Bookkeeping – Debits and Credits in Asset Accounts (Lesson 4)
Asset accounts customarily end with a debit balance.
Debits and credits are two words that are the most recognized terms synonymous to bookkeeping and accounting. I have read over 30 different articles as to how other authors define debits and credits with bookkeeping. Several authors try to get the reader to visualize the terms as the left side and the right side of the ‘T’-Account (Lesson 2). Others use windows and doors to explain debits and credits. Even I scratch my head on that one. One site simply stated that debits increase assets and expenses. But every accountant and bookkeeper knows you can have debits in liabilities, equity and revenue. It is quite normal to see debits in liability accounts. In reality, debits in a liability account is a wonderful entry; it means you are paying your bills! You end up owing less money.
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.
Given this, 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, below is a chart 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 lesson is the first of six educating you about the effect for each type of account. The first one is assets.
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 RARELY 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; there is one exception known as a contra account explained in Lesson 12.
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. Therefore, the typically first entry for the financial records looks like this:
Debit Credit
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. 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. Immediately all you reading this will say: ‘Hey Dave, you stated assets cannot have negative balances’.
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. Thus, you still OWE the person the money. This means you have a liability. A liability is not an asset and therefore, it 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 converted into 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 (normal) 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.
For the sake of further understanding, assume we continue with the example of the investor starting a business as illustrated above. 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.
Trial Balance
08/02/15
DR CR
Cash $100.00
A/R 40.00
Stock $100.00
Sales 40.00
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 sign or the wrong thing related to asset types of accounts. But the author disagrees. Let’s go back to the A/R account. 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
In this case, there is a credit entry to an asset account. Every business wants their customer to pay their respective amount owed, thus credit entries are a good even in asset accounts. The primary lesson here is that asset accounts receive both debit and credit entries; however, their preferred respective ending balances should be a debit value.
Now for a couple of points related to the above entry. Almost every accountant enters the debit first, so if you did, the cash row 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. You may 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. Now let’s take a look at the trial balance after this entry.
Trial Balance
08/02/15
DR CR
Cash $140.00
Stock $100.00
Sales -0- 40.00
Totals $140.00 $140.00
Again, it is essential that the two summation balances are equal.
The above shows you why credits are actually not a bad thing. Honestly, anybody would prefer cash in the bank account instead of somebody owing them 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. With asset-based accounts, debit balances are the traditional ending balance. Any credit ending balance shifts the asset to liability status. With 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 are a part of entry merely shift a value from one asset account to another. ACT ON KNOWLEDGE.
Value Investing
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.