Accounting 101: Debits and credits explained

 

Whether you’re an accounting enthusiast or an adamant arithmophobe, accurate bookkeeping is essential to your success. It’s how you generate invoices, compensate your staff, pay your bills and measure your business’s overall financial well-being. By having a clear view of your cash flow with detailed financial records, you can budget more easily, track your profits and identify strategic ways to grow.

But there are two bits of accounting jargon that often leave new business owners scratching their heads — debits and credits.

What exactly does each term mean? How can debits make some accounts go down but make others go up? And how does any of this affect your business?

Here’s what you need to know.

 

The basics of DR and CR

To keep your business’s financial records in order, you need to track the money coming in and going out — also known as balancing your books. The individual entries on a balance sheet are referred to as debits and credits.

Debits (often represented as DR) record incoming money, while credits (CR) record outgoing money.

How these show up on your balance sheet depends on the type of account they correspond to.

 

What “balance” really means

Any business that’s spending and receiving money will likely assign transactions to one of five main account types:

• Asset accounts contain the resources a company relies on to generate revenue (inventory, accounts receivable, cash).

• Expense accounts reflect the company’s cost of doing business (delivery expenses, advertising expenses, materials, labor).

• Liability accounts show what the business owes to creditors (accounts payable, salaries and wages, income taxes).

• Equity accounts refer to the owner’s equity in their company (initial investments or stock holdings).

• Revenue/income accounts reflect the income your business generates.

The world of accounting has two main systems: single-entry and double-entry accounting. Single-entry records only revenues and expenses, while double-entry covers assets, liabilities and equity by recording each transaction twice — once as a debit and once as a credit.

Most businesses follow the double-entry system, in which every financial transaction affects at least two accounts. Money coming into one must come out of another. When these two entries balance and result in a total of zero on your balance sheet, your books are considered balanced. This satisfies one of the golden rules of accounting:

Assets (what you own) - Liabilities (what you owe) = Equity (what’s left for you)

 

In simpler terms, every item your business owns (inventory, equipment, even loans) can be classified as either something you owe (liabilities) or something that belongs to you (equity). Think of it like this: If you borrow $100, that $100 is both an asset (cash) and a liability (loan). When you spend $200 on new equipment, that $200 becomes an asset (the equipment) as well as your equity (money you’ll eventually get back). That’s the fundamental concept behind credits and debits.

For every debit in one account, another account must have a corresponding credit of equal value to offset it.

Whether a debit or credit means an increase or decrease in an account depends on the account type. In traditional double-entry accounting, debits are entered on the left, and credits are entered on the right, like so:

• Asset accounts Debit Increase, Credit Decrease

• Expense accounts Debit Increase, Credit Decrease

• Liability accounts Debit Decrease, Credit Increase

• Equity accounts Debit Decrease, Credit Increase

• Revenue/Income accounts Debit Decrease, Credit Increase

 

Putting it into practice

Now we’ll take a look at how you can apply debits and credits to a few common business scenarios.

Purchasing equipment

Say you own a bakery and decide to buy a new oven for $2,000. You decrease, or debit, your cash balance by $2,000 to pay for the oven, but you increase, or credit, the value of your assets by $2,000. Here’s how this purchase affects your balance sheet:

Account

• Assets: Equipment Debit: $2,000

• Assets: Cash Credit: $2,000

Loan for business expansion

To expand your bakery, you take out a $10,000 loan from a bank. You increase (debit) your cash balance by $10,000 because you received the loan, and you record a liability (credit) for the $10,000 loan amount, which you’re obligated to repay. You record each transaction like so:

• Assets: Cash Debit: $10,000

• Liability: Loans payable Credit: $10,000

Employee salaries

It’s payday, and you need to pay your employees $2,500 in salaries. You increase (credit) your expenses by $2,500, reducing your equity. You decrease (debit) your cash balance by $2,500 to pay your employees. Your balance sheet reads:

• Assets: Cash Debit: $2,500

• Equity: Salaries expense Credit: $2,500

 

Remembering the fundamentals

The next time you approach your balance sheet, it’s important to remember that debits and credits are the invisible hands keeping everything in balance. By understanding their roles, you can confidently manage your money to make strategic decisions that set your business on the path to lasting success.

For the support you need to stay on top of your finances, be sure to speak with a Chase business banker today.