Debits and credits in accounting seem to mystify some small business owners, yet these terms are quite simple to grasp and fun to use. Payroll Systems for Small Business takes great delight in clarifying what Debit and Credit mean. Regardless of the type of accounting and bookkeeping system you use (whether you are doing your accounting manually, or using a small business software, or outsourcing your accounting, or doing your accounting online), understanding Debits and Credits truly is important — and it’s not that hard to get a handle on.
Years ago when everyone posted their accounting records by hand, knowing the difference between a debit and credit and when to do which to what was crucial. Today, almost everyone tends to utilize a computer to make these decisions. However, people can enter their accounting information up to a certain point and then, if they don’t understand debits and credits, they try to use a debits and credits cheat sheet, (which probably confuses them even more) and they have to turn their accounting and bookkeeping records over to an expert in order to make any necessary adjustments by journal entries.
Debits and Credits are the language of these journal entries and accounting adjustments.
To enter a Journal Entry accurately, one MUST understand what a debit or credit means
For starters, here’s the easiest way to remember what a debit or credit means. This assumes you are using the standard two column journal paper.
‘Debit’ is on the left hand side and ‘Credit’ is on the right hand side — and what you do to one side you must also do to the other side.
There are many misinterpretations of this statement. People will argue and say, “Debit means to increase and Credit means to decrease or take away!” NO! NO! NO! This is not correct! ‘Debit’ does not mean to increase and ‘credit’ does not mean to decrease! Or vice versa! OK — sometimes that does happen when you are making an accounting entry, but that is NOT what those words mean.
KEEP IT SIMPLE
Keep it simple! Debit only means that a figure is on the left side, or to put it on the left side, and Credit only means that a figure is on the right side, or to put it on the right side.
The real question is what item belongs on the left and what item belongs on the right in accounting statements. This amazing system of accounting using Debits and Credits was supposedly designed by Julius Caesar, and it has not changed over the centuries. I have great respect for Caesar’s brilliance in figuring this system out, and am truly in awe of how it works.
ASSETS normally go on the Left
Here’s an overview of how his accounting system tracks everything. We start with what we HAVE/OWN. These are our ASSETS. We put them on the left hand side or ‘Debit’ them. (This reflects how you read a book. You start reading on the left side of the page. And, we start with all you own — your Assets.)
LIABILITIES normally go on the Right
What we OWE is the opposite of what we have, and these are our LIABILITIES.
We put these items on the opposite side of the left side — which means to put them on the right hand side — or we ‘Credit’ them.
NET WORTH is the difference between ASSETS and LIABILITIES
The difference between what we HAVE and what we OWE is what we are WORTH. Or, to put it in accounting terms: The difference between our ASSETS and our LIABILITIES is our NET WORTH. Hopefully, this will be a Credit amount.
FINANCIAL STATEMENTS — The Balance Sheet and the Profit and Loss Statement
The above three items, Assets, Liabilities and Net Worth are the three items that are reflected on a Balance Sheet, which is one of the two main financial statements.
The other main financial statement is called a Profit and Loss Statement, or a Statement of Income. It starts out just the opposite of the Balance Sheet.
INCOME and EXPENSES and PROFIT
INCOME is posted on the right hand side (credited), and EXPENSES are posted on the opposite side, the left hand side (debited).
The difference between these two items is reflected by: INCOME less EXPENSES equals PROFIT. In accounting terminology, you would Credit the Income and Debit the expenses.
TIE IT ALL TOGETHER
To tie the two statements together, you take the PROFIT from the Profit and Loss Statement and put it in the NET WORTH section of the Balance Sheet, and end up with a beautiful accounting system based on the wisdom of Caesar.
At Payroll Systems for Small Business we really believe that if you take the above information one step at a time, one paragraph at a time, you will see how logical it is. Think in terms of opposites and the pieces of the puzzle will fall into place.
Debits and Credits in accounting can actually be fun! And you don’t need a debit credit cheat sheet to master them!