So far we have talked about the accounting equation and how a change in one account, will cause a change in another account in order to balance the equation.
Now, in this unit, we move to the official terminology for the increases and decreases to the accounting equation.
Do not confuse debits and credits with the way it is defined in normal English. You have to understand debits and credits specifically the way it is used in accounting.
Debits and credits are terminologies we use to classify the corresponding increases and decreases in accounts in the accounting equation (such as we learned in the previous unit).
The elements of the financial statement and debits and credits:
Each element of the financial statement has a natural balance. A natural balance is the codification of debit or credit terminology to the corresponding increase in the element of the financial statement.
The best way to learn debits and credits is by memorizing the natural balances of the elements of the financial statement. Once you know what the natural balance of the elements of the financial statement, then determining the debits and credits for accounts will come more naturally. For instance, I know that assets has a natural debit balance, so cash, land, accounts receivable, prepaid assets will also have a debit balance to increase it. Once I know the increase I can determine the decrease.
Natural balances of the element of the financial statement
Element
Natural balance (terminology to define increase)
Terminology used in previous lessons
Assets
Debit
Increase
Liabilities
Credit
Increase
Equity
Credit
Increase
Contributed Capital
Credit
Increase
Distributions to owners e.g. dividends
Debit
Increase
Revenues
Credit
Increase
Expenses
Debit
Increase
Gains
Credit
Increase
Losses
Debit
Increase
Once you know the natural balance that is whether a debit or credit increases the account, you can decrease the account by using the opposite term. For instance to increase an asset account you debit the transaction so to decrease the same asset account, you will credit the transaction.
The T- account
The T- account is used to demonstrate the effect of debit or credit.
It is a good starting point for learning double-entry recording procedures. A T-account looks like the letter T drawn on a piece of paper. The account title is written across the top of the horizontal bar of the T.
The left side of any account is the debit side. The right side of any account is the credit side. Debit means left and credit means right. Just as we have all agreed that a red light means stop and a green light means go, accountants have agreed to the use of these special terms to refer to different sides of an account.
T – account
Debit
Credit
Note
A debit can represent an increase or a decrease. Likewise, a credit can represent an increase or a decrease.
Debits increase asset accounts and decrease liability and stockholders’ equity accounts.
Credits increase liability and stockholders’ equity accounts and decrease asset accounts.
In every transaction, just as assets must equal liabilities plus stockholders’ equity, the total dollar value of all debits must equal the total dollar value of all credits.
