Debits vs. Credits: The Accounting Equation
Money doesn’t appear and disappear and accountants certainly aren’t magicians. Debits and Credits are words that describe the movement of cash and assets that occur in transactions. In this article, we simplify a fundamental accounting equation used in small business bookkeeping.
Debits, Credits, and Misconceptions
Before we get into the small business accounting basics of debits vs. credit, it’s important to address two common misconceptions.
#1 Debits and credits are not defined as being good or bad, nor is one better than the other
#2 Debit and credit have nothing to do with adding or subtracting
Debits and credits are used to express the double-sided nature of every financial transaction kept in small business bookkeeping. Think of debits and credits as a single coin. One head, the other tails since there are equal and opposite sides to financial transactions.
What is the Difference Between a Debit and a Credit?
To best understand the terms and differences of debit vs. credit, the understanding of economic benefit can help. As defined by Market Business News, an economic benefit is any benefit that can be quantified in terms of the cash it generates.
Transactions involve a flow (not an exchange) of “economic benefit” from a source to a destination. Credits represent the source and debits represent the destination.
Debits can increase an expense or an asset account or decrease an equity or liability account. When these events are recorded in small business bookkeeping they are positioned on the left of the accounting entry.
Credits can increase a liability or equity account, or credit decreases an asset or expense account. When these events are recorded in small business bookkeeping they are positioned on the right of the accounting entry.
Debit vs. Credit Examples
Now that we know the role debits and credits play in an economic benefit, let’s break down the accounting equation a little more and view some samples.
Debits (assets) = Credits (Liabilities) + Equity
Debits and credits are small business bookkeeping entries that balance each other out.
To simplify, consider debit as a “positive” number listed on the left adding to an asset or expense account. Simultaneously, a credit increases liability, revenue, or equity accounts and decreases asset or expense accounts on the right. Equity is equal to the value of a company’s non-operational assets once liabilities are paid.
For example, your organization may record the following under your assets account:
Your business pays $5,000 of its cash for inventory, the business asset Cash decreases by $5,000 while the business asset account Inventory increases by $5,000. The following shows that the transaction is in balance.
|01/15 Cash $5,000||01/15 Inventory $5,000|
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It’s a challenge to simplify into a few hundred words the role of debits vs. credits–that’s why we study the functionality of accounting equations for years so that you don’t have to.
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