Recording the Outflow and Inflow of Money – Debt and Credit
The terms 'Debit' and 'Credit' are fundamental in accounting. You may ask, what exactly are debits and credits? This topic raises interesting questions. For instance, why does debiting some accounts increase their balance while debiting others results in a decrease? Most importantly, why is this knowledge crucial for any business? Essentially, debits represent all the money entering the account, while credits account for all the money leaving it.
Here, we will explore the definition of debits and credits and examine their significance in accounting, know its effect in the accounting transaction of a business, know the rules engaging debit and credit, journal entries in effect to it.
What is Debit and Credit in Accounting
Debit and credit are two essential accounting tools. Business transactions need to be recorded, and thus, two accounts—debit and credit—are utilised. These events have a monetary impact on the financial system. When maintaining records of these transactions, the accounting tools of debit and credit come into play. Accounting transactions significantly affect these two accounts.
'In balance' refers to an accounting transaction where the total of the debit and credit is equal. Conversely, if the debit does not equal the credit, generating a financial statement becomes problematic.
The business transaction is separated into accounts while doing the bookkeeping. The commonly affected accounts are-
Assets
Expenses
Liabilities
Equity
Revenue
Different Effects of Debit and Credit are as Follows
Essentially, a debit raises an expense account in the income statement, while a credit lowers it. Liability, revenue, and equity accounts typically carry a credit balance. Therefore, applying a debit to any of these accounts will reduce their balance.
Difference between Debit and Credit
Now, that you are clear about what is debit and credit, let’s check out the basic differences between debit and credit. It's quite interesting that debits and credits, although equal, represent opposite entries. A debit increases an account, and to boost that specific account, we merely credit it. We utilize this opposing approach to achieve the intended outcome.
A debit, positioned on the left side, raises the balance of an asset or expense account or lowers equity, liability, or revenue accounts. For instance, in the case of 'Purchase of a new computer,' the asset acquired (the computer) is recorded on the left side of the asset account.
Conversely, the right side features the credit entry, which either enhances equity, liability, or revenue accounts or reduces an asset or expense account. In the ‘Purchase of a new computer,' the payment for the computer is credited on the right side of the expense account.
Below is a comparison chart that helps clarify the distinctions between debit and credit.
Golden Rules of Debit and Credit
Knowing what is debit and credit is not enough as you must know the rules for debit and credit. The golden rules of accountancy govern the rule of debit and credit. Before we examine further, we should know the three famous golden rules of accountancy:
First: Debit what comes in and credit what goes out.
Second: Debit all expenses and credit all incomes and gains.
Third: Debit the Receiver, Credit the giver.
To compress, the debit is 'Dr' and the credit is 'Cr'. So, a ledger account, also known as a T-account, consists of two sides. As talked about earlier, the right-hand side (Cr) records credit transactions and the left-hand side (Dr) records the debit transaction.
If we buy machinery outright, this will lead to an increase in the machinery account and a decrease in the cash account, as machinery enters the business and cash exits. Both the rise in machinery and the fall in cash should be recorded in their respective accounts, and this information will also be documented in the ledger account.
On which side does the increase or decrease of the accounts appear? This is answered by studying the 'normal balance of accounts' and 'rules of debit and credit.' Understanding the normal balance will accelerate the learning of the rules.
The normal balance for all asset and expense accounts is consistently on the debit side. We will record increases to these accounts as debits. We will note it on the credit side to decrease the account.
Conversely, the normal balance for liabilities and equity (or capital) accounts is always on the credit side. We will record increases as credits and decreases as debits side.
It only follows the opposing force or the vice versa factor.
A level-up concept, Contra Accounts, is only the opposite of the relevant accounts. The normal balance can be both debit or credit. Here, to neutralize this, a contra account is used. To recall, the utmost rule of debit and credit is that total debits equal total credit which applies to all the totaled accounts.
Accounting Journal Entries
In an accounting journal entry, we find a company's debit and credit balances. The journal entry consists of several recordings, which either have to be a debit or a credit.
Below is a list of basic five journal entries, we will straight away delve into it-
1. Manav started the business with cash of Rs. 50,000
Bank A/C..........Dr. 50,000
To Capital A/C 50,000
2. Bought goods from Rita for Rs. 800
Purchase A/C.....Dr. 800
To Rita A/C 800
3. Sold goods to Mr. Nayak at Rs. 10,000
Mr Nayak A/C.....Dr. 10,000
To Sales A/C 10,000
4. Paid wages Rs. 50
Wages A/C...........Dr. 50
To Bank A/C 50
5. Carriage outwards Rs.60
Carriage Outwards A/C.....Dr.60
To bank A/C 60
Be it economic or noneconomic, we keep and make records of any transaction and this is the root meaning of journal entries which is represented above.
Debit and Credit Examples
This study is incomplete without the citing of examples. For practical application, the hereinafter examples will be worthy to understand the basal of debit and credit.
Examples-
The following transactions are related to a trading business:
1. Started business with cash Rs. 1,50,000.
Accounts involved - A cash account and a Capital account
Nature of the account - Asset and Equity
Increase/Decrease - Both will increase
2. Furniture purchased for cash Rs. 10,000
Accounts involved- Furniture account and cash account
Nature of the account- Asset and Asset
Increase/Decrease - The asset account will increase and the cash account will decrease
3. Purchased goods for cash Rs. 1000
Accounts Involved - Purchase account and cash account.
Nature of the account- Expense and Asset.
Increase/Decrease- Increase in the expense account and decrease in the cash account.
To wrap up the two sides, Debit and Credit indicate destination and source respectively.
The Source of monetary benefit is credited and the destination account is debited. The concept of debit and credit is much of interest to an accounting student as it is the base for overall commerce study.
Example of Debit and Credit
The following transactions are related to ABC Traders:
Started business with cash Rs. 1,00,000.
Purchased goods for cash Rs. 50,000.
Purchased furniture for cash Rs. 30,000.
Purchased goods on credit worth Rs. 80,000.
Sold goods for cash Rs. 20,000.
Sold goods on credit worth Rs. 30,000 to Vikram traders.
Paid salaries to employees - Rs. 15,000.
Solved Example
Pass the journal entries for the following:
Cash brought by the owner - Rs. 1,00,000
Rent paid - Rs. 10,000
Repayment of loan - Rs. 50,000
Ans: The following are the journal entries
How Debit and Credit Affects Business Accounts?
1. Debits increase assets (e.g., cash, inventory) and decrease liabilities, equity, and revenues.
2. Credits increase liabilities (e.g., loans, accounts payable), equity, and revenues while decreasing assets.
3. In asset accounts, a debit adds value, and a credit reduces value.
4. For liability accounts, a debit reduces the balance, and a credit increases it.
5. Equity accounts are decreased by debits (e.g., withdrawals) and increased by credits (e.g., profits).
6. Revenue accounts increase with credits when income is earned and decrease with debits for refunds or returns.
7. Expense accounts increase with debits as costs are incurred and decrease with credits for adjustments.
8. Debits and credits must always balance each other in double-entry bookkeeping.
9. Correct application of debits and credits ensures accurate financial statements.
10. Proper recording helps businesses track financial health and avoid errors in accounting.
Conclusion
In summary, every financial transaction impacts two accounts. Debits and credits are crucial accounting tools forming the foundation of business transactions. The sum of debits must always match the total of credits. If there’s an imbalance, the accounting transaction is not balanced, complicating the preparation of financial statements. Therefore, employing debits and credits in a two-column recording format is essential for maintaining accurate accounting records.
FAQs on Know What is Debit and Credit- Differences and Rules
1. What is a credit and a debit?
A debit and a credit are two basic accounting entries used to record financial transactions. Debits and credits help maintain the balance in a company’s books.
- Debit increases assets or expenses and decreases liabilities or equity.
- Credit increases liabilities, income, or equity and decreases assets or expenses.
- They work together: every transaction has both a debit and a credit to keep the accounting equation balanced.
2. Is debit money in or out?
Whether a debit means money in or out depends on the type of account. For most accounts, a debit typically means money is coming in.
- For asset accounts (like cash or inventory), a debit adds money or value.
- For liability accounts (like loans), a debit reduces the amount owed.
- On a bank statement, a debit usually means an expense or withdrawal—money going out from your account.
3. What is an example of a debit and credit?
A simple example of a debit and credit is when a business pays rent with cash. The transaction affects two accounts.
- Debit: Rent Expense account (increases the company's expenses).
- Credit: Cash account (decreases the company’s cash balance).
- In this example, $$ Rent\ Expense = Debit,\ Cash = Credit $$, which keeps the books balanced.
4. What are the 7 rules of debit and credit?
The 7 rules of debit and credit guide how different accounts are increased or decreased. These rules help ensure precise bookkeeping.
- Assets: Debit increases, credit decreases.
- Liabilities: Credit increases, debit decreases.
- Capital: Credit increases, debit decreases.
- Revenue: Credit increases, debit decreases.
- Expenses: Debit increases, credit decreases.
- Drawings: Debit increases, credit decreases.
- Losses: Debit increases, credit decreases.
5. How do debits and credits affect financial statements?
Debits and credits directly impact financial statements by changing balances in key accounts. They ensure accurate preparation of reports.
- Debits increase assets and expenses, affecting the balance sheet and income statement.
- Credits increase liabilities, equity, and revenue, reflecting company growth or obligations.
- The use of both keeps the fundamental equation $$ Assets = Liabilities + Equity $$ balanced.
6. Why are both debit and credit needed for every transaction?
Every transaction receives both a debit and credit to follow the double-entry system, which keeps accounts balanced.
- The debit records where value increases or is used.
- The credit records where value decreases or is sourced.
- This method prevents errors because the total debits must always equal total credits for every entry.
7. What is the difference between a debit and credit balance?
A debit balance occurs in accounts where debits exceed credits, while a credit balance happens where credits are greater.
- Debit balance: Common in assets and expenses accounts, showing value owned or costs incurred.
- Credit balance: Typical for liabilities, equity, and revenue, representing amounts owed or earned.
- Knowing the balance type helps identify totals in balance sheet and income statement accounts.
8. How do you remember which accounts are debit or credit?
An easy way to remember is to use the DEALER acronym, which sorts accounts by debit or credit increases.
- DEALER: Debit increases for Dividends, Expenses, and Assets.
- DEALER: Credit increases for Liabilities, Equity, and Revenue.
- Group your accounts when making entries to ensure you debit or credit them correctly.
