One of the most fundamental, and often most confusing, aspects of basic business accounting is the distinction between debits and credits. In accounting, the ultimate goal is to have your financials balance (such as on a balance sheet). In order to balance financial records, every business transaction has both a debit and credit (if money is being added to one account, it has to be coming from somewhere else, and vice versa).
Debit and Credit Confusion
For those new to accounting, and just learning the basics for their small or online business, the terms credit and debit may only be familiar through things like credit cards or debit cards through a bank. This causes confusion, because it sometimes leads to the assumption that debits are “bad” (such as a debit card taking money from a bank account) and that credits are “good” (such as a credit card giving someone extra finances). In fact, neither debits nor credits are “good” or “bad” at all. They’re simply opposite sides of the same coin, used to balance the books. Here’s how:
In accounting, there are a series of account types that transactions fall into. These include assets, liabilities, owner’s equity, income, and expenses. When one account is debited, another is credited, hence causing a balance. For example, let’s just focus on assets and liabilities.
Assets are things a business (or its owner) owns that have some kind of value in the future (from bank accounts to owned property). Liabilities are essentially debts that the business (or owner) has to others. Let’s use an example of a company’s asset being their bank account, and a liability being the yearly salary of the company’s sole employee (the total amount owed to that employee for that year). If the employee is owed $52,000 for the year, the liability of the company is $52,000. Let’s assume the company has $200,000 in the bank account (asset), and a payment is being made for $1000 for one week. That $1000 has both a debit and a credit (it’s being reflected as a decrease in assets, but it’s also a decrease in the company’s liabilities).
Debits and Credits in Relation to Accounts
Debits and credits don’t mean the same thing for every type of account. Here’s what happens when you debit or credit assets, liabilities, owner’s equity, income, and expense accounts:
Assets – Debits increase, and credits decrease asset accounts.
Liabilities – Debits decrease and credits increase a liability account (think about credit cards – when the credit limit is increased, the cardholder’s debt to the credit card company increases).
Owner’s Equity – Debits increase, and credits decrease owner’s equity.
Income – Debits decrease and credits increase income.
Expenses – Debits increase and credits decrease expenses.
So using the salary payment example above, there would be a $1000 credit decreasing the company’s assets, but at the same time, there would be a $1000 debit to the liabilities account, decreasing the total amount owed by the company, causing a balance of debits and credits in the account.