounts will be transferred to a permanent owner’s equity account or stockholders’ equity account. After the transfer, the temporary accounts are said to have “been closed” and will then have zero balances.

By starting each year with zero balances, the income statement accounts will be accumulating and reporting only the company’s revenues, expenses, gains, and losses occurring during the new year.

Recap: The revenue, expense, gain, and loss accounts are known as income statement accounts, temporary accounts, and are sometimes known as nominal accounts.

After the Temporary Accounts are Closed

Immediately after the temporary accounts are closed by transferring their balances to an owner’s equity or stockholders’ equity account, the only accounts with non-zero balances will be the permanent accounts.

With the balances from the temporary accounts now included in the permanent accounts, the balance sheet and the accounting equation can be prepared in the following format:

or

The Income Statement Accounts Have an Immediate Effect on Owner’s Equity or Stockholders’ Equity

Even though we do not record revenues, expenses, gains and/or losses directly into an owner’s equity account (or stockholders’ equity account) when we record the transaction, you must realize that owner’s equity or stockholders’ equity is also increasing or decreasing.

For example, at the time that a company earns and receives $500 of cash from providing a consulting service, the company’s assets increase by $500 and its owner’s equity or stockholders’ equity increases by $500. This is occurring even though the transaction is recorded with an entry to Cash (a permanent asset account) and an entry to Consulting Revenues (a temporary account). Again, you need to understand that the $500 credit entry to Consulting Revenues is causing a $500 increase in a permanent account that is part of owner’s equity or stockholders’ equity.

We will continue this discussion later, but for now take note that a credit entry is required to increase owner’s equity or stockholders’ equity.