Basic knowledge of your startup’s financial statements and accounting processes can help business owners understand their company’s financial status and outlook. The first blog post in our Accounting 101 for Startups series focused on the Chart of Accounts. Now, we’re diving into debits and credits in double entry accounting.
You’ve probably heard the accounting phrase, “debits need to equal credits”. Debits and credits equaling helps keep the accounting equation in balance and your financial statements accurate. Double entry accounting means for every debit, there must be an equal credit.
What is double entry accounting?
Double entry accounting is making journal entries that affect at least two accounts, and have balancing debit and credit amounts. There can be multiple accounts in journal entries, but the total amount of debits must equal the total credits. Now that we know debits and credits need to equal in a journal entry, it might be helpful to know what debits and credits are.
What is a debit and a credit?
A debit will always be on the left side of an account, and a credit will always be on the right side of an account. Below is an illustration of a T-account:
Regardless of the type of account you’re using, the debit and credit sides on a T account do not change. What changes in relation to debits and credits for different accounts is what they do to the account balance. For example, debiting certain accounts increases them, while debiting others decreases them. It depends on the type of account as to what a debit or credit will do to it.
How do I know the effect of a debit or credit on an account?
Essentially, the Balance Sheet accounts, such as Assets, Liabilities, Owner’s Equity and Income Statement accounts, including Revenue, Expenses, Gains, Losses are all affected differently by a debit or credit. Refer to our Accounting 101 blog post on Chart of Accounts for common accounts for each Balance Sheet and Income Statement item.
Assets, Expenses, and Losses will always increase with a debit balance and decrease with a credit balance. To illustrate this concept, we will use asset accounts in an example to show the effects of debits and credits.
Example 1: Customer A paid $100 towards an outstanding invoice. Cash goes up, Accounts Receivable goes down.
The journal entry would be:
Debit: Cash $100
Credit: Accounts Receivable $100
Using T-accounts:
By debiting our asset account, Cash, you can see we increased the balance. Whereas by crediting our accounts receivable, which is also an asset, we decreased the balance. All other asset, expense and loss accounts work the same way, they increase with debits and decrease with credits.
Even though this is a simple example with only two accounts, it demonstrates the important idea that no matter how many accounts are used or what accounts are used, the debits and credits in the entry should always balance.
Liabilities, Revenues, and Owner’s Equity are the exact opposite. A debit to any of these accounts decreases the account, and a credit to these accounts increases the account. We will demonstrate this concept using the Revenue account, Sales Revenue.
Example 2: Sold merchandise to Customer B for $20,000, but only received $12,000 in cash. The rest will be paid at a later date.
The journal entry would be:
Debit: Cash $12,000
Debit: Accounts Receivable $8,000
Credit: Sales Revenue $20,000
Using T-accounts:
If we look at our Revenue account in this example, Sales Revenue, it is being increased for the total amount of the sale to Vendor B by crediting the account. Our other accounts utilized in this example, Cash and Accounts Receivable, are asset accounts. As we mentioned earlier, both are increased with a debit. Cash is debited for the amount actually received from Customer B, and Accounts Receivable is debited for the amount Customer B will pay at a later date.
This example shows us, even if we are using multiple accounts, the total debits must equal the total credits. If we add up our debits to both Cash and Accounts Receivable, we get $20,000 which is also the amount we credited to our Sales account; therefore, we are still in balance. This is essential in every journal entry made by a company.
Accounting software, such as QuickBooks, will figure out the double entry accounting for you. For example, writing a check for office supplies. You know the bank account balance went down, and your office supplies expense just went up, but you don’t need to know which account is being debited and which is being credited. Although accounting software takes care of the journal entry, it is still important to have a basic understanding of debits, credits, and their relationship to the chart of accounts. If you have any questions about double entry accounting, or would like more information, please contact an Anders Advisor.
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