- In accounting, money coming in and out of your small business is recorded as debits and credits.
- Double-entry accounting — a good option for reducing accounting errors — records two book entries to balance a business’s books to zero. Debits record incoming money, whereas credits record outgoing money.
- When using the double-entry system, it's important to assign transactions to different accounts: assets, expenses, liabilities, equity and/or revenue.
To some, accounting — the pillar of a small business — can sound like a chore. But it's an integral business activity that helps you generate invoices, pay your employees and bills and understand your business's overall health.
Tracking the movement of money in and out of the business, also known as debits and credits, is an essential accounting task for small business owners. Single-entry accounting tracks revenues and expenses, whereas double-entry accounting also incorporates assets, liabilities and equity. The latter method tends to provide a fuller view of your business’s accounts.
Understanding accounting basics is critical for any business owner. Read on to understand debit and credit accounting, the concept of double-entry accounting and a few accounting best practices.
What are debits and credits in accounting?
Simply put, balancing a business’s books involves recording how money flows in and out of the business and ensuring the entries "balance" each other out. These bookkeeping entries, which appear on a company’s financial statement, are also referred to as debits and credits.
You may be asking: what’s the difference between a debit and a credit? In double-entry accounting, debits record incoming money, whereas credits record outgoing money. For every debit in one account, another account must have a corresponding credit of equal value.
What is a debit?
A debit entry increases an asset or expense account. A debit also decreases a liability or equity account. Thus, a debit indicates money coming into an account. In terms of recordkeeping, debits are always recorded on the left side, as a positive number to reflect incoming money.
What is a credit?
A credit entry increases liability, revenue or equity accounts — or it decreases an asset or expense account. Thus, a credit indicates money leaving an account. You can record all credits on the right side, as a negative number to reflect outgoing money.
How does an account reflect debits and credits?
Understanding the definition of an account in accounting terms is important. An account has many different applications in finance, and its usage and terminology can differ.
An accounting system tracks the financial activities of a specific asset, liability, equity, revenue or expense. You’ll record each individual account in a ledger and use this information to prepare your financial statements. Records increase and decrease as accounting transactions occur, and this movement represents the diametrical relationship between debits and credits.
|Assets = Liabilities + Equity|
The accounting equation given above illustrates the relationship between assets, liabilities and equity. As one side changes, so does the other.
Types of accounts
Your business is likely spending and receiving money. A common accounting practice is to assign transactions to one of five main account types:
- Asset accounts: Assign resources relied on to generate revenue now and in the future (e.g., inventory, accounts receivable, cash account)
- Expense accounts: Assign resources used to generate income (e.g., delivery expenses, advertising expenses)
- Liability accounts: Assign liabilities owed to creditors (e.g., accounts payable, salaries and wages, income taxes)
- Equity accounts: Assign an owner’s equity in their company (e.g., initial investments, stock)
- Revenue/income accounts: Assign income that your business generates (e.g., interest income, rent income)
If a business owner wants to get a closer picture of their income taxes, they can analyze the activity in their liability account. When recording debits and credits, remember that all of these accounts relate to one another; when one account changes, so do the others.
A chart of accounts, or COA, provides a bird’s-eye view of a business’s financial data. A COA lists all financial accounts in the general ledger for a business, and business owners can use this organizational tool to perform a financial analysis.
Debits and credits in double-entry accounting
The double-entry system requires both debit and a credit entries. When these two items balance out — or equal zero — on your balance sheet, your books are balanced.
The double-entry system can reduce accounting errors because the balancing-out step works like a built-in error check.
Additionally, the double-entry system tracks assets, expenses, liabilities, equity and revenue. Remember that debits are always recorded on the left with credits on the right. A transaction that increases your revenue, for example, would be documented as a credit to that particular revenue/income account.
Debits and credits in a journal entry
Business owners can visualize their business transactions in two methods: a T-account or journal entry. For a T-account, you can record bookkeeping entries in a way that resembles a T shape. On the other hand, for a journal entry, a business owner records a single transaction in journal format.
In the below example of a journal entry, a business owner paid their employee’s salary. Cash was used to pay the salary, so the asset decreases on the credit side (right), and salary expenses increase on the debit side (left).
Debit and credit examples
Although the accounting system you choose will be unique to your business and its industry, business owners are likely to encounter some common situations.
Documenting a sales transaction
The below example illustrates a financial transaction in which a catering company provided its services for a client’s party. In this case, the client didn’t immediately pay in full; rather, they asked to be billed. For this reason, the asset must be documented as a receivable account and not cash. The revenue account is increasing, as is the assets account.
|Asset||Account Receivable, $3,000|
|Revenue||Service Revenues, $3,000|
Documenting receipt and payment of a bill
In many instances, business owners are responsible for resolving their accounts payable — another word for short-term liabilities — or an amount they owe to a supplier or vendor.
In the below example, Jaclyn, the owner of a coffee shop, purchased an espresso maker. While the new espresso maker is an asset that is increasing, the supplier of the espresso maker agreed to bill Jaclyn at a later date. As such, this liability is increasing, as Jaclyn now owes that money to her supplier.
|Liabilities||Accounts Payable, $5,000|
Documenting a business loan
In the below example, Kai has received a bank loan to get his pet grooming business started. The cash injection is an asset that is increasing. In accepting the bank’s terms, Kai must repay the bank, so the $10,000 is listed as a liability that is increasing.
|Asset||Cash in Bank Account, $10,000|
|Liabilities||Bank Loan Debt Amount, $10,000|
Debits vs. credits in accounting
In double-entry accounting, debits refer to incoming money, and credits refer to outgoing money. For every debit in one account, another account must have a corresponding credit of equal value. When this happens, your books balance.
If you're a small business owner, having a strong grasp of accounting fundamentals will help you keep your books balanced for your company's long-term success.