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Business Analysis For Dummies Cheat Sheet
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$ 0, 555 + =, 555 + =, $ <. () = At first glance, the field of debit and credit may not seem like a simple concept to navigate. the same meaning in the accounts as in everyday life and may in principle be contradictory. However, when properly understood, the double entry system and its fundamentals (debits and credits) become an essential tool in any aspiring accounting kit.
Simply put, debit means to reduce or subtract. In everyday life, our ‘debit’ cards allow us to make payments from our savings or income, which are ‘debited’ each time we do so.
As in accounting practice, when a pizzeria buys flour from the local supermarket, it “debits” the company’s bank account.
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Going on credit, on the other hand, means exceeding your available finances. Credit cards allow us to buy goods or cover expenses for which we may not have the necessary funds. In exchange for the line of “credit”, we pay a monthly or annual fee. Often we also have to pay interest depending on how much of the limit we have used up. Likewise, when a hamburger shop applies for an overdraft from their local bank, they now have a “line of credit.”
Modern accounting grows out of the principle of debits and credits and applies them to items such as assets, liabilities and equity. These three mainly form the basic accounting equation.
The basic accounting equation states that your assets should always equal your liabilities and equity. This has major consequences for accounting practice.
Now this is where things get more exciting. We have already covered the meaning of assets, liabilities and equity. Let’s see how they behave when it comes to debits and credits.
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Assets are by nature “debit” items. This means that every time an asset increases in value, kind or amount, you “debit” that account. And when an asset decreases, you “credit” that account.
Debt and equity are the opposite, they are “credit” items. So whenever a liability occurs, you “credit” that line item, and when it’s reduced, you debit it.
Revenue is the money or cash flow that we generate from selling a particular product or service. For example, income from our product sales through our store or online. Revenue is by nature a “credit” line item. So every time it increases we credit it and every time it decreases we debit it. Just as our salary is “credited” to our accounts every month, or withdrawn with a “debit card” from the ATM.
Expenses can be the cost of making the product we sell (known as cost of goods sold), or the general cost of running our business. For example utilities or even the cost of fuel for our transport vehicles. A third type of expense is depreciation and amortization, which are costs that a company incurs from the obsolescence and inadequacy of its fixed assets. Expenses in nature are a “Debit” line item. So every time our expenses rise, they are “debited” in the ledger, and every time they fall, they are credited.
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There is an important difference in the way these accounts are registered. Income and costs are items in the income statement. Meanwhile, assets, liabilities and equity are part of the balance sheet. However, both of these accounts are governed by the principle of double entry.
The concept of double entry is visible in the accounting equation itself. Your company’s assets must equal what your company owes and owns (ie debt and equity).
For double registration, we traditionally use paper-and-pencil “journal entries”, which we organize into parent and subsidiary companies. Of course, advanced software like Sage no longer requires us to maintain physical records.
The general ledger account is the name of the container where we store information about balance sheet items and income. Note that these are assets, liabilities and equity for the balance sheet, income and expenses for the income statement. In the example above, a company has the following general ledger accounts on the asset side of the balance sheet: Cash, Accounts Receivable, Inventory, Property, Plant and Equipment, etc.
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Usually a ledger has sub-books, which contain the respective details of the account. For example, a receivables ledger will have sub-tabs that contain information about the amount each customer owes. An inventory ledger will contain suborders showing the distribution between raw materials, work in progress and finished goods.
The general ledger accounts are known as “T-accounts” because we set them up in the form of the letter “T”. Debit entries always fall to the left and credit entries to the right of a T-account.
However, the burger joint purchased some of its inventory on credit for $2,500 from a vendor and is now due.
Now, if Burger Binge Ltd continues to pay its creditor $2,500, it will credit the $5,000 bank balance by $2,500. At the same time, they will have to charge the borrower’s account because they are eliminating a liability. This maintains balance in the accounting equation: Assets decrease and so do liabilities, but equity remains the same.
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Tip: Compare this with the graph shown earlier to get a better sense of the dynamics of debits and credits.
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