13 Debits and Credits

Part 1

Introduction to Debits and Credits, What's an "Account"?, Double-Entry Accounting, Debits & Credits

Part 2

T–accounts, Journal Entries, When Cash Is Debited and Credited

Part 3

Normal Balances, Revenues & Gains are Usually Credited, Expenses & Losses are Usually Debited, Permanent & Temporary Accounts

Part 4

Bank's Debits & Credits, Bank's Balance Sheet, Recap

If the words "debits" and "credits" sound like a foreign language to you, you are more perceptive than you realize—"debits" and "credits" are words that have been traced

back five hundred years to a document describing today's double-entry accounting system.

Under the double-entry system every business transaction is recorded in at least two accounts. One account will receive a "debit" entry, meaning the amount will be entered on the left side of that account.

Another account will receive a "credit" entry, meaning the amount will be entered on the right side

of that account. The initial challenge with double-entry is to know which account should be debited and

which account should be credited.

What Is An Account?To keep a company's financial data organized,

accountants developed a system that sorts transactions into records called accounts. When a

company's accounting system is set up, the accounts most likely to be affected by the

company's transactions are identified and listed out. This list is referred to as the company's

chart of accounts. Depending on the size of a company and the

complexity of its business operations, the chart of accounts may list as few as thirty accounts or as

many as thousands. A company has the flexibility of tailoring its chart of accounts to best meet its needs.

A chart of accounts is a listing of the names of the accounts that a company has identified and made available for

recording transactions in its general ledger. A company has the

flexibility to tailor its chart of accounts to best suit its needs, including adding

accounts as needed.Within the chart of accounts you will

find that the accounts are typically listed in the following order:

Balance sheet accounts

Assets Liabilities Owner's (Stockholders')

Equity

Income statement accounts Operating

Revenues Operating

Expenses Non-operating

Revenues and Gains

Non-operating Expenses and Losses

Within the categories of operating revenues and operating expenses, accounts might be further

organized by business function (such as producing, selling, administrative, financing)

and/or by company divisions, product lines, etc. A company's organization chart can serve as

the outline for its accounting chart of accounts.

For example, if a company divides its business into ten departments (production, marketing, human resources, etc.), each department will likely be accountable for its own expenses (salaries, supplies, phone, etc.).

Each department will have its own phone expense account, its own

salaries expense, etc.A chart of accounts will likely be as

large and as complex as the company itself. An international corporation

with several divisions may need thousands of accounts, whereas a

small local retailer may need as few as one hundred accounts.

Each account in the chart of accounts is typically assigned a name and a unique number by which it can be

identified. (Software for some small businesses may not require account

numbers.) Account numbers are often five or more digits in length with each

digit representing a division of the company, the department, the type of

account, etc.

As you will see, the first digit might signify if the account is an asset,

liability, etc. For example, if the first digit is a "1" it is an asset. If the first

digit is a "5" it is an operating expense.A gap between account numbers allows for adding accounts in the future. The

following is a partial listing of a sample chart of accounts.

Current Assets (account numbers 10000 - 16999)10100   Cash - Regular Checking10200   Cash - Payroll Checking

10600   Petty Cash Fund12100   Accounts Receivable

12500   Allowance for Doubtful Accounts13100   Inventory14100   Supplies

15300   Prepaid InsuranceProperty, Plant, and Equipment (account numbers 17000 - 18999)

17000   Land17100   Buildings

17300   Equipment17800   Vehicles

18100   Accumulated Depreciation - Buildings18300   Accumulated Depreciation - Equipment18800   Accumulated Depreciation - Vehicles

Current Liabilities (account numbers 20000 - 24999)20100   Notes Payable - Credit Line #120200   Notes Payable - Credit Line #2

21000   Accounts Payable22100   Wages Payable23100   Interest Payable

24500   Unearned RevenuesLong-term Liabilities (account numbers 25000 - 26999)

25100   Mortgage Loan Payable25600   Bonds Payable

25650   Discount on Bonds PayableStockholders' Equity (account numbers 27000 - 29999)

27100 Common Stock, No Par27500 Retained Earnings

29500 Treasury StockOperating Revenues (account numbers 30000 - 39999)

31010   Sales - Division #1, Product Line 01031022   Sales - Division #1, Product Line 02232015   Sales - Division #2, Product Line 01533110   Sales - Division #3, Product Line 110

Cost of Goods Sold (account numbers 40000 - 49999)41010   COGS - Division #1, Product Line 01041022   COGS - Division #1, Product Line 02242015   COGS - Division #2, Product Line 01543110   COGS - Division #3, Product Line 110

Marketing Expenses (account numbers 50000 - 50999)50100   Marketing Dept. Salaries

50150   Marketing Dept. Payroll Taxes50200   Marketing Dept. Supplies

50600   Marketing Dept. TelephonePayroll Dept. Expenses (account numbers 59000 - 59999)

59100   Payroll Dept. Salaries59150   Payroll Dept. Payroll Taxes

59200   Payroll Dept. Supplies59600   Payroll Dept. Telephone

Other (account numbers 90000 - 99999)91800   Gain on Sale of Assets96100   Loss on Sale of Assets

Within the chart of accounts the balance sheet accounts are listed first, followed by the income statement accounts. In other words, the accounts are organized in the chart of

accounts as follows:Assets

LiabilitiesOwner's (Stockholders') Equity

Revenues or IncomeExpenses

GainsLosses

Because every business transaction affects at least two accounts, our accounting system is known as a double-entry system. (You can refer to the company's chart of accounts to

select the proper accounts. Accounts may be added to the chart of accounts when an appropriate account cannot be found.)

For example, when a company borrows $1,000 from a bank, the transaction will affect the company's Cash account and the company's Notes Payable account.

When the company repays the bank loan, the Cash account and the Notes Payable account are also involved.

If a company buys supplies for cash, its Supplies account and its Cash account will be affected. If the company buys

supplies on credit, the accounts involved are Supplies and Accounts Payable.

If a company pays the rent for the current month, Rent Expense and Cash are the two accounts involved. If a company provides a service and gives the client 30 days in

which to pay, the company's Service Revenues account and Accounts Receivable are affected.

Although the system is referred to as double-entry, a transaction may involve more than two accounts. An

example of a transaction that involves three accounts is a company's loan payment to its bank of $300.

This transaction will involve the following accounts: Cash, Notes Payable, and Interest Expense.

(If you use accounting software you may not actually see that two or more accounts are being affected due to the user-friendly nature of the software.

For example, let's say that you write a company check

by means of your accounting software. Your

software automatically reduces your Cash account

and prompts you only for the other accounts

affected.)

Accountants and bookkeepers often use T-accounts as a visual aid for seeing the effect of the debit and credit on the two (or more) accounts. We will begin with two T-accounts: Cash and Notes Payable.

                       Cash (asset account)

Debit

Increases an assetReceived $

Credit

Decreases an assetPaid $

 Notes Payable (liability account)

Debit

Decreases a liabilityRepaid loan

Credit

Increases a liabilityBorrowed more

Let's demonstrate the use of these T-accounts with two transactions:

On June 1, 2009 a company borrows $5,000 from its bank. This causes the company's asset Cash

to increase by $5,000 and its liability Notes Payable to also increase by $5,000. To increase the asset Cash the account needs to be debited. To increase the company's liability Notes Payable this account needs to be credited. After entering the debits and credits the T-accounts look like

this:

                       Cash (asset account)

DebitIncreases an assetReceived $

CreditDecreases an assetPaid $

June 1, 2009 ENTRY

5,000

                         Notes Payable (liability account)

DebitDecreases a liabilityRepaid loan

CreditIncreases a liabilityBorrowed more

5,000ENTRY June 1,

2009

2.     On June 2, 2009 the company repaid $2,000 of the bank loan. This causes the company's asset Cash to decrease by $2,000 and its liability Notes Payable to also decrease by

$2,000. To reduce the asset Cash the account will need to be credited for

$2,000. To decrease the liability Notes Payable that account will need to be debited. The T-accounts now

look like this:

                       Cash (asset account) 

Cash

Debit

Increases an asset

Received $

Credit

Decreases an asset

Paid $

June 1, 2009

ENTRY5,000

2,000 ENTRY June

2, 2009

June 2, 2009

BALANCE3,000

                            Notes Payable 

Debit

Decreases a liability

Repaid loan

 Credit

Increases a liability

Borrowed more

June 1, 2009 ENTRY 2,000

  5,000 ENTRY June 1, 2009

BALANCE

June2,2009

3,000 

Another way to visualize business transactions is to write a general journal entry. Each

general journal entry lists the date, the account title(s) to be debited and the corresponding

amount(s) followed by the account title(s) to be credited and the corresponding amount(s).

The accounts to be credited are indented. Let's illustrate the general journal entries for the two transactions that were shown in the T-accounts

above.

Date Account Name Debit Credit

June 1,

2009Cash 5,000

Notes Payabl

e

5,000

Date Account Name Debit Credit

June 2,

2009Notes Payable 2,000

Cash 2,000

Because cash is involved in many transactions, it is helpful to memorize the following:  Whenever cash is received, debit Cash.   Whenever cash is paid out, credit Cash.

With the knowledge of what happens to the Cash account, the journal entry to record the debits and

credits is easier. Let's assume that a company receives $500 on June 3, 2009 from a customer

who was given 30 days in which to pay. (In May the company recorded the sale and an accounts

receivable.)

On June 3 the company will debit Cash, because cash was received. The amount of the debit and

the credit is $500. Entering this information in the general journal format, we have:

Date Account Name Debit Credit

June 3, 2009 Cash 500

??? 500

All that remains to be entered is the name of the account to be credited. Since this was the collection of an account receivable, the credit should be Accounts Receivable.

(Because the sale was already recorded in May, you cannot enter Sales again on June 3.)

On June 4 the company paid $300 to a supplier for merchandise the

company received in May. (In May the company recorded the purchase

and the accounts payable.)

On June 4 the company will credit Cash, because cash was paid. The amount of the debit and credit is

$300. Entering them in the general journal format, we have:

Date Account Name Debit Credit

June 4, 2009 ??? 300

Cash 300

All that remains to be entered is the name of the account to be debited. Since this was the payment on an

account payable, the debit should be Accounts Payable.

(Because the purchase was already recorded in May, you cannot enter

Purchases or Inventory again on June 4.)

To help you become comfortable with the debits and credits in accounting, memorize the following tip:

Whenever cash is received, the Cash account is debited (and another account is credited). Whenever cash is paid out, the Cash account is credited (and another account is debited).

Whenever cash is received, the Cash account is debited (and another account is credited).Whenever cash is paid out, the Cash account is credited (and another account is debited).Normal BalancesWhen looking at a T-account for each of the account classifications in the general ledger, here is the debit or credit balance you would normally find in the account:

Account ClassificationNormal

Balance

Assets Debit

Contra asset Credit

Liability Credit

Contra liability Debit

Owner's Equity Credit

Stockholders' Equity Credit

Owner's Drawing orDividends Account

Debit

Revenues (or Income) Credit

Expenses Debit

Gains Credit

Losses Debit

Revenues and Gains Are Usually CreditedRevenues and gains are recorded in accounts such as Sales, Service Revenues, Interest Revenues (or Interest Income), and Gain on Sale of Assets. These accounts normally have credit balances that are increased with a credit entry. The exceptions to this rule are the accounts Sales Returns, Sales Allowances, and Sales Discounts--these accounts have debit balances because they are reductions to sales. Accounts with balances that are the opposite of the normal balance are called contra accounts; hence contra revenue accounts will have debit balances.

Expenses normally have their account balances on the debit side (left side). A debit increases the balance in an expense account; a credit decreases the balance. Since expenses are usually increasing, think "debit" when expenses are incurred.

(We credit expenses only to reduce them, adjust them, or to close the expense accounts.) Examples of expense accounts include Salaries Expense, Wages Expense, Rent Expense, Supplies Expense, and Interest Expense.

To illustrate an expense let's assume that on June 1 your company paid $800 to the landlord for the June rent. The debits and credits are shown in the following journal entry:

Account Name Debit Credit

Rent Expense 800 Cash 800

Since cash was paid out, the asset account Cash is credited and another account needs to be debited. Because the rent payment will be used up in the current period (the month of June) it is considered to be an expense, and Rent Expense is debited.

If the payment was made on June 1 for a future month (for example, July) the debit would go to the asset account Prepaid Rent.

As a second example of an expense, let's assume that your hourly paid employees work the last week in the year but will not be paid until the first week of the next year.

At the end of the year, the company makes an entry to record the amount the employees earned but have not been paid. Assuming the employees earned $1,900 during the last week of the year, the entry in general journal form is:

Account Name Debit Credit

Wages Expense 1,900

Wages Payable 1,900

As noted above, expenses are almost always debited, so we debit Wages Expense, increasing its account balance.

Since your company did not yet pay its employees, the Cash account is not credited, instead, the credit is recorded in the liability account Wages Payable. A credit to a liability account increases its credit balance.