Some even falsely explained that the two terms mean positive and negative value. When in reality a credit is not a negative value in your revenue types of accounts as ‘Sales’ are a good thing in business. Therefore credits are great for business just like debits.
Accounting uses a mindset that is different than traditional thinking. To make the dual entry system work you have to have two sides of an equation – debits and credits.
So what is the best way to explain debits and credits?
Simply stated, they are just offsetting values (two sides of an equation) and no more. For a bookkeeper or an accountant your requirement is to understand where to place the values and ask yourself if this makes sense. To fully grasp this concept I have developed a chart of laying out the six different types of accounts and their corresponding NORMAL ending balance status, i.e. debit or credit.
Type of Account Normal Ending Balance
• Asset Debit
• Liabilities Credit
• Equity Credit
• Revenue Credit
• Cost of Sales Debit
• Expenses Debit
Notice that three of the types of accounts should have ending balances that are debit in nature and the remaining three are credit driven.
To help you develop a keen understanding of how debits and credits affect each type of an account, this article is the first of six educating you about the effect for each type of account. The first one is assets.
Assets are reported on the balance sheet. They are considered the entire upper half of the balance sheet. When it comes to assets you only need to remember one thing. The ending result should be a debit balance in the account. YOU CAN NEVER END UP WITH A CREDIT BALANCE IN AN ASSET ACCOUNT. There is no such thing as a negative asset balance. If the balance isn’t a debit, it can’t be an asset.
To illustrate the fact that assets have to have debit balances let’s look at the cash account. On day one, an investor usually starts a business by purchasing stock and paying cash. So the typically first entry for the financial records looks like this:
Cash (Asset) $100.00 -0-
Stock (Equity) -0- $100.00
Notice that the debits equal the credits? In this case the balance sheet is reported in a similar format. In the upper half is one asset account – Cash; and in the bottom half is one equity account – Stock. From here on, the cash account receives debits and credits depending on the activity of the business. As customers pay for goods and services, debit entries are generated increasing the balance. As the bookkeeper pays bills, credit entries are recorded in the ledger and the balance decreases. So it is a continuous up and down; hopefully more ups (increases) than downs. If one writes more checks than there is money, you end up with a negative balance (credit balance) in your cash account. So immediately all you reading this will say: ‘Hey Dave, you stated assets cannot have negative balances’.
So let’s think about this for a moment, if you write a check for money that doesn’t exist then the physical transaction is the person gets the check and tries to cash. The end result is that bank refuses to honor the check. So you still OWE the person the money. This means you have a liability. A liability is not an asset and is located in the bottom half of the balance sheet.
When Certified Public Accountants prepare financial statements, any credit balance in an asset account is recorded as a liability; therefore there are no credit balances in any asset account. You simply still owe the money. Not to mention the associated bank fees, a possible legal issue related to writing a bad check and a ticked off recipient of the check.
Assets normally have debit balances as their end result. Any credit balance in an asset account is reported as a liability or revenue depending on the nature of the underlying economic transaction.
Asset accounts can have both debits and credits recorded to their ledgers. The end result for assets should be a debit balance. Since the normal result is a debit balance, debits general means a positive result from the transaction. Any credit entries are general considered detrimental but in reality it just simply decreases the overall balance. It is OK to have credit entries in asset based accounts. In many cases it is a good thing.
Think of receivables from customers. When a customer purchases an item on his account from the business, a bookkeeper debits (a good thing) the accounts receivable (A/R) and credits (another good thing) sales.
So for the sake of understanding more; assume we continue with the example of the investor starting a business as illustrated above and the business generated a $40 sale. First is the entry from the sales journal (Lesson 3).
Sales Journal DR CR
08/02/15 A/R 1 Hour of Service on Account $40.00
Sales 1 Hour of Service – Smith Family $40.00
Remember the dual entry system and our two lines of data in this journal. Each line is then transferred over to the respective ledger. Once the entries are transferred to the ledger the trial balance (T/B) is updated. Let’s take a look at the T/B.
Totals $140.00 $140.00
Notice the ending balances for both the Debit column and Credit column are the same. They have to be the same as required under the dual entry system used in bookkeeping.
Many authors will have you believe that credits are a bad thing or the wrong thing related to asset types of accounts. But I disagree. Let’s go back to the A/R account. So let’s assume the next day the customer pays cash for the service invoice of $40. Another journal (cash receipts) records this entry. It looks like this:
Cash Receipts Journal DR CR
08/02/15 A/R Mr. Smith pays cash $40.00
Cash Smith Family Payment $40.00
Now for a couple of points related to this entry. Almost every accountant enters the debit first, so if you did, the cash line would be first and the A/R line would be second. More importantly, THERE IS NO REQUIREMENT TO ENTER THE DEBIT LINE FIRST. The key to an entry is that the lines balance. So you can enter the credit first if you want. Don’t let somebody tell you otherwise.
Alright, now the cash account increases by $40 and the A/R account decreases by $40. Credits in asset types of accounts decrease the balance in the account. So now let’s take a look at the trial balance after this entry.
Sales -0- 40.00
Totals $140.00 $140.00
Again it is essential that the two ending balances are equal.
Now I’ve shown you why credits are actually not a bad thing. Honestly I would prefer cash in the bank account instead of somebody owing me money.
Summary – Asset Accounts
Debits and Credits are merely values assigned to accounts and offset each other in order for the dual entry system to work effectively. In asset based accounts debit balances are the traditional ending balance. Any credit ending balance shifts the asset to liability status. In asset based accounts debits increase the balance and credits decrease the balance. Naturally debits are preferred especially for the cash accounts. However, credits are not a bad thing as sometimes credits merely shift a value from one asset account to another. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.