Debits and Credits

There are five account types: Assets (what the company owns), Liabilities (what the company owes to someone else), Revenues (how the company makes money), Expenses (how the company spends money), and Shareholder Capital (company stock). Double-entry accounting establishes rules for each account type that determines when an amount should be recorded as a debit or a credit. It also tells you when the number should be treated as a positive number or negative number. Table A-1 lists what these rules are. Once you understand this table, everything else will start to fall into place.

Table A-1. Double-entry accounting rules.

Listed next to each account are the Debit and Credit columns. Each column either has a + or a – in it. If an entry increases the account value, it goes in the + column. If the entry decreases the account value, it goes in the – column.

Let’s see how this chart is used with the two previous examples. In the first example, we received cash from the bank and now we have a new loan to pay back for $1,000. Cash is an asset and Table A-1 shows that when an asset increases then the amount goes in the debit column. Consequently, for the second line we got a loan and owed the bank money (a liability). If you look in Table A-1, you see that when a liability increases then the amount should go in the credit column.

The second example had us buying a car for $30,000. The value of the car, $30,000, was put in the debit column because it increases the value of the asset. We also had to pay a down payment of $3,000 and this was put in the credit column. This is because Table A-1 states that when an asset decreases value then the amount goes in the credit column. We also had a new loan that was payable to the bank (a liability), so $27,000 was put in the credit column because it increased the liability balance.

As you can see, by determining the account type that an entry relates to and if it increases that account or decreases it, we can look at Table A-1 and see whether the amount should be a debit or a credit. The beauty of this whole system is that once you understand how to use Table A-1, you can make the appropriate entries in the accounting system. The debits will always equal the credits and everything balances (this makes auditors very happy).

So that you get a better idea of how to classify accounts in the proper account type, Table A-2 gives you examples of some accounts and how they are classified.

Table A-2. Sample accounts for each account type.

This table isn’t supposed to make you an overnight expert on classifying financial transactions. It’s to help you look at someone’s database records and get an idea of what is going on. If you see that there are a lot of credit entries relating to loans, when you look at your financial report you will probably see a large debt balance. If you don’t see a lot of debt, either they are paying it off (e.g. credit entries for the cash accounts), or your report might be completely wrong and you need to go back and check that you didn’t miss something.

Of course, if you’re not an accountant, it’s difficult to know how to classify every account. Fortunately, you don’t have to do this. In most accounting systems, the different accounts are grouped together by the first digit in their account number. For example, all assets might start with a ‘1′ and all liabilities might start with a ‘2′. So it’s pretty easy to look at the chart of accounts and immediately know the classification system. The easiest thing to do is start at the top of the chart and look for the obvious accounts every company has. For assets, look for the cash accounts. If they start with a ‘1′ then all the assets will start with a ‘1′. The next thing to look for are the liability accounts. If you see account names like ‘Accounts Payable’ and ‘Long Term Loans’ and they start with a ‘2′, then all liabilities will start with a ‘2′. You can use Table A-1 to jot down notes listing the numerical pattern for each account type. After that you won’t have to worry about it anymore.

Now that you are an ‘expert’ on debits and credits, the next time you get your bank statement you might notice something that appears wrong. Sometimes you’ll see a note that says something like, “This month your account has earned X dollars of interest. It has been credited to your account.” After reading this appendix, you might be thinking, “Wait a minute. I know that cash is an asset and when I increase an asset I put it in the debit column. So why does the bank say they are crediting my account when they are putting money into it?”

Banks are in the business of holding your money for a period of time and giving it back to you in the future. They actually owe you this money and they think of you as a liability. We now know that to increase a liability you list the amount in the credit column. When a bank says that they are putting more money in your account, this is more money that they owe you (a liability) and in their accounting system this will be recorded as a credit for your account. So you should always be happy when a bank says that they are going to “credit your account”.

Although it’s great that debits and credits are used so that everything stays in balance, there is one aspect of them that will most likely cause you confusion. Look at Table A-1 and see how revenues are accounted for. When revenues increase they are recorded as credits. Since credits are negative numbers, when the company makes money the report will show negative numbers. This is going to cause a lot of problems when people think the company is losing money. Unfortunately, we know that we have to keep credits negative so that they offset the debits and everything balances. To get around this problem, we’ll find out later how to switch the signs on certain balances, but behind the scenes we’ll use the natural numbers for the calculations.