Lesson 14 - Beginner accounting course

14. Rules of Debits and Credits in Different Accounts

Understanding the rules of debits and credits is fundamental in accounting, as it ensures the accuracy and balance of financial transactions. Each type of account reacts differently to debits and credits, depending on whether the account is an asset, liability, equity, revenue, or expense. Knowing how each account behaves when debited or credited is essential to correctly recording transactions in the double-entry system.

The Five Types of Accounts

1. Assets

2. Liabilities

3. Equity

4. Revenue

5. Expenses

Each of these account types has specific rules regarding debits and credits. Below, we’ll break down the rules for each type and explain how they affect the financial position of a business.

1. Asset Accounts

Asset accounts represent what a company owns, such as cash, inventory, property, and equipment. These are resources that the company uses to conduct business.

• Debit: Increases assets. For example, when a company receives cash from a customer, its cash account is debited.

• Credit: Decreases assets. For example, if the company purchases inventory, cash is credited, because cash decreases when money is spent.

Example:

• Debit: Cash (Asset) increases when the company receives $1,000 from a customer.

• Credit: Accounts Receivable (Asset) decreases by $1,000 if the company initially recorded the sale as credit.

2. Liability Accounts

Liabilities represent what the company owes to others, such as loans, accounts payable, or other debts. These accounts reflect obligations that require future settlement.

• Debit: Decreases liabilities. For example, when a company repays a loan, the liability account (e.g., Loan Payable) is debited.

• Credit: Increases liabilities. For example, when a company borrows money from a bank, its loan payable account is credited.

Example:

• Debit: Loan Payable (Liability) decreases when the company repays $500 of its loan.

• Credit: Cash (Asset) decreases by $500 when the company pays the loan.

3. Equity Accounts

Equity accounts represent the owner’s claim on the company’s assets after liabilities have been settled. It includes common stock, retained earnings, and other forms of ownership.

• Debit: Decreases equity. This can occur if the company experiences a loss, or if dividends are paid out to shareholders.

• Credit: Increases equity. For example, when the company earns profits or issues new shares, the equity account is credited.

Example:

• Debit: Retained Earnings (Equity) decreases when the company pays out dividends to shareholders.

• Credit: Common Stock (Equity) increases when the company issues new shares to raise capital.

4. Revenue Accounts

Revenue accounts track the income a company earns from its normal business activities, such as sales or service fees. This category is also called income or sales revenue.

• Debit: Decreases revenue. This happens when there is a sales return or when a customer cancels a purchase, reducing the company’s revenue.

• Credit: Increases revenue. For example, when a company sells a product or provides a service, the revenue account is credited.

Example:

• Debit: Sales Returns and Allowances (Revenue) decreases when the company refunds $100 to a customer.

• Credit: Sales Revenue (Revenue) increases when the company sells goods for $500.

5. Expense Accounts

Expense accounts track the costs incurred by the company in order to operate the business, such as rent, salaries, utilities, and raw materials. These are necessary costs for running the company’s operations.

• Debit: Increases expenses. When a company incurs an expense, such as paying rent or purchasing supplies, the expense account is debited.

• Credit: Decreases expenses. This could occur when the company receives a refund for an expense, like an overpayment for rent.

Example:

• Debit: Rent Expense (Expense) increases when the company pays its rent.

• Credit: Cash (Asset) decreases when the company pays the rent.

Summary of the Rules for Debits and Credits

Here’s a quick reference chart summarizing the basic rules for debits and credits in different types of accounts:

Why is This Important?

The rules of debits and credits are essential for maintaining the balance in the accounting equation (Assets = Liabilities + Equity). If debits and credits are not recorded correctly, the financial statements will be inaccurate, leading to potential issues with financial reporting and compliance.

By understanding how debits and credits affect each account type, accountants and business owners can ensure that their financial records are accurate, balanced, and reliable. This also helps in generating accurate financial reports, which are crucial for decision-making, taxation, and regulatory purposes.

Practical Example

Let’s say a company sells a product for $1,000 and offers a 10% discount to the customer, who pays in cash. Here’s how the transaction would be recorded:

1. Debit: Cash (Asset) increases by $900 (the payment made by the customer).

2. Credit: Sales Revenue (Revenue) increases by $1,000 (the amount of the sale before the discount).

3. Debit: Sales Discounts (Revenue) increases by $100 (the discount given to the customer).

This is a practical example of how the double-entry system works, with each transaction affecting at least two accounts while maintaining balance in the financial records.

Conclusion

The rules of debits and credits are fundamental to understanding accounting and the double-entry system. By ensuring that every financial transaction has equal debits and credits, businesses can maintain accurate records, produce reliable financial statements, and ensure compliance with accounting standards. Whether dealing with assets, liabilities, equity, revenue, or expenses, knowing how to correctly apply debits and credits is crucial for every accountant.