Whether you consider yourself an accounting enthusiast or a number phobe, accurate bookkeeping is essential to your success. It’s how you create receipts, compensate your employees, pay invoices, and measure the overall financial well-being of your business. By having a clear view of your cash flow with detailed financial records, you can budget more easily, monitor your profits, and identify strategic ways to grow.
But there are 2 terms in accounting jargon that often leave a new business owner scratching their head: debits and credits.
What exactly does each term mean? How can debits cause some accounts to go down while others go up? And how does all this affect your business?
This is what you have to know.
Debits (DR) and credits (CR)
To keep your business’s financial records in order, it is necessary to monitor the money coming in and the money going out; This is also known as balancing your accounts. The individual entries on a balance sheet are called debits and credits.
Debits (often represented as DR) record money incomingwhile credits (CR) record money outgoing.
They will be represented on your balance sheet according to the type of account to which they correspond.
What is the real meaning of “balance”
Any business that is spending and receiving money will likely assign transactions to 1 of 5 main account types:
-
Asset accounts They contain the resources that a company has to generate income (inventory, accounts receivable, cash).
-
Expense accounts They reflect what it costs the company to conduct its business (delivery costs, advertising costs, materials, labor).
-
The liability accounts They show what the business owes creditors (accounts payable, salaries, income taxes).
-
The capital accounts They refer to the capital that the owner has in his company (initial investments or stock holdings).
-
Income/receipt accounts They reflect the income your business generates.
The world of accounting has two main systems: single-entry or double-entry accounting. Single entry only records income and expenses, while double entry includes assets, liabilities, and equity by recording each transaction twice: once as a debit and once as a credit.
Most businesses follow the double entry system, also known as double entry, in which each financial transaction affects at least 2 accounts. Money that goes into one account must come out of another. When these two entries balance and give a total result of zero on the balance sheet, your accounts are considered balanced. This complies with one of the golden rules of accounting:
Assets (what you have) – Passives (what you owe) = Capital (what you have left)
In other words, every item your business has (inventory, tools, even a loan) can be classified as something you owe (liabilities) or something you own (equity). Think about it like this: If you borrow $100, that $100 is both an asset (cash) and a liability (loan). When you spend $200 on new tools, that $200 becomes an asset (the tools) and your capital (money that sooner or later you will get back). That is the fundamental concept behind credits and debits.
For every debit on one account, another account must have a corresponding credit of equal value to offset it.
Whether a debit or credit means an increase or decrease in an account depends on the type of account. In traditional double-entry accounting, debits are written on the left and credits on the right, like this:
-
Asset accounts Debit increase, Credit decrease
-
Expense accounts Debit increase, Credit decrease
-
Liability accounts Debit decrease, Credit increase
-
Capital accounts Debit decrease, Credit increase
-
Income/receipt accounts Debit decrease, Credit increase
Let’s see it in practice
Now we will see how you can apply debits and credits to some practical examples of a business.
Buy work tools
Let’s say you own a bakery and decide to buy a new oven for $2,000. You decrease, or debit, your cash balance by $2,000 to pay for the furnace, but increase, or credit, the value of your assets by $2,000. Here’s how this purchase affects your balance sheet:
Account
-
Assets: Tools Debt: $2,000
-
Assets: Cash Credit: $2,000
Loan for business expansion
To expand your bakery, you get a $10,000 loan from a bank. You increase (debit) your cash balance by $10,000 because you received the loan and record a liability (credit) for the loan amount of $10,000, which you must repay. You record each transaction like this:
-
Assets: Cash Debt: $10,000
-
Liability: Loan payable Credit: $10,000
Employee salaries
Payday has arrived and you have to pay your employees $2,500 in wages. You increase (credit) your expenses by $2,500, which reduces your equity. You decrease (debit) your cash balance by $2,500 to pay your employees. Your balance sheet looks like this:
-
Assets: Cash Debt: $2,500
-
Capital: Salary expenses Credit: $2,500
Remember the basics
The next time you get to work with your balance sheet, it’s important to remember that debits and credits are the invisible hands that keep everything in balance. By understanding the roles they play, you can manage your money with confidence to make strategic decisions that put your business on the path to lasting success.
To get the support you need to stay on top of your finances, be sure to talk to a Chase Business Banker today
2024-01-20 08:04:42
#Accounting #Basics #Understand #Debits #Credits
