(1) Debits and credits explained

Overview of Debits and Credits

• Understanding accounting terminology is crucial for grasping financial statements and transactions.

• Debits are recorded on the left side, while credits are on the right side in accounting journal entries.

Types of Accounts

• Accounts are categorized into two main groups: balance sheet accounts and income statement accounts.

Balance Sheet Accounts

• Three primary types:

  1. Asset Accounts

     • Natural state: Debit balance

     • Example: Cash, inventory, property

     • Increase: With a debit

  2. Liability Accounts

     • Natural state: Credit balance

     • Example: Loans, accounts payable

     • Increase: With a credit

  3. Equity Accounts

     • Natural state: Credit balance

     • Example: Retained earnings, owner's capital

     • Increase: With a credit

Income Statement Accounts

• Two primary types:

  1. Expense Accounts

     • Natural state: Debit balance

     • Example: Rent, utilities, wages

     • Increase: With a debit

  2. Revenue Accounts

     • Natural state: Credit balance

     • Example: Sales revenue, service income

     • Increase: With a credit

Journal Entry Examples

• Raising Capital from Shareholders:

  • Cash (assets) increases (debit)

  • Shareholder capital (equity) increases (credit)

• Taking a Loan from a Bank:

  • Cash (assets) increases (debit)

  • Liabilities increase for owed money (credit)

• Receiving an Invoice from Supplier:

  • Expenses (debit) increase for cleaning service

  • Liabilities (credit) increase for accounts payable

• Paying the Supplier:

  • Liabilities decrease (debit) as the debt is settled

  • Cash decreases (credit) as payment is made

• Invoicing a Customer:

  • Accounts receivable (assets) increases (debit)

  • Revenue (credit) increases for services rendered

Year-End Closing Process

• At year-end, net income from the income statement adjusts the balance sheet:

  • Net Income Calculation:

    • If Revenue = 100 (credit) and Expenses = 90 (debit):

      • Net Income = 10 (credit), added to retained earnings (equity).

    • If Revenue = 90 (credit) and Expenses = 100 (debit):

      • Net Income = -10 (debit), deducted from retained earnings (equity).

• Impact on Shareholder Equity:

  • Profits increase, while losses decrease shareholder equity.

Key Takeaway

• Remember:

  • Debits are always on the left and generally indicate an increase in asset or expense accounts.

  • Credits are always on the right and generally indicate an increase in liability, equity, or revenue accounts.

• Understanding this framework is essential for analyzing financial transactions effectively.