Debits and Credits in Accounting

What exactly do the terms "debit" and "credit" an account mean? Why is it that debiting some accounts causes them to rise while debiting others causes them to fall? And why is any of this relevant to your company?

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What exactly are debits and credits?

In a nutshell, debits (dr) record all money that flows into an account, whereas credits (cr) record all money that flows out of an account.

What does this imply?

The double-entry method of accounting is now used by the majority of businesses. Your entire business is divided into individual accounts under this system. Consider these to be individual buckets of money representing each aspect of your business.

As an example:

One bucket (the "cash" bucket) could hold all of the cash in your business bank account.

Another bucket could represent the total value of all the furniture in your company's office (the "furniture" bucket).

Another bucket could represent a recent bank loan (the "bank loan" bucket).

When your company does something—buys furniture, takes out a loan, invests in R&D—the amount of money in the buckets changes.

It would be tedious to record what happens to each of these buckets using full English sentences, so we need a shorthand. This is where debits and credits come into play.

When money enters a bucket, it is recorded as a debit (sometimes accountants will abbreviate this to just "dr.")

Assume you deposited $300 in cash into your business bank account:

An accountant would say we're "debiting" the cash bucket by $300 and enter the following line into your accounting system:

When money flows out of a bucket, it is recorded as a credit (abbreviated "cr." by accountants).

For example, if you took $600 out of your business bank account:

An accountant would say you're "crediting" the cash bucket by $600 and would record the following:

In use debits and credits

One thing is missing from the preceding examples. Money does not simply vanish or appear out of nowhere. It has to start somewhere and end somewhere.

Credits and debits show you where your money is going and where it is coming from.

Assume you go to your friend's startup one day. Your friend shows you a beautiful ergonomic standing desk after giving you a tour of the office. You've been looking for this model for months, but every furniture store is out of stock. Your friend ordered an extra one and can sell it to you for a low price. You agree to pay her $600 for it.

Here's how it would look if we used our bucket system. First, we withdraw $600 from your cash bucket.

We credit your cash account because money is flowing out of it, just as we did in the previous section.

However, this isn't the only bucket that shifts. Your "furniture" bucket, which represents the total value of all the furniture owned by your company, is also updated.

It rises by $600 in this case (the value of the chair).

Because money is flowing into your furniture account, you debit it (a desk).

Every debit (inflow) has a corresponding credit in double-entry accounting (outflow). As a result, we combine them into a single entry.

The entry in this case would be:

We are crediting the bank account $600 and debiting the furniture account $600, according to an accountant.

What effect do debits and credits have on liability accounts?

The two buckets in the preceding example, cash and furniture, are both asset buckets. (In other words, they keep track of what you own.)

However, not all buckets contain assets. Some buckets track what you owe (liabilities), while others track the total value of your business (equity).

Assume you want to get some extra cash for your business after purchasing that expensive desk. So you take out a $1,000 bank loan and increase (deduct) $1,000 from your cash account.

Now comes the difficult part.

In addition to adding $1,000 to your cash bucket, we would need to add $1,000 to your "bank loan" bucket.

Why? Because your "bank loan bucket" measures how much you owe rather than how much you have. The more you owe, the greater the value in the bank loan bucket.

In this case, we're crediting a bucket, but the bucket's value is rising. That's because the bucket keeps track of a debt, and in this case, the debt is increasing.

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