Lesson Objectives:- How debits and credits drive transaction analysis
- Use of the financial accounting equation
- Examples of debits and credits
- Applying the accounting rule to real life situations
We discussed double entry accounting in the previous lesson and the fact that every transaction has at least one credit and one debit. This is a very important concept when it comes to financial accounting as debits and credits are essentially the basis of transaction analysis.
Make sure to pay close attention to this lesson as we review debits and credits as they are critical to the preparation of financial records. It is likely that you can increase or decrease the wrong account or miscalculate figures on the financial statements if you don't know how to properly record transactions.
When you see the financial accounting equation (Assets = Liabilities + Equity), there are a multitude of account types within each element. Accounts keep economic transactions organized.
Depending on the company size and structure, the total number of accounts can range from a few dozen to thousands.
Each account must be either credited or debited in order to balance the accounting equation. Remember, not only must both sides of the equation balance but at least two accounts are affected by every business transaction.
To see how the double entry system feeds into debits and credits, let's review at a few common examples of how different accounts change. We will be breaking these examples into more detail towards the end of this lesson to understand exactly how the accounts change.
Al's Landscaping Company buys $50,000 worth of equipment on credit; both the equipment and accounts payable are affected.
Ebony's Beauty Supply pays the $2,000 rent for their store for the current month; both the cash and rent expense accounts are affected.
Sam's Electric Company takes out a loan from the bank for $130,000; both the notes payable and cash accounts are affected.
Accounts are subject to change as a result of economic events, as the business is not always going to have the same amount of cash, accounts payable or owners' equity. These events that cause the balance to change are referred to as transactions.
Once you know which account needs to be involved in the transaction, you must determine which account is to be debited and which is to be credited.
When it comes to financial accounting, don't think of debits and credits like you would think of when making a deposit or withdrawal at the bank. These terms are not intended to be applied as a decrease in cash or on increase in revenue.
In short, credits and debits will either increase or decrease an account within the accounting equation. The graphic above describes how debits and credits are used when accounts are increasing. Assets and expenses are debited when they are increasing while liabilities and income are credited.
Debits increase the left side of the accounting equation, that includes all accounts that fall under the assets category. Cash is the most commonly account that we think of as an asset but this also includes property, equipment, accounts receivable and much more.
Debits also decrease the right-side accounts that consist of liability and equity accounts.
Credits work in the reverse, they increase the right side of the accounting equation and decrease the left side.
This concept can be confusing to remember, because it is contrary to what you would think of when looking at your personal bank account transactions. Use the graphic above as a reference to determine whether an asset, liability or equity account should be credited or debited, depending on whether the account is increasing or decreasing.
Debits and credits play a specific role in financial accounting that is best understood by continuing to practice how this concept works in the real world.
Now that you've been introduced to the way debits and credits work, let's review the examples that we looked at earlier in this lesson.
Al's Landscaping Company buys $50,000 worth of equipment on credit; They are increasing the equipment account, therefore debiting the assets on the left side of the equation. On the right side, they are crediting the accounts payable account which falls under liabilities.
Ebony's Beauty Supply pays $2,000 in rent for their store for the current month; both the cash and rent expense accounts are affected. The cash account under assets is decreased, therefore crediting the assets. The rent expense is increased, therefore debiting the Owners Equity on the right side.
Sam's Electric Company takes out a loan from the bank for $130,000; both the notes payable and cash accounts are affected. They are increasing the amount of cash, therefore debiting assets. The notes payable liability account is increasing, therefore crediting the right side of the accounting equation.
As you can see in those examples, the equation may not always balance out the same way but it must equal out with the double entry accounting system. The important practice to remember is you will use debits to increase the asset accounts while credits will increase the liabilities and equity accounts.