Debits and credits made easy!
I guarantee that you will understand the accounting term debits and credits once and for all after
watching this video!
There is very broad agreement globally on some terminology.
For example, any captain will tell you that (when facing forward on a ship) the left side
is called port and the right side is called starboard.
In the same way, any accountant will tell you that when making accounting journal entries,
the debits go on the left and the credits go on the right.
How do debits and credits work?
Does a debit increase an account, and does a credit decrease an account?
Or is it the other way around?
That really depends on the type of account we are looking at.
For balance sheet accounts, we essentially have three types of account.
Assets accounts, where the natural state is for an asset account to have a debit balance.
Liability accounts, where the natural state is for a liability account to have a credit balance.
Equity accounts, where the natural state is for an equity account to have a credit balance.
Assets increase with a debit.
Liabilities and equity increase with a credit.
For income statement accounts, we have two types of account.
Expense accounts, where the natural state is for an expense account to have a debit balance.
Revenue accounts, where the natural state is for a revenue account to have a credit balance.
Expenses increase with a debit.
Revenues increase with a credit.
Let’s go through some journal entry examples for business transactions to illustrate that.
If a company raises cash from shareholders when it starts out,
then assets and equity are affected.
More specifically: the cash account within assets increases (the debit side of the journal entry),
and so does the shareholder capital in equity (the credit side of the journal entry).
If a company raises cash through a loan from a bank, assets and liabilities are affected.
More specifically: the cash account within assets increases (the debit side of the journal entry),
and so do the liabilities (the credit side of the journal entry)
as you owe this money to the bank.
If a supplier invoices you for cleaning services, expenses in the income statement and liabilities
on the balance sheet are affected.
Expenses increase (the debit of the journal entry), and so do liabilities (the credit
of the journal entry), more specifically the accounts payable account within liabilities.
If you subsequently pay the supplier (settle your debt to the supplier), then the liabilities
decrease (the debit of the journal entry) and the assets decrease (the credit of the
journal entry) as cash is transferred from your company to the supplier.
If you invoice your customer for services rendered, the assets on the balance sheet
increase (the debit of the journal entry, in an asset account called accounts receivable),
and the revenue in the income statement increases (the credit of the journal entry).
Balance sheet accounts: assets (debit balance), liabilities and equity (credit balance).
Income statement accounts: expenses (debit balance), revenue (credit balance).
At year end closing, the results of the income statement during the year get added to the
balance sheet position at the end of the year.
If the company had a revenue of 100 (credit balance) during the year and expenses of 90
(debit balance) during the year, then this sums to a net income of positive 10 (credit
balance, a profit), which gets added to retained earnings in equity.
If the company instead only had a revenue of 90 (credit balance) during the year and
expenses of 100 (debit balance) during the year, then this sums to a net income of negative
10 (debit balance, a loss), which gets deducted from retained earnings in equity.
Revenue increases shareholder equity, expenses decrease shareholder equity.
Profits increase shareholder equity, losses decrease shareholder equity.
Debits on the left, credits on the right.
I hope you enjoyed this short explanation of debits and credits in accounting.
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