Each time you complete a financial transaction of any sort, you’ll need to make an account entry that describes what you lost and gained in the process. The balance obviously changes, although because it always changes two ways, accountants can use a system of debits and credits.
Debits and credits allow you to quickly scan through a financial statement and see how much value was lost or gained after the transaction. That being said, if you want to not just read the statements but also understand what they mean, you need to spend some time learning about various types of financial accounts.
There are three major types of accounts bookkeeper register while compiling financial statements:
Each transaction contains two accounts because something is always lost and something is always gained. The job here is to understand what in it was an asset, a liability, or equity. It’s important not just for your own clarity, but also because different account types behave differently when it comes to debits and credits.
Debits and Credits Explained
For different accounts, it means different things. You might think that credits would always mean a decrease of balance, while the debits always increase the balance. But it’s not really so. Different categories react differently to debits and credits, and reading these properly is the whole other art.
Remember: there are always at least two accounts for each transaction. For instance, buying the materials means you lose money, but also gain materials as a new asset. The value of money lost and materials gained must be equal. If it’s not, then it won’t be possible to create accurate financial statements past that point.
Debits and credits must always be balanced.
Assets, equity & liabilities
As mentioned before, different account types react differently to credits and debits.
Assets lose value when they are credited and gain value when debited. Liabilities and equity, on the contrary, gain value when credited and lose value when debited. There’s logic in it, and these rules didn’t appear out of anything. It has a lot to do with how transactions work.
In order to gain an asset, you need to sacrifice either liabilities or equity. In other words, you need money to buy something for future use. In this case, these are assets, while money comes from accounts payable (liability). Therefore, assets here must be marked as debited, and accounts payable/cash should be credited. It’s simple, even if slightly confusing.
Revenues, expenditures, losses, and gains are the usual types of accounts in the big three that get listed in financial statements, so you may want to look out for them.
Writing them down
Whenever the transaction happens, the financial statement that registers it has to be filled in with the details. The details include the names of the accounts affected by the transaction, alongside the values of them both.
The entries are usually written down using three columns (from left to right):
- Name/type of the account
- Debit value
- Credit value.
Note that the same account can’t be both debited and credited. For each transaction, you need to add at least two accounts – something that was lost, and something that was gained. There can also be more than two: for instance, if you paid for several types of assets with one check.
Regardless of what happened during the transaction, there must be at least one account debited and one account credited. The debited usually go first, followed by all the credited stuff. Don’t forget that numbers should add up in the end so that they can be in balance. This doesn’t reflect the overall profits of the company – that’s all just for accounting records.
There are many various combinations of asset-liability-equity exchange.
In some cases, both credited and debited accounts increase. For instance, if you pay for a new asset with money, your accounts payable increases (because you now owe more money to other parties, while also enjoying a new asset worth this much money).
Sometimes you sell something and decrease the assets’ balance but also increase the balance of your accounts receivable (because you’re now owed money). But both numbers are still equal, so it’s fine.
The decrease of both debited and credited accounts doesn’t usually happen because that wouldn’t make much sense. You also can’t debit and credit the same type of account in the same transaction because it’s not how transactions work. If this happens, you might be misrepresenting one of the elements in the statement.
You could make many practical examples of such transactions, but let’s create just a few basic ones.
- Revenue-cash transactionSuch transactions happen often if you sell something for cash. In this example, the Nameless Productions Company decides to sell their product for $100 in cash. In this example, the company debits $100 to cash, while also credits $100 to revenue. As a result, the transaction is perfectly balanced.
- Asset-liability purchaseThe other good example is the purchase of any sort of asset by the company. In this scenario, the Nameless Productions Company decided to buy premises for future use. Since the cost is significant – $100,000, their accounts payable liability has increased by this amount. However, since it’s an asset, the assets account has also increased by this amount.
The importance of Debits and Credits
The value of this system can’t be underestimated. It’s occasionally difficult to correctly determine which sort of account is in front of you, but it’s an important job because if you misplace the debit and credit entries, it may seriously damage the financial statements for the month.
The main purpose of these two is to represent the balance. If the assets, liabilities, and equity are not in balance, then there’s a technical mistake. After all, assets are liabilities added to equity.