Accounting Fundamentals: Debits and Credits

Debits and credits are bookkeeping entries made to record transactions and adjust the balance of accounts inside of a double entry accounting system.

the building blocks of accounting

Debits and credits (abbreviated as Dr and Cr respectively) refer to entries made in a double entry accounting system to record transactions and increase or decrease account balances accordingly. In a double entry system debits and credits must always balance each other out, and every transaction must be recorded with at least one debit and one equal credit. This means that every transaction a business makes, regardless of complexity, can be boiled down to a series of simple debits and credits, and because of this principle, debits and credits can be referred to as the building blocks of accounting.

In order to properly understand the nuances of debits and credits, we must first understand what an account actually is in a business accounting system, and we must also understand the difference between “double entry” and “single entry” accounting.

What is an account?

In simple terms, an account is just a category label for transactions. Expense accounts represent various types of business expenses such as phone, internet, rent, utilities, etc. Asset accounts represent various business assets such as vehicles, machinery, equipment, buildings, etc. When a business accounting system is set up, the company must identify the accounts that are most relevant to the business and list them out in something called the “Chart of Accounts” or “COA” for short. At a fundamental level, the chart of accounts is simply a list of all the various categories a business uses to sort its transactions.

It is important to note that the term “account” in an accounting system does not always reference a physical account with a tangible balance like a checking or savings account. For example, an expense account titled “Rent Expense” would not reference any physical account, it exists to track the total amount of rent the business has paid during a given accounting period.

There are many different accounts (and subaccounts) in a proper double entry system, however, these accounts can generally be rounded up into 5 basic account types and two separate account classes.

The two classes of accounts are:

Balance Sheet Accounts
- These are the accounts that appear on a company’s balance sheet
- They include Assets such as bank accounts, cash, vehicles, etc. Liabilities such as loans and credit cards, and Owners Equity accounts.
Income Statement Accounts
- These are the accounts that appear on a company’s income statement (or P&L).
- These include all the various Revenue and Expense accounts.

The 5 basic account types are:

Assets
- Cash & equivalents, vehicles, machinery, equipment, land, buildings, etc.
Liabilities
- Debts payable by the company. Unearned revenue/customer deposits. Accrued expenses.
Equity
- Contributions and withdrawals made by owners
Revenue
- Earned income from sales.
Expenses
- COGS: inventory, raw materials, direct labor costs, etc.
- Overhead expenses: SG&A payroll, rent, utilities, phone, internet, software subscriptions, marketing, etc.

Double Entry vs. Single Entry

Double-entry accounting is the most common and most useful system of accounting. Larger businesses are required to use the double entry system by law. Single-entry accounting is a much simpler system, however, this type of accounting is not nearly as useful. It can be used by very small “solo-preneurs” and freelancers who just need to track their basic income and expenses as it doesn’t require much learning and a simple spreadsheet will often suffice. Beyond the most basic of applications, however, single-entry accounting should not be relied on, and any serious business should be on a proper double entry system.

Single entry systems do not track balance sheet accounts such as assets, liabilities, or equity. Single entry systems only track income statement accounts (i.e. revenue and expenses). In a single entry system, you might have a simple spreadsheet that tracks your income in one column and your expenses in another column. Any time you receive a payment you will record the transaction in the income column, and any time you pay a bill you’ll record the transaction in the expense column, along with the date and a brief description of the transaction. This gives you a very rudimentary breakdown of your profit and loss. Single entry accounting is better than nothing, however, since assets, liabilities, and equity are not tracked, you’ll never be able to view the true picture of your businesses finances using a single entry system.

Double entry accounting is a more complex system that comes with a much steeper learning curve, however, double entry systems are much better than single-entry systems in terms of overall usefulness and practicality.

In double entry accounting systems every transaction is recorded in at least two accounts (hence the term ‘double entry’). For example, if a business purchases a piece of equipment for $5,000, this transaction would affect both the company’s cash (or bank) account balance AND the company’s equipment asset account balance. In this scenario, since the company is spending money to purchase an asset, the transaction results in decrease to “Cash” and an increase to “Equipment” and would be recorded on the journal entry as a debit “Dr” to “Equipment” and a credit “Cr” to “Cash”.

The reason why transactions always affect two or more accounts in a double entry system is because this system illustrates the entire financial picture. It tells us not only where the money is going, but where the money came from to begin with. On the surface it may seem as if a single entry system tells us the same thing as it allows us to compare revenue to expenses, however, its important to note that expenses are ultimately paid from a company’s assets, not from their sales revenue. When a company earns revenue, that revenue is added to the assets of the company, and when the company goes to pays its expenses it uses its assets to make the transaction.

Enter the T-Chart

Accounts in a double entry system can be visualized as T-Charts with the left side being the debit column and the right side being the credit column. See the image below for reference:

When transactions are recorded in a journal entry, the corresponding debits and credits are added to the appropriate columns of each account affected by the transaction. For example, if a company purchases supplies for $500 in cash, the transaction results in a decrease to “Cash” and an increase to “Supplies Expense”. In this scenario you’d record the journal entry as: Dr – “Supplies Expense”, Cr – “Cash”.

Once the journal entry is recorded, you will add the debit from the journal entry to the debit column (left side) of the “Supplies Expense” account and the credit from the journal entry to the credit column (right side) of the “Cash” account in the general ledger. Computerized systems will automatically do this and calculate the resulting balances for you, however, pretending we’re in 1962 and doing everything with pen and paper, it would look like this:

From there, we can calculate the balance of each account by taking the sum of all the debits in the debit column and subtracting it by the sum of all the credits in the credit column (or vice versa depending on which column ends up having the larger value). In this scenario, since there’s only one transaction affecting each account, the calculation is simple. We can calculate that “Supplies Expense” has a debit balance of $500 and “Cash” has a credit balance of $500.

This doesn’t really tell us anything though, until we understand what a “normal balance” is and which accounts should be debited and credited.

What is a Normal Balance?

Each type of account in an accounting system has what’s called a “normal balance”. This can either be a debit or a credit balance, and it indicates whether the account is increased by either debits or credits. For example, all expense accounts have a normal debit balance, meaning that debits made to these types of accounts always increase the balance of the account, whereas credits to these accounts decrease the balance. Asset accounts also have a normal debit balance. Liability accounts on the other hand have a normal credit balance, meaning that debits made to these accounts actually decrease the account balance while credits increase them. If this is confusing, don’t worry, we’ll give you an easy way to remember the normal balances of each account type in the next section.

In the example above, we can see that “Supplies Expense” has a debit balance of $500, and “Cash” has a credit balance of $500. This makes sense for “Supplies Expense” considering that all expense accounts have normal debit balances. The fact that “Supplies Expense” currently has a debit balance of $500 simply means that we paid a total of $500 towards supplies expenses. However, since Assets also have normal debit balances, the fact that “Cash” (an asset) currently has a credit balance is not so logical. On paper, it means that our “Cash” account is currently negative $500.

This sounds like it should be incorrect (and it should), but if you scroll back up to our original example and re-read what exactly took place when we recorded the transaction, you’ll see the issue immediately. We recorded a transaction of $500 to purchase supplies, which affects both the “Cash” and the “Supplies Expense” accounts, however, we also determined that this was the only transaction affecting each account. This means that we spent $500 that we didn’t actually have, since our cash balance was zero prior to the transaction. As a result, we end up with a credit balance of $500 in our “Cash” account telling us “Hey, you’re in the red here!”.

In practice this sort of thing won’t happen often, as you can’t purchase $500 worth of supplies if you don’t have $500 to begin with (unless you’re putting it on credit, and in those cases the transaction would be recorded a bit differently).

A more realistic T-Chart breakdown for this scenario would look like this:

Where our “Cash” account has a previous debit balance of $15,000 resulting from an initial investment made by the business owner. We’ve included a third account titled “Owners Equity” with a credit balance of $15,000 to illustrate the other side of this transaction. In this scenario, “Supplies Expense” still has a debit balance of $500, but our “Cash” account now also has a debit balance of $14,500, showing that we started with $15,000 (debit), spent $500 (credit), and still have $14,500 leftover.

when to use debits and when to use credits??

This is a very confusing concept to grasp for most beginners. It’s hard enough to understand all the various account types, let alone their normal balances and when to debit them or when to credit them. My advice, and what clicked for me during my first year of college is to use the “DEALER” method to remember the normal balance of the most common account types.

DEALER is an acronym that stands for:

Dividends
Expenses
Assets
Liabilities
Equity
Revenue

Shoutout to finallylearn.com for this image (url: https://finallylearn.com/debits-and-credits-explained-illustrated-guide/#What-are-debits-and-credits)

The first three account types in the DEALER acronym all have normal debit balances and the last 3 all have normal credit balances. Any time you need to record a transaction, you’ll want to consider which accounts are being affected, and then evaluate which category the accounts fall under this acronym. This will give you a solid idea of which account to debit to and which account to credit.

For example, lets say our business sells a service for $1,000. In order to record the transaction, we want to first examine what exactly is taking place here and which accounts are affected. We’re making a sale, which means we’re receiving $1,000 in revenue, and this revenue is going to be added to our “Cash” account. Looking at it like this, we’ve identified that the two accounts that are affected by this transaction are “Cash” and “Service Revenue”. Next we’ll want to determine how these accounts are going to be impacted. We’re receiving $1,000 which means our revenue has increased, this $1,000 is then added to our “Cash” account, which means our cash has also increased. Knowing this, when we record the transaction we want to apply debits and credits appropriately to increase both “Cash” and “Service Revenue”.

From here, we can take a look at the DEALER acronym to see where we should place the debits and credits. We know that “Cash” is an asset, so according to the DEALER method, we need to apply a debit to increase this account. The DEALER method also tells us that in order to increase “Revenue” accounts we need to apply a credit. We know that each transaction in a double entry system should consist of at least one debit and one equal credit, so in this case the resulting journal entry is simple.

According to the DEALER method, we need to make a $1000 debit to “Cash” and a $1000 credit to “Service Revenue”. Upon recording the journal entry in a computerized system, the affected accounts will automatically update and their account balances will be adjusted accordingly. The resulting T-Charts would look like this:

As you can see it gets more complicated as transactions flow through the system and new accounts come into play. For the sake of this article though, we’re simply focusing on the relationship between debits and credits. As you can see above, our new “Cash” account balance is $15,500, showing that we started with a $15,000 investment, spent $500 on supplies, and then generated $1000 in service revenue.

Why does it work this way?

Frankly, because some very smart people decided it should a long time ago. The concept of why certain accounts have normal debit balances and why others have normal credit balances is an arbitrary one and has a lot to do with the way the accounting formula works and how the various accounts interact with each other. I personally wasted way too much time in my intro to accounting class trying to wrap my head around why revenue increases with a credit and why cash increases with a debit, when in reality asking that question is like asking why Y=MX+B… The best answer I can give you as a beginner is that it just does. It’s not really important to understand why at first, and as you learn more about accounting and start to understand the larger picture, it’ll all make a lot more sense.

If debits increase assets, then why do banks credit your account to increase it?

This is something that confuses a lot of people who are new to accounting. You’ve likely gone your entire adult life understanding the terms “Credit” to mean an increase and “Debit” to mean a decrease because that’s how all the banks word it, and they aren’t necessarily wrong. The disconnect here is because people fail to realize that banks are speaking from their own perspective, not your perspective as the customer.

When you deposit $100 into your bank account, think about what happens on the back end at the bank. They’re receiving $100 which increases their assets, so they have to record a Debit to their “Cash” account, but this $100 doesn’t belong to them. It’s your money, not theirs, so they wouldn’t record it as revenue. They have to be able to pay this money back to you whenever you request it. In this sense, it’s almost like you’re giving the bank a loan of $100. And we know that loans are liability accounts, and liabilities have normal credit balances.

So when you deposit $100 at the bank, the transaction is recorded on the bank side as a $100 debit to “Cash” and a $100 credit to the liability account they have set up for you as a customer. This is why the banks use the term “credit” when they refer to money going into your account. It’s because your checking/savings account balance is a liability to the bank, and we know (thanks to the DEALER method) that credits increase liabilities.

Where can i go to learn more?

Aside from poking around our own blog, we recommend you check out accountingcoach.com. It’s a great FREE course to learn all about the basics of accounting. They offer self paced modules, practice tests, and various certificates for completion. This is one of the best free resources available, however, there is no shortage of paid courses you can take on platforms like Udemy. Just be sure you’re taking high-quality courses with good reviews.

Unlike most subjects, I actually don’t recommend trying to learn accounting on your own through YouTube videos or blog posts like this one. This sort of content can be a great refresher or a helpful addition to structured course material, but to really grasp the concepts of accounting you’ll likely have better luck taking an actual course.