Accounting has a weird way of making everything seem more confusing than it should be.
Maybe it's the numbers. Perhaps it's the jargon. Maybe it's the anxiety-inducing memories of barely scraping by in the accounting classes you took as part of your minor.
Whatever the case, one thing is clear: Accounting makes concepts as basic as buying stuff, selling stuff, and monitoring your account balance seem baffling and even a little scary.
It really shouldn't feel so complicated, right?
And yet, here we are.
Take the concept of debits and credits, for example. You're probably familiar with the terms in specific contexts — debit cards, credit cards, lines of credit — but the words take on a whole new and potentially confusing dimension when it comes time to boot up QuickBooks.
So what do debits and credits mean in the context of accounting? How should small business owners understand what they mean, how to use them, and how do the two concepts impact their operations?
Debits and Credits
In everyday life, the word "debit" is usually used when taking out your debit card to pay for gas or groceries; the same goes for "credit." The difference, of course, is that a debit card uses funds you already have in your checking account to pay for stuff, whereas a credit card uses borrowed money that you'll have to pay back later.
In the language of accounting, a debit represents a transaction or relocation of funds from one account to another when using a double-entry accounting system. Credits are the opposite. Instead of transactions with positive or neutral values, credits represent a decrease in assets or an increase in liabilities. Every transaction has a corresponding equal and opposite value, which means debits and credits should equal out at the end of the day.
Debit and credit cards can be instructive here: let's say you run a landscaping company and use a debit card to buy a new lawn mower. You understand that the amount you pay for the mower is deducted from your bank account. From an accounting standpoint, that amount is deducted from a "cash account" (your bank), and the value of your new lawn mower is transferred over to your "equipment account" to account for your new machine.
Now, say you buy a new lawn mower using a credit card instead. You still add the value of the mower to your equipment account, though this time, you don't deduct the value from your "cash account." Instead, that purchase creates an equal entry on the liabilities side of your balance sheet because you now have an increased liability due to the credit you owe.
So yes, you're right to be confused. It isn't very clear.
Debits, Credits, and Small Businesses, Too
It'd be one thing if debits and credits always acted the same way: A debit adds, and a credit subtracts. Except, that's not how it works a lot of the time. Why?
There are roughly five different kinds of standard accounts:
- Income Accounts: Money the business earns
- Expense Accounts: The money it costs to run the business
- Asset Accounts: The stuff the company owns
- Liability Accounts: Money the company owes to suppliers, lenders, and others.
- Equity Accounts: Money that could be paid or collected from the business owners. These are also called Capital Accounts.
Naturally, you might think earning revenue would be a debit to the income account, right? And if an expense account decreases, you'd credit it, right? And the same goes for all other asset accounts.
Nope. Here's how debits and credits actually work.
- Income Accounts: Credit to increase, debit to decrease
- Expense Accounts: Debit to increase, credit to decrease
- Asset Accounts: Debit to increase, credit to decrease
- Liability Accounts: Credit to increase, debit to decrease
- Equity Accounts: Credit to increase, debit to decrease
Let's try to break this down even further.
The Double Entry Methodology
Accounting is all about balance. Credits and debits are how transactions interact amongst accounts. The credit and debit system allows accountants to record and maintain a balanced equation. Accounting is built based on the "Double Entry" method. Every entry, from a sale of products to a lawn mower purchase, gets recorded in two corresponding accounts.
There is a reason it works this way. The accounting equation: Assets = Liabilities + Owner's Equity, is a hard rule in accounting. This equation represents the way a Balance Sheet is organized! At the close of an accounting period, assets must be equal to liabilities and owner's equity.
Example: Assets ($1,000) = Liabilities ($900) + Owner’s Equity
In the case above, simple math allows us to solve for owner's equity by subtracting liabilities from assets resulting in an owner's equity of $100. It works the same way if your assets are lower than your liabilities, except you'll get a negative number for owner's equity, meaning the owner has lost some money or equity value.
Say your business earns $1,000 in revenue. You'll receive the cash or note for $1,000 and add that $1,000 to your Cash, Assets, Accounts Receivable, or another account you're using, thus bumping up the Asset side of the equation by $1,000.
But the Balance Sheet has to balance. Instead of recording a $1,000 increase in Assets and calling it a day, you need to create an equal and opposite entry that reflects the source of that increase. It's at this point where Income and Expense accounts come into play.
Businesses generate cash flow through a sale. When sales occur, money received increases our sales number. As the company operates, it also incurs expenses. When the business generates an income and has fewer expenses than what was earned, it records a "Profit." A "Loss" happens when expenses are more significant than income.
So while you debit your Assets by $1,000, you also need to credit your Income accounts by $1,000. After your expenses and income are appropriately recorded, your profit on that $1,000 sale becomes Owner's Equity.
This is Why We Have Accountants
Accountants spend a long time in school to understand the implications of credits and debits. Some go further, becoming certified to serve the general public. Many accountants spend their entire lives unwinding mistakes made by others without the same understanding. And they do it for one reason:
Accounting is not easy. But, it is essential for all businesses.
It starts making sense once you've figured out the logic of it all and take some time to learn how to speak the language, but there is no shame in asking for help from a professional. Doing it right the first time ensures that you don't have to pay more to get it fixed later.