Understanding the fundamentals of accounting is no small feat, especially for small business owners and franchisees who wear many hats each day.
However, learning the basics is essential for keeping your business’s financial records straight and making informed business decisions. Central to these basic accounting principles are two elements: debits and credits.
What Are Debits And Credits?
Debits and credits are the foundation of bookkeeping and the double-entry accounting system. In basic terms, they are used to document all the money that enters and exits your business accounts.
But what exactly are they? A debit (dr) signifies money entering an account. This could be a result of different transactions, such as receiving payment from a customer or investing more capital into your business.
Meanwhile, a credit (cr) indicates money exiting an account. This happens when you pay a supplier, withdraw profits, or cover other expenses.
Why Are Debits And Credits Important?
Debits and credits are crucial for creating financial statements, like income statements and balance sheets. These tools use precise methods to track and analyze financial transactions.
Your financial records could become unbalanced without correctly applying debits and credits. An imbalance could cause wrong financial statements, leading to uninformed decisions that may harm your business’s health and growth.
Also – understanding the interplay of debits and credits is crucial in case your business is audited. Properly recorded transactions ensure your business can quickly provide the necessary documentation and pass any financial scrutiny.
How Are They Used?
As stated above, the use of debits and credits stems from the double-entry accounting system, which maintains that every transaction affects at least two accounts. This system keeps your books balanced by ensuring that the sum of each (dr) and (cr) are equal.
While this may sound simple enough, it requires a good grasp of which attributes to debit or credit in a given transaction based on the type of account involved.
- Asset accounts show the value of company-owned resources like cash, accounts receivable, inventory, and property.
- Expense accounts record costs involved in business operations and revenue generation, such as COGS, salaries, travel, advertising, and rent.
- Equity accounts denote shareholders’ interests in the company’s assets – stocks, distributions, contributed capital, dividends, and retained earnings.
- Liability accounts indicate what the company owes, including credit card balances, accounts payable, notes payable, taxes, and loans.
- Revenue accounts track money generated from operating activities like sales and consulting services and non-operating activities like interest and investment income.
- Gain accounts reflect increased value from non-core business activities, like selling an asset at a profit.
- Loss accounts are the opposite of gain accounts. Recording value decreases from non-business events, such as losing a lawsuit or selling an asset at a loss.
Pro Tip! (dr) raises the value of asset, expense, and loss accounts, while (cr) does the same for the value of liability, equity, revenue, and gain accounts.
Ceterus As Your Solution
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With us, you get:
- Get P&L and Balance Sheets in consistent, brand and industry-compliant formats.
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Dig into our Bookkeeping 101 resources here and then schedule a consultation to learn more about how we can help you!
