Debit & Credit. Probably one of the most confusing concepts of accounting for many - especially for non-accountants and for students of business who didn’t go deep into accounting concepts. Being a student of business, I did my fair share of struggle understanding debits and credits properly. And since then, I have faced the same questions so many times - what is debit and credit? After explaining many times to many, I myself got a clearer picture of this and I think this thought process can help to understand this confusing concept easily.
As a disclaimer, I would like to make it clear that I am not some kind of accounting purist or scholar. I just developed this thought process for my understanding which might conflict with pure accounting definition and explanation. But I can tell you that, you will understand it properly if you follow this.
At the outset, we should understand the word debit or credit. We often imply debit or credit as verbs. But debit and credit are nouns that mean different things in different contexts. To understand different contexts, a little bit of knowledge of accounting helps.
In accounting, there is a system called “Double Entry Accounting System”. In this system, we put two entries for the same transaction - one debit entry and one credit entry. Both entries are for the same amount. So, end of the day, if we sum all debit entries and all credit entries, the result should match. Or, if we subtract the sum of credit entries from the sum of debit entries, the result should be zero.
In accounting, all transactions are recorded into “Head of Accounts” i.e. Cash on Hand, Bank, Machineries and Equipment, Lands and Buildings, Sales, Marketing Expenses, etc. These heads of accounts are generally classified into five distinct groups or classes. They are Asset, Liabilities, Equity, Revenue, and Expenses. Any head of accounts will fall under any of these five classes.
Now, we have to wield a little memory power here. Assets and Expenses generally have their end balance as Debit, and Liabilities, Equity, and Revenue have their end balance as Credit. We have to remember this part.
So, when we want to increase the balance of Assets or Expenses, we “debit” the account. When we want to decrease the balance of Assets or Expenses, we “credit” the account. In other words, “debit” increases Assets and Expenses, and “credit” decreases them.
On the other hand, when we want to increase the balance of Liabilities, Equity, and Revenue, we “credit” the account. When we want to decrease the balance of Liabilities, Equity, and Revenue accounts, we “debit” them. In other words, “debit” decreases Liabilities, Equity, and Revenue, and “credit” increases them. Just the opposite of Assets and Expenses.
The reason behind this contrasting phenomenon is something called the balance sheet equation. The balance sheet equation says that the total assets of a company or entity will be equal to the sum of its liabilities and equities.
So, when any asset account (i.e. Computer) is increased, to comply with the balance sheet equation, there are only two scenarios when it can happen. First, a liability or equity account balance increase for the same amount at the same time. Or, second, another asset account decreases for the same amount at the same time. This is achieved by the dual-entry accounting system and our guys “debit” and “credit”.
I hear you say “an example please”. All right. Here it is. Let’s say we just bought a computer for 500 of whatever is your favorite currency. So, our Computer account balance increases by 500 since we added a new computer to our inventory. But according to the double-entry accounting system, and the balance sheet equation, another account must be impacted. Let’s say, we purchased the computer with cash. So, naturally, our cash balance has decreased, and we have to record that decrease here in the double-entry accounting system.
Here, both the computer and the cash accounts are from the asset class. When the computer balance increased, our cash balance decreases. So, to increase our computer balance, we will debit the computer account, and to decrease the cash balance, we will credit the cash account.
Another way we can buy the computer is to request the computer seller to pay him later. In that case, we are getting the computer now in exchange for a loan or future commitment. Any future commitment that we have to pay is our liability. So, as we buy the computer, we will debit the account to increase the balance of the computer account. And we will credit our accounts payable account since we have created an additional liability. Since accounts payable is a liability account, a credit in the liability account will increase its balance. Notice that, both sides of the balance sheet equation are impacted and increased by the same amount, so our equation will be balanced.
Now, let’s say, we pay the computer seller in cash after a month. In that case, our cash account balance decreases, since we paid some of the cash to the seller. As well as, since we have paid the amount owed to our computer seller, now we have less liability, hence, liability will decrease too.
In the accounting terms, to decrease our liability, we will debit the account payable account, and to decrease our cash balance, we will credit the account. Notice that, we have decreased on both sides of our balance sheet equation. So the balance still holds.
Accounting is a fairly complex subject. The explanation I tried to give here is for non-accountants. I hope this explanation will make the concept of Debit and Credit a bit clearer to you.