Credits and Debits and how They Affect Financial Reports
Understanding what credits and debits are, what they do, and the rules for which they add or subtract is vital to figuring out why accounting data is what it is and how it got that way. Please learn the rules of credits and debits.
Total Office Manager does not use the terms Credit and Debit very often. We have provided this topic as a reference for those of you who need to know more about this subject.
When you deposit money in the bank, the cashier will tell you “I’ll credit your account.” From that experience, most people assume that cash is a credit, and so credits are good. That is further reinforced when reductions in the accounts are referred to as debits. Besides, if you remove the “i” from debit, you get “debt.” So, debits are bad.
Unfortunately, the conditioning we receive at the bank is causing real confusion in the accounting class. Why? Because in accounting we understand that the bank account is a debit account, and that debts are credit accounts – the opposite of what most people expect.
In fact, debits and credits are neither good nor bad. Each transaction, whether it be a good transaction (deposits), or a bad transaction (bills) has both a debit and an equal credit. That’s why they call it “double-entry accounting.” When the cashier is telling you he or she will “credit your account”, they are also entering a debit for the same amount that they are not telling you about. The same is true for the debits to your account – there is also a credit being made at the same time.
The best way to understand debits and credits is to identify two components of each transaction: 1) what did you get; and, 2) where did it come from. The debit is what you got, and the credit is the source of the item you received. For instance, let’s imagine that you purchase a computer with your credit card. Since the computer is what you received it’s going to result in a debit to the asset account for your computer. The credit will be applied to the credit card liability account for the same amount.
The banks tend to confuse us because they are telling us the entry to their liability account. When you deposit money in the bank, their liability to you increases. Since liabilities are credit accounts, they are crediting our account. When they reduce their liability to us, they are debiting their liability account.
Rules for Applying Credits and Debits
- To increase an asset account, debit it
- To decrease an asset account, credit it
- To increase a liability or equity account, credit it.
- To decrease a liability or equity account, debit it.
- To record expenses, debit an expense account.
- To increase Accumulated Depreciation, credit it.
- There is no exception to the rule that debits must equal credits Debit is often abbreviated as “Dr.” and credit as “Cr.”
- Credits increase income, liability, and fund accounts and reduce asset and expense accounts
- Debits increase expense and asset accounts and reduce income and liability accounts
- When recording expense transactions, the word “charge” is often used in place of the word “debit.”
- A Credit increases sales, income, liability, equity, and accumulated depreciation accounts. Credits decrease expense and asset accounts.
- A Debit increases expense and asset accounts. A Debit reduces sales, income, liability, equity, and accumulated depreciation accounts.
What is a Contra Account?
An account that offsets another account. A contra-asset account has a credit balance and offsets the debit balance of the corresponding asset. A contra-liability account has a debit balance and offsets the credit balance of the corresponding liability.
Bad Debt is an example of a “contra-account.” The notion that the account is an income account that is expected to hold a balance opposite to what is normally expected, to counteract the balance in another income account. Accumulated Depreciation, used to diminish the value of an asset over time, is another example of a contra-account.
Understanding Debit Balance Accounts and Credit Balance Accounts
You might hear the phrase debit balance account or credit balance account. A debit balance account is one where a debit adds to the balance. Examples include assets and expenses. A credit balance account is one where a credit adds to the balance. Examples include liabilities and income.
Credits and Debits Cheat Sheet
There are just five main account types used in accounting. They are asset, liability, income, expense, and equity. Accountants will often break those main types down into sub-types. Total Office Manager has thirteen account types, but they are sub-types of the five main account types used in accounting.
|Journal Entry Debit and Credit Cheat Sheet|
|Account Type||Account Type Name Used in TOM||Debits||Credits|
|Asset||Other Current Asset||Increases||Decreases|
|Expense||Cost of Goods Sold||Increases||Decreases|
|Liability||Other Current Liability||Decreases||Increases|
|Quick Tip: Debit all expenses and losses and credit all income and gains. Another way to say it is, debit what comes in and credit what goes out.|
Tips on Credits and Debits
- Recall that there are several types of COA (Chart of Accounts). COAs are used to keep track of where to place currency in the GJ (General Ledger). They are Income, Expense, Asset, Liability, and Equity. There are others but they are sub-types of these. For example, Cost of Goods Sold (COGS) is really just an Expense type. COGS is a way of further defining it. When you are looking for the source of currency, understanding COA types and what they mean is essential.
- Debit all expenses and losses and credit all income and gains. Another way to say it is, debit what comes in and credit what goes out.
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