In this post I am going to explain to you exactly what Debits & Credits are, and how you can fully understand the concept behind them going forward.
You might have been like me when I was at University, and completely failing to get my head around Debits & Credits. Every time I thought I understood it, something else came along to confuse me further.
So, let’s get to it, I’ll explain to you exactly what a Debit & Credit is, common misunderstandings, and some helpful hints & tips to help you ace your exams.
About Me & My Background
Just a small introduction here. My name is Al, and I’m a Qualified Chartered Accountant (CA), with Big 4 Accounting experience. I created this website initially to help people with their finances, as well as help aspiring accountants, business owners, and bookkeepers.
This is my first post in what will hopefully be a long line of “Accounting Simplified” posts, where I aim to break down Accounting Concepts in a really simple manner that anybody could understand. If there’s a specific area of Accounting you would like a breakdown of, then please leave a comment, and I will put something together for you.
Get your notepad out.
Are you ready?!
Understanding Debits and Credits
Let’s start off by trying to erase any misconceptions or misunderstandings related to Debits & Credits. Here is a breakdown of some common queries/misunderstandings I have heard over the years:
- Don’t think of Debits & Credits as “Addings & Subtracting” it isn’t the same
- Debits & Credits are equal – Neither is ‘Good’ or ‘Bad’
- Debits & Credits are directly linked to one-another. They represent the double sided nature of a set of accounts
- Debits & Credits MUST balance
In the real world, when you buy something, the money doesn’t just disappear from your bank account, from an accounting standpoint. Your bank balance reduces, and you gain something in return. For example, if you buy a computer:
This would be the opposite from the seller’s point of view:
Credit ASSETS (Or stock)
For every ACTION within accounting, there must be a RE-ACTION. In Accounting Terms, the flow of cash from one account to another is called “Economic Benefit”
What is “Economic Benefit”?
The definition of economic benefit, is the ability for an asset to contribute directly OR indirectly to the flow of an entity’s cash. A simple example of this is if you own a book store, and sell a book, the asset you just sold created ECONOMIC BENEFIT to your business by receiving cash in exchange for it.
Flow of Economic Benefit
There are various key areas which Economic Benefit can flow to/from.
Items Economic Benefit Flows:
Assets: Examples of assets could be cash, buildings, amounts owed to you (receivables), furniture etc. These can directly or indirectly create economic benefit for your company.
Expenses: The economic benefit here is the movement of payment in exchange for a good or service
Dividends: A business will often pay out a financial benefit to shareholders. This is a flow of economic benefit from the company to the shareholder. However, the shareholders themselves created economic benefit for the company initially when shares were purchased (but that is a different topic).
Equity: The owner of a business can give their cash to the business as an injection of funds. When shareholders buy shares during a public offering, this creates equity in the business, therefore economic benefit is flowing from the shareholder’s bank account, into the accounts of the business. The shareholders in this example are the source of economic benefit.
Revenue: The economic benefit here is flowing from the sales/income of the business into the accounts of the business. If I sell 1,000 pencils at £1 each. I have made Revenue of £1,000. This causes a flow from the pockets of the people I sold to, into my bank account. The revenue is a source of economic benefit for the company.
Liabilities: An example of this could be amounts owed to suppliers for stock, or a loan liability to the bank. The flow of cash is from my bank account to the providers bank account, however, I am gaining economic benefit from that stock, or that loan.
If you look at the equation “Assets = Liabilities + Equity” – We can see that Assets are under Debits, and Liabilities are under Credits. However, equity isn’t quite as simple as that. Let’s dive into it.
Equity Definition: Equity = Equity Paid in by Owners – Dividends Paid Out + Retained Earnings.
Retained Earnings Definition: Profits held within the business which can be used in the future
Profit Definition: Profit = Revenue – Expenses
Based on the above, let’s create a long version of the equity formula:
Equity = Owners Equity – Dividends + Revenue – Expenses
SO – If ASSETS = LIABILITIES + EQUITY, we can make it longer as followers:
ASSETS = LIABILITIES + OWNERS EQUITY – DIVIDENDS + REVENUE – EXPENSES (Notice how this now includes all aspects of the table up above?)
Let’s rearrange slightly: DIVIDENDS + EXPENSES + ASSETS = LIABILITIES + EQUITY + REVENUE (DEALER)
Everything on the LEFT is a DEBIT, everything on the RIGHT is a CREDIT. Remember the acronym – D.E.A.L.E.R
D – Dividends
E – Expenses
A – ASSETS
L – LIABILITIES
E – EQUITY
R – REVENUE
That is how you are going to remember what is a debit and what is a credit.
Let’s be clear on how debits and credits move.
Debits INCREASE when Debited, and decrease when Credited
Credits INCREASE when Credited, and decrease when Debited
Think of them as opposites in this sense, They move in alignment with their allocation. Is it a Credit on the above table? Is it being Credited? Two Credits = INCREASE. The same applies for Debits.
DEBITS & CREDITS RECAP
Please feel free to print this off, and use it as a Cheat Sheet for Debits & Credits knowledge.
Let’s summarise what we have learnt so far…
- Debits & Credits act as a pair. For every Debit, there must be a Credit
- Debits create Economic Benefit to a destination (EG Expenses being paid)
- Credits create Economic Benefit from a source (EG Receipt of Owner’s Equity)
- Debits = Dividends, Expenses & Assets
- Credits = Liabilities, Equity & Revenue
- Remember the DEALER acronym
Thanks for coming to Normanie.com to help with your Accounting knowledge. If there are any specific areas you would like to learn about, don’t hesitate to recommend in the comments section below.