More on Debits and Credits in Accounting

Generalization of Debits and Credits

Debits and credits form the double-entry system, the way in which transactions are handled. In the previous part, we looked at the concept behind debits and credits and how we can use them to express transactions.

However, transactions are usually not as simple and straightforward as those listed in the previous examples. We therefore need to generalize the terms “debit” and “credit”. Here is how it works:

 

Assets

  • Increase in the value of assets: Debit an asset item
  • Decrease in the value of assets: Credit an asset item

How to think about it: The more assets the business receives (hence a debit), higher the value of assets the business has

Example: Your business purchased a machine with cash

Transaction Change in Accounting Equation Entry
Business receives a machine Increase in asset (plant and machinery) Dr. Plant and Machinery
Business takes out cash Decrease in asset (cash) Cr. Cash

 

Shareholders’ Equity and Liabilities

  • Increase in shareholders’ equity or liability: Credit the account
  • Decrease in shareholders’ equity or liability: Debit the account

How to think about it: To make a higher contribution to the firm (hence higher shareholders’ equity), shareholders need to take a higher amount out of their pockets (hence credit)

The more lenders lend to the business (increase in liabilities), the more lenders take out of their pockets (credit).

Example 1: You as a shareholder invested cash into the business

Transaction Change in Accounting Equation Entry
Business receives cash Increase in asset (cash) Dr. Cash
Shareholders take out cash Increase in shareholders’ equity (capital contribution) Cr. Shareholders’ Equity – Capital Contribution

 

Example 2: Sellers sell goods to your business on credit (buy now, pay later)

Transaction Change in Accounting Equation Entry
Business receives inventory Increase in asset (inventory) Dr. Inventory
Seller gives up goods Increase in liabilities (accounts payable) Cr. Accounts payable

 

Revenue

  • To record revenue: Credit
  • The opposite (say your business overcharged someone): Debit

Explanation: Higher the value of outflow of goods and services from the firm (a credit), higher the revenue earned by the firm

Example: Your firm earned service income in cash

Transaction Change in Accounting Equation Entry
Business receives cash Increase in asset (cash) Dr. Cash
Business provides services Increase in revenue (services revenue) Cr. Service Revenue

 

Expenses

  • To record expenses: Debit
  • The opposite: Credit

How to think about it: Higher the value of goods and services received (hence a debit), the higher its expenses

Note: goods and services here excludes inventory; inventory is treated as assets

Example: Your company paid cash for office supplies

Transaction Change in Accounting Equation Entry
Business receives goods and services Increase in miscellaneous expenses (expenses) Dr. Miscellaneous expenses
Business pays cash Decrease in asset (cash) Cr. Cash

 

 Brief Summary

With the above, we can arrive at the following table summary:

Increase Decrease
Asset Debit Credit
Liability Credit Debit
Shareholders’ Equity Credit Debit
Revenue Credit Debit
Expense Debit Credit

More Examples

Say your business carried out the following transactions:

(1) Bought inventory with cash for $200.

As we have explored previously, purchases are supposed to be expenses but are temporarily classified as assets until they are sold. We therefore put down the following entries:

Dr. Inventory (Increase in asset, Debit) 200
Cr. Cash (Decrease in asset, Credit) 200

 

(2) The business sold the inventories for $500 on credit

The business just got $500 in sales revenue. Our customers owe us money, so accounts receivable increases by $500 too.

Dr. Accounts receivable (Increase in asset, Debit) 500
Cr. Sales Revenue (Increase in revenue, Credit) 500

 

Think you are done? Wait. When the goods are sold, we have to reclassify the cost of the goods from “Inventory” to “Expenses”. There is now a decrease in inventory (asset) and increase in expenses. Therefore, we put down the following entry to record this:

Dr. Cost of Goods Sold (Expense, Debit) 200
Cr. Inventory (Decrease in asset, Credit) 200

 

With an understanding of debits and credits, you are now ready to prepare closing entries for the Income Statement!

 

References:

Horngren, C., Sundem, G., Elliott, J., & Philbrick, D. (2014). Recording Transactions. In Introduction to Financial Accounting (11th Edition)

 

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