Understanding Debits and Credits once and for all.
Why do most people get debits and credits confused? You’ll be happy to learn it’s not your fault. More on that later. Here’s the easy way to remember debits and credits. Hint: think Balance Sheet. (To get my article on Balance Sheets, drop me an email).
Draw a huge “T” on a sheet of paper. Write “Balance Sheet” on top of the “T”. First, the left side of the vertical line is for Assets which are debit balances normally. In fact, debit really only means “the left side”, nothing more, and is the home of the Assets on the Balance Sheet. On the right side are normally credit (credit only means “the right side”) balances and is the Balance Sheet home of Liabilities and the Equity. For every debit there must be a credit. If cash, an asset, increases, then it must be a debit to cash. Now, since there are two sides to every transaction, and since we already have the debit, now we must find the credit. (Hint: an easy way to figure this stuff out is by process of elimination; find one and you will know what the other must be.) If cash increased because we collected on A/R (reducing A/R–also an asset), then we know that we must be crediting A/R. This makes sense because we decreased A/R, an asset. If cash increased because we borrowed the money from the bank, then the credit goes to the bank loan liability, which makes sense because we increased a (right side) liability, which are normally credits.
Asset increases are debits, decreases are credits. Liability and Equity (opposite side of the “Balance” Sheet) increases are the opposite, so their increases are credits and decrease with debits. Now, was that so bad?
What about the Profit and Loss or Income Statement? Now that you know the basic rule, you know what to do here as well. If the P&L has a positive bottom line, a profit, then profit is going to increase the value of the company, right? If profit increases the value, it will increase the equity of the company, right? And we already know that means a credit to the equity. Since profit comes from having more income than expense, incomes must be credits and expenses must be debits. Spend cash to buy pens; debit supplies expense and credit the asset cash. Bill a customer; debit A/R, credit Income.
So, who’s fault is it anyway for all the confusion? Blame your bank! People have learned that the bank “credits” their account and it goes up, so they think increasing cash must be a credit. Wrong! In reality, from your perspective, they are actually debiting your account, what they really mean is they are crediting their account, from their perspective, specifically, their liability account that has your name on it. They are holding your money, so they owe it to you! So, they are crediting their account! Now you know the greatest accounting secret!