Making sense of debits and credits in this business owner’s guide to important accounting principles

What are debits and credits used for?

Debits and credits are both commonly used words and components of accounting transactions, which are used in the following three distinct ways:

• Payment cards. Payment cards are either credit cards or debit cards — we’ll ignore gift cards for the sake of simplicity here. Credit cards are promises to pay a lender later for a purchase you make today. They are backed by nothing but this promise.On the other hand, debit cards are tied to an account (typically a bank account) that has been pre-funded with money. Each time you use the debit card, you draw against the balance of this account.

• In banking. Your bank credits your account when a deposit is made. It debits your account when you withdraw money, either directly, with a debit card, or a check. So, when you hear the word “credit,” you probably think “addition.” And when you hear the word “debit,” you likely will think of “subtraction.”

• In accounting. Then your accountant tells you that debiting an asset account increases it — while crediting it reduces it. Which you can accept, until you remember that your checking account shows up in the assets section of your Balance Sheet. This seems to put your accountant at odds with your bank and might prompt a bit of head-scratching when you’re speaking with your accountant.

Demystifying debits

Debits increase asset accounts — checking, savings, inventory, buildings — everything your business owns. Debits also increase expense accounts.

To illustrate, let’s look at a few examples:

Assets (example one)
You are a graphic designer, and you just completed your first project for $5,000.00 (yes, you are that good!) You take the check to the bank and deposit it into your checking account. Your accountant makes the following entry:

• Debit: ← Checking for $5,000.00
• Credit: → Income for $5,000.00

The debit records the money coming into your checking account as an asset.

Assets (example two)
You just purchased a new computer and were fortunate enough to  pay cash for it. Your accountant makes the following entry:

• Debit: ← Equipment for $2,500.00
• Credit: → Checking for $2,500.00

In this example, the debit records something — the purchase price of the computer — coming into your bookkeeping Equipment account. Equipment is an asset account. Simultaneously, the credit records the cash leaving your checking account.

Expenses
You are committed to furthering your skills as a designer, so you attend a workshop with an enrollment fee of $1,000.00. Your accountant makes the following entry:

• Debit: ← Education for $1,000.00
• Credit: → Checking for $1,000.00

In this example, the debit records the increase in an expense account — Education — while the credit once again records cash leaving your checking account.

Uncovering credits

Credits increase liability, income, and equity accounts, which means they decrease asset and expense accounts. Another way to look at it is that credits decrease what your company owes — either to others, or to you as the business owner.

Get a closer look at these principles in play with these examples:

Liabilities
You use a credit card for some of your startup costs to buy laptops for your first official new employees. Now that you have a few projects under your belt, you are ready to pay off the $3,000.00 balance of the laptops. Your accountant makes the following entry:

Debit: ← Credit Card Payable for $3,000.00
Credit: → Checking for $3,000.00

With the debit, you have decreased what your company owes to the credit card company by $3,000.00 with the debit. You have also decreased your checking account balance by $3,000.00.

But you just heard about a great opportunity to stock up on some inexpensive office furniture, since these new hires will need a place to sit! But because you used your cash surplus to pay down your credit card, you don’t have enough in your checking account to cover the full purchase. So, you put $150.00 of the $750.00 furniture purchase total back on the credit card. Your accountant records the following:

• Debit: ← Small Furniture Expense for $750.00
• Credit: → Checking for $600.00
• Credit: ⇔ Credit Card Payable for $150.00

This is an example of a simple split transaction, which is very common in accounting. What has happened in this scenario is that the Small Furniture Expense account is increased by the total amount of $750.00. This is a debit (remember, expenses are increased by a debit.) You’re already familiar with your checking account being reduced by a credit, from your accountants, and now your perspective. However, you have also increased your Credit Card Payable liability by $150.00 and liabilities are increased by credits.The entire transaction has $750.00 in debits and $750.00 in credits, and the transaction is in balance. There’s that symmetry we talked about earlier.

Equity
Equity is your stake in the business, or what would belong to you if all your assets were used to pay off all your liabilities. One of the most common forms of equity is when a business owner uses some of their personal money to start the business.

Let’s say you invested $10,000.00 of your personal savings to launch your graphic design business. You transferred that money from your savings account into a business checking account. Your accountant applauds your good business sense (since we recommend never mixing business and personal funds) and records the following transaction:

• Debit: ← Checking for $10,000.00
• Credit: → Paid in Capital for $10,000.00

The debit, of course, increases your checking account. The credit also indicates an increase, but this time in the equity account called Paid In Capital.

Now, let’s say it’s time for you to pay yourself a salary for the month because you, my friend, are no starving artist. Your graphic design business is a sole proprietorship, so you will take draws from the business. These draws are not business expenses. Instead, they are taken from your stake — or equity — in the business. Your accountant records the following transaction:

• Debit: ← Owner’s Equity for $2,000.00
• Credit: → Checking for $2,000.00

The debit to the equity account decreases your stake in the business, or what the business “owes” to you. And the credit decreases your business’s checking account balance.

Income
Last, but certainly not least, is income (and we put it toward the end for a reason). That income, like liabilities and equity, is increased by a credit seems counterintuitive until you have seen how credits and debits impact your other accounts.

Let’s refer back to Example 1 under Assets which we touched on earlier in the article. In that example, you completed your first graphic design project for $5,000.00. The entry your accountant made was:

• Debit: ← Checking for $5,000.00
• Credit: → Income for $5,000.00

Debits and credits vs. addition and subtraction

It’s reductive to try to position debits as additions and credits as subtractions. As we’ve seen, debits increase asset and expense accounts and decrease liability, equity, and revenue accounts. And credits increase liability, equity, and revenue accounts while decreasing asset and expense accounts. Neither case is a matter of simple addition and subtraction. Trying to view it in those terms will only serve to frustrate you.

How businesses (and accountants) keep track of debit and credit accounts

Any accountant who says that they don’t have to stop and think about whether to debit or credit an account to properly record a transaction is likely bluffing. This process isn’t intuitive, so here’s a table to help you keep it all straight.

The basics of keeping debits and credits organized

When your business is very small — meaning you only have a few transactions per month in your business bank account — your bank statements can serve as your accounting records. Though your bank statements only tell you so much about your business,you will quickly want to start keeping your debits and credits organized in an accounting system.

You have three options: paper ledgers, spreadsheets, and accounting software.

Paper ledgers
A young accountant spends a week at their new office, training under the retiring accountant whom they are replacing. Every morning, the retiring accountant opens their desk drawer, takes out a worn sheet of paper, reviews it, and then begins their day’s work.

The new accountant takes over their desk after their mentor retires. On their first day working solo, they find that their mentor has left the paper behind! Giddy with anticipation, the new accountant flips over the paper and reads: “Debits in the column by the window. Credits in the column by the door.”

That bad joke is how I learned to keep track of debits and credits using paper ledgers. Debits go in the left-hand column — credits go in the right-hand column.

Although doing your accounting in paper ledgers will give you an excellent understanding of the fundamentals of accounting, it is inefficient, the opportunities for errors are endless, and your chances of catching and correcting those errors are small. The reality is that there are much better ways to use your time.

Spreadsheets
Recording your debits and credits in a spreadsheet is a step above keeping track of them in paper ledgers. A very, very small step.

Yes, you can keep a list of expenses and income in Excel or Google Sheets, using calculating features to ensure the accuracy of your recordkeeping. Unless you set up your spreadsheet to serve as a full general ledger using double-entry accounting rules, you are not doing true accounting or bookkeeping. You will also miss out on vital information about your business’s profitability and other performance indicators.

Software
True, the cost of good quality accounting software can be eye-opening, but it’s likely to pay dividends.

These days, most accounting software uses a “form entry” interface, meaning that you’ll enter transactions using a screen that looks like an accounting document you are familiar with, such as a check, an invoice, or a bill, and the software will take care of the debits and credits for you.

The downside is that you’ll lose the thorough understanding of the fundamentals of accounting you would have if you used paper ledgers. And you’ll spend more on software than you would if you tracked your debits and credits using a spreadsheet. But you will gain accuracy, quick access to vital information about the financial position of your business, and perhaps most importantly, time.

A word to the wise
However you decide to track your debits and credits — whether in paper ledgers, in spreadsheets, or using accounting software — it can be worthwhile to invest in the services of an accountant or a bookkeeper to set up the system for you and to show you how to use it.