What are Debits and Credits?
Debits and credits are a vital part of accounting because they allow you to keep track of financial transactions in an accurate way.
Debts increase the balance while Losses decrease it, but both sides should always balance out when recording any kind of transaction or gain/losses from one day’s activities with another.
The new system will not only help you keep track of your spending, but also make sure that the next generation can look at their company’s financials with confidence.
What are debits and credits?
When most people think of accounting, they likely imagine debits and credits.
The easiest way to explain it is Debits represent money you owe, and credits represent money someone owes you.
A debit card represents expenses, whereas a credit card represents income.
You can record outgoing payments as well as incoming payments using debit and credit.
The practice of double-entry bookkeeping has been around for centuries and it’s still one the most important ways to keep track of financial transactions in an organized manner.
By recording both a debit and a credit for each transaction, accountants can ensure that their books remain balanced.
Though debits and credits may seem like technical jargon, understanding how they work is essential for anyone who wants to keep track of their finances.
What Is the Difference Between a Debit and a Credit?
You might not realize it, but every time you make a purchase, you’re using accounting principles.
When you buy something with cash, you debit the account “Cash” and credit the account “Expenses.”
When you buy something on credit, you debit the account “Accounts Receivable” and credit the account “Expenses.”
In both cases, the total of all debits must equal the total of all credits.
Debit accounts and credit accounts
This basic financial accounting equation is the foundation for everything else in financial accounting.
Debit and credit are just terms that describe which side of the equation an account is on.
On the left side of the equation (the “asset” side) are accounts that normally have a positive balance. Their name is debit accounts.
On the right side of the equation (the “liability and equity” side) are accounts that normally have a negative balance. Their name is credit accounts.
The key to understanding debits and credits is to remember that they always come in pairs.
For every debit, there must be a corresponding credit, and vice versa.
This is what keeps the accounting equation in balance.
Debit and credit are the lifeblood of any business, without them, there would be no transactions to record.
3 common examples of debits and credits
In accounting, there are two types of entries: debits and credits.
Here are three common examples of each:
1. Accounts Receivable
When a customer owes money to a business, the account is Known to be “in the red.”
This account typically has a debit balance, which means that the total amount of money owed to us (the debits) is greater than the total amount of money we’ve received (the credits).
The goal in accounting is to ultimately have a zero balance in accounts receivable.
This means that we’ve collected all the money that was owed to us.
To do this, we need to constantly track our account receivables and send out invoices to our customers on a timely basis.
We also need to follow up with them regularly to make sure that they are paying their invoices.
When we’re diligent about paying off our balance, it can eventually reach a zero-sum.
2. Accounts Payable
Accounts payable account tracks money that a business owes to its suppliers.
This account is usually made up of short-term debts, such as invoices for goods or services that have been received but not yet paid for.
In accounting terms, accounts payable is considered a liability account, because it represents money that the company owes to someone else.
When a company receives an invoice from a supplier, it records the expense account as a debit in the accounts payable account.
At the same time, the company records a credit in another account, such as an inventory or expense account.
When the company pays off the invoice, it records a debit entry in the cash account and a credit in the accounts payable account.
Accounts payable is an important account for any business because it shows how much money the company owes to its suppliers.
This information can be useful in negotiating better terms with suppliers or in managing cash flow.
Inventory is a key account in any business’s accounting system.
It represents the balance sheet that accounts for the various resources a company has.
These include raw materials, work-in-progress and finished goods.
As such, it is important to carefully track inventory levels and keep them in line with customer demand.
When inventory levels get too high, that leads to tying up working capital and there is a better use for that.
On the other hand, if inventory levels get too low, it can lead to stockouts and lost sales.
The goal is to strike a balance between these two extremes.
To do this, businesses typically use a system of debits and credits.
When you purchase an inventory, it is recorded as a debit entry to the inventory account.
Similarly, when you sell an inventory, it is recorded as a credit to the account.
The key to success in business is knowing how much of what you have on hand, and that’s where accounting comes into play.
Carefully tracking these debits and credits with an accountant or bookkeeper for your company will allow businesses to get a clear picture of their inventory levels so they can make sure shelves are stocked without tying up too much working capital
Normal accounting balances
Most businesses use a cash account to track cash receipts and payments.
The cash account is an asset account that typically has a credit balance.
This means that cash inflows (receipts) are recorded as positive numbers, while cash outflows (payments) are recorded as negative numbers.
When the total of all cash inflows exceeds the total of all cash outflows, the cash account has a positive balance and the business is said to have “extra cash on hand.”
On the other hand, if the total of cash outflows exceeds the total of cash inflows, the account has a negative balance and the business is said to be “short on cash.”
It’s important to make sure there are enough funds
To cover a negative balance, businesses may take out loans or use credit cards.
Debit cards are another form of payment that businesses often use to pay for goods and services.
Debit cards are a convenient and secure way for businesses to process purchases.
They work by withdrawing funds from your checking account, which you can use any time as long as there are no any transactions still in progress.
There is a link between the business’s checking account and debit cards.
So it’s important to make sure there are enough funds available in the account to cover the purchase.
If there aren’t enough funds available, no transaction will occur.
You may also get a fee for that.
A contra account is an account that can offset or reduce the value of another account.
The most common type of contra account is an asset account, which is able to offset a liability account.
For example, if a company has a bank loan, the contra asset account “Loan Losses” will be used to offset the credit balance and debit balance in the loan liability account.
This reduces the company’s total liabilities and gives a more accurate picture of its financial health.
Similarly, you can use a contra liability account to offset an asset account.
For example, if a company has plenty of cash sitting around in their bank account then they can use contra liability Bank Service Charges to offset that balance.
This is a great way for investors and creditors alike, to get an accurate picture of the company’s financial health.
The goal of using contra accounts is to produce more accurate financial statements by adjusting the balances in related accounts.
Which account is the best choice for credit and debit?
If you want a checking account that offers low fees and easy access, then it’s worth looking into what banks offer.
If you plan on using it for most credit and debit transactions, then make sure that the account has low fees or an excellent interest rate.
However, if you plan to use the account mainly for savings, then you’ll want to look for a high-interesting interest rate.
Choose the best account for your needs
Another factor to consider is whether you want assets or liability accounts.
Assets are often good for earning interest, while Liabilities cannot provide any return on your investment but they can still help pay bills.
Lastly, you’ll need to decide whether you want savings or expense accounts.
A checking account allows you to write checks and make withdrawals, while a savings account doesn’t allow these activities but typically has a higher interest rate.
By taking all of these factors into consideration such as debit balance, bank account, debit entry, debit balances, and revenue accounts, you can choose the best asset accounts for your needs.
At Financopedia, we’re committed to assisting small businesses and individuals with their finances and taxes. Occasionally, this leads us to generalize tips. Please email firstname.lastname@example.org if you have questions.