Understanding the basics of accounting helps small business owners, independent contractors, or entrepreneurs see their financial track record and keep their financial data organized.
A key element to better understand all this is to be familiar with the differences between credit and debit.
In this article, we compare credit vs. debit, how businesses use credit vs. debit, and the benefits of using a double-entry bookkeeping system.
In accounting, a debit is an entry to an account. How a debit transaction affects an account depends on the nature of the account itself.
Debits can increase the value of an expense account or an asset account, and decrease income, equity, or liability accounts. It’s helpful to remember that a debit transaction is recorded on the left side of a financial journal entry.
Like debit entries, credits are also entries made to accounts. It works the same way as a debit transaction, but affects different accounts.
Credit entries increase the value of equity, income or liability accounts, and decrease the value of asset or expense accounts.
It is helpful to remember that a credit transaction is always entered on the right side of a financial journal entry.
Although debits and credits are used to record financial transactions in an account, they vary in how they affect accounts. Credits and debits always have an opposite effect on the same financial account.
To understand the differences between credit and debit entries, you can learn about the types of accounts that are credited and debited when a business records financial transactions.
Accounts are organized collections of records of financial transactions. Any financial action a company takes is recorded in the accounts.
This process helps small business owners and accountants keep track of cash flow and expenses.
Classifying each financial transaction in its corresponding account helps to avoid any errors.
It is this classification process that uses credits and debits to categorize each function.
The main types of accounts that businesses use to keep track of are assets, income, expenses, liabilities, and equity.
Everything a business owns is included in assets. For small business owners, this may include office space, company vehicles, or equipment used to run the business.
Assets are divided into tangible and intangible. Tangible assets are any physical assets, while intangibles encompass intellectual property rights such as trademarks.
Some common examples of assets are:
- accounts receivable
- Expenses paid in advance
- property and equipment
All money a business earns is recorded as revenue. The most common way for a business to make money is by selling goods and services.
Some common examples of income are:
Expenses refer to any costs that are necessary to keep the business running, from a business mortgage to business insurance.
Common examples of expenses include
- Public services
Liabilities refer to all the money a business owes. This includes debts accumulated while the business is in operation.
The most common examples of liabilities include:
- Accounts payable
- bank fees
- Income tax
Share capital is used to classify the owner’s share of interest in a business.
Common examples of fairness include:
- investment funds
- retirement plans
In double-entry bookkeeping, there are also gains and losses. They are similar to credits and debits, respectively, but slightly different:
Earnings: Earnings are like income, except that they occur outside of the company’s primary channel of activity. These non-operating activities are listed as earnings rather than income accounts.
Losses: When a company sells an asset for less than it is worth, a loss is recorded. Since asset accounts differ from income accounts, these losses are recorded as non-operating losses.
Double-entry bookkeeping is an accounting method that requires each transaction to be reflected in a minimum of two accounts.
It’s a great accounting system for small business owners because it helps them keep track of their financial transactions in the most transparent way possible.
It also makes it much easier to spot errors that may appear in any financial records.
Debits and credits are used in a double-entry bookkeeping system to show basic changes between multiple accounts. Within this system, debits and credits work together.
Any change in a debit account is also reflected in a credit account. They are essentially opposite elements that work together to create clarity in financial transactions.
Understanding the elements that work in the double-entry bookkeeping system makes it easier to see the impact it has on the organization of financial records. Most companies handle daily value changes in the most common accounts.
Organizing these constantly changing numbers can be challenging, which is why many accountants and owners use double entry to keep track of how credits vs. debits affect accounts.
Here are the key functions of a double entry bookkeeping system within a business:
Double-entry bookkeeping systems make it easy to record sales transactions for any given day.
Sales transactions typically include the cost of goods and services and applicable taxes.
Companies segment these into their respective accounts as credit or debit. A sales transaction typically causes asset accounts to be debited and revenue and liability accounts to be credited.
Another basic function of a double-entry bookkeeping system is the tracking of accounts payable. These accounts are part of a company’s liabilities.
Liability accounts consist of money that a business owes. These outstanding payments are properly tracked and classified thanks to the double-entry bookkeeping system.
For example, if a business receives a utility or mortgage bill, it is debited from its expense account and credited to accounts payable (liability).
Once the invoices are received and posted to the liability account, the next step is to move them to a different category.
Once a business submits your invoice payment, it will be debited from your liability account and credited to your revenue account to show the deduction.
Another key function of the double-entry bookkeeping system is that it helps businesses keep track of loans and interest payments.
Without having a double entry system, the money received from a loan could be mistaken as an asset.
Although there will be a debit to asset accounts, there will also be a credit applied to expenses and liabilities.
This distinction is important because a company will have to repay the principal amount borrowed as well as the interest.
Another advantage of double-entry bookkeeping is that companies can compare their financial records across different tax periods.
Small business owners looking to expand and gain more investors and shareholders use this type of data to showcase their steady growth over time.
The detailed nature of double-entry accounting systems makes it easy to view every financial transaction, including the starting point of the business.
This information allows them to act on their financial reports and improve various aspects of their business.