Debits and Credits
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If you want to learn accounting, the concept of debits and credits is one of the most important to understand.
But, many struggle with it and for me, it was the same in the beginning because it’s not something that’s completely explainable with logic.
But, I managed to understand it and by the end of this post, so will you.
Debits & Credits
In accounting, debits and credits always go together. Every transaction will have debits and credits and at least two accounts will be affected.
Remember, one transaction affects two accounts. If one account is debited, then the other one must be credited.
Just think of it as a bank transfer. When you send someone money, it comes out of your bank account and it goes into their account.
In accounting, instead of these piggy banks, we use T accounts.
Every account has it’s own T. The left side of the T is where the debits go. Credits go on the right side.
That’s already the first main rule you have to remember. Debit and credit do not mean plus or minus. It literally just means debit goes to the left side of a T account and credit goes to the right side of a T account.
Debit means left, credit means right.
That’s rule number one.
The second important rule is that for every transaction, the total amount of debits must equal the total amount of credits.
If you debit an account for 100, you must credit another one with 100.
There can be more than two accounts involved in a transaction, but never less than two.
That’s rule number two.
Now, the third rule usually creates a lot of confusion, but you’ll be fine because I have a secret weapon for you.
More on that later.
Before we dive right in, let’s do something else first that we’ll need in the process, and that’s to figure out the balance in a T account.
Get the Balance Right
The balance is basically the total of an account.
So, let’s say we have these two accounts visualized at T’s.
Then, we record some transactions to them.
First, account number one gets a debit of 500, and account number two gets a credit of 500.
For the second transaction, account number two gets a debit of 100 and account number one gets a credit of 100.
With that, we successfully applied the first two rules of debit and credit. We put debits on the left side of the accounts, credits on the right side.
And, for each transaction, the total of debit and credit was the same, so far so good.
Now to calculate the balance or total for the accounts, we add up the amounts on the debit and credit side for each account separately.
Account number one has 500 on the debit side and 100 on the credit side.
We deduct the smaller sum of credits from the bigger total of debits which gives us 400.
In accounting, we call this a debit balance of 400.
For account number two, it’s the opposite. It has a credit total of 500 and total debits are 100. Again, we deduct the smaller one from the bigger one, account number two has a credit balance of 400.
Here comes the confusing part.
Let’s say we have another transaction that adds another debit of 50 to account number one and one more transaction with a debit of 100 going to account number two.
Let’s just say the credits for these transactions go to different accounts. We don’t need to worry about these for now.
What would happen is that the balance of account number one would increase while the total of account number two decreases.
Both received a debit, but one account increases while the other one decreases. They are behaving differently.
And, that’s rule number three.
It depends on the account if a debit or a credit increases the balance or if it decreases it. And, that’s really the secret to understanding debit and credit.
Like we saw in our example, the balance of account number one increases with the debit while the balance of account number two decreases.
Two Groups to Remember
You may ask, “Well how do you know which one it is?” Fortunately, there are only two groups to remember.
- ASSETS – That’s the resources the company owns and uses, like buildings, machines, equipment and so on.
- DIVIDENDS – That’s when the company distributes its profit and cash to the owners.
- EXPENSES – That’s money we pay for goods or services the business purchased.
All accounts in this group are debits, which means that their balance will usually be a debit. Therefore, the total of these accounts will increase when they get another debit and will decrease with they get another credit.
So, account number one in our previous example would be in this group.
- LIABILITIES – Money we still owe to others, like to the bank, to suppliers or to the IRS.
- OWNER’S EQUITY – Money the owners of the company put into the business.
- REVENUE – Money we receive for sales to our customers.
All accounts in this group are credits which means that their balance will usually be a credit.
Therefore, the total of these accounts will increase when they get another credit and will decrease when they get another debit.
So, account number two in our previous example would be in this group.
And, that’s rule number three. It’s really important that you memorize this because to record any transaction, you have to answer two questions.
Which accounts are affected? Did accounts go up or down?
In order to answer question number two, you need to understand if an account is a debit or a credit account.
If you have trouble remembering this, just think of ADEx LER: Accountants Don’t Expect Low Earning Rates.
Assets, Dividends, Expenses, Liabilities, Equity, and Revenue.
ADEx are Debits.
The balance of these accounts increases with debits and decreases with credits.
So, let’s take cash for example. Cash is an asset. So, it resides on the debit side of our equation.
When you take money out of your account to pay for something you reduce your cash balance.
Remember our rule; the balance on the debit side increases with debit and decreases with credit.
So, do we debit or credit the cash account? We credit it because we reduce it.
LER are Credits.
The balance of these accounts increases with credits and decreases with debits.
Take a loan, for example, which is a liability.
When you take out a higher loan, you credit the loan account.
When you pay back a loan, what do you do? You debit the loan account, which will reduce its balance.
So, that’s really all there is to it.
All you must remember is “Accountants Don’t Expect Low Earning Rates”.
ADEx LER: Assets, Dividends, Expenses, Liabilities, Equity, and Revenue.
This will help you determine debit and credit accounts.
Just practice it and it’s eventually going to become second nature to you. In the end, you’re not even going to have to think about it anymore.
How does my debit card
fit into this definition?
I want to clear this up because it creates confusion for a lot of people.
The reason for the confusion are banks and how we talk to them.
For instance, when you put money in your account the bank will credit it.
When you take money out of your account, they will debit it.
A debit card is issued for the purpose of accessing your funds and to take money out from your account.
Now, if you think about this, it really seems like it’s exactly the opposite of what we just learned.
Cash is an asset. And, according to ADEx LER, resides on the debit side of the account equation. And, therefore, increases with a debit.
If you’re adding money, you will debit it, and if you’re taking money out, it will be credited.
So, why is this backward with banks? Do the general rules of accounting not apply to them? Actually, they do, but they look at it from their point of view, not yours.
Think about that.
When you put money in your checking account, it belongs to you, not to the bank. The bank just holds it for you.
So, for the bank, this money really is a liability, because at some point, they’re going to have to pay it back to you.
According to ADEx LER, liabilities are on the credit side of the equation, right? And, to increase a liability, you will have to credit it. Therefore, the bank will credit your account when you put money into it.
Likewise, when you buy stuff with your debit card, this will reduce the balance in your account. The bank owes you less money. Therefore, it will be debited and hence the name, debit card.
This is why it seems backwards. The same accounting rules apply to banks as well as to any other business in the world.
The terminology they use may be confusing because it’s from the point of view of the bank and not from your point of view.
What about credit cards?
Well, if you’re issued a credit card, the bank or the provider of the card, is providing a line of credit to you.
In other words, credit cards combine payment services with the extension of credit.
And, like for any loan, you’re going to be charged interest, actually very high interest, for the balance you carry over from month to month.
In addition, credit cards may offer additional insurance on purchases or make it easier to request a refund or a return.
But, in the end, the main purpose is to award you a line of credit or credit limit, hence the name.
I hope this was helpful to avoid confusion.
Please just stick to the definitions of debits and credits that we just learned and always remember ADEx LER and you’re going to be fine.
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