The accounting formula is assets less liabilities equals owner’s equity. The bookkeeping process categories transactions into subcategories under these three broad categories.
How the transaction is recorded depends on whether the transaction increases or decreases the account. The increases and decreases are classified as debits and credits.
While this may not sound like the most interesting topic to read about, please note that you can answer just about any bookkeeping question by understanding how to identify whether a transaction is a debit or credit. This is one of those categories that a little effort can go a long way to understanding the bookkeeping process.
Assets & Liabilities
Assets and liabilities include asset accounts and liability accounts. Debits and credits are recorded differently for each type of account.
As the name implies, asset accounts are accounts that record the value of assets. This includes cash, usually in the form of bank account balances, accounts receivable, supplies, prepaid rent, and other tangible, intangible, and real property.
To increase the amount of an asset account you debit the account. To decrease the amount of an asset account you credit the account.
Liability accounts are debts or amounts owed. This includes short and long term debts.
Liability accounts are the opposite of asset accounts. Thus, to increase liability accounts, you credit the account. To decrease liability account, you debit the account.
The owners equity account is made up of the owners capital account and revenue and expense accounts.
The Owners Capital Account
The owners capital account records the owners investment in the business. It is what is left in the business.
To increase the owners capital account, you credit the account. To decrease the owners capital account, you debit the account.
Revenue accounts record the income received by the business. To increase the revenue accounts, you credit the account. To decrease revenue accounts, you debit the account.
Expense accounts record the expenses incurred by the business. To increase the expense account, you debit the account. To decrease the expense account, you credit the account.
Putting it All Together
To understand debits and credits, it is often helpful to think about where the accounts are found on the business’ financial statements.
The asset, liability, and owners equity account are found on the balance sheet. The balance sheet reports the value of the business as of the date of the balance sheet. If you go back thru the debits and credits above for just these three accounts in isolation, you can better understand why the specific accounts use debits and credits as they do.
Compare this to the revenue and expense accounts. These accounts are found on the income statement. The income statement is used to determine how much profit or loss the business made for the period stated in the income statement. By viewing these two accounts in insolation, you can better understand why the specific accounts use debits and credits as they do.
There are several good tutorials online that provide examples that can help understand debits and credits. The effort required to learn these concepts is well effort that is well spent. A working knowledge of debits and credits can help answer most bookkeeping questions
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