How Debits and Credits Impact Your Financial Reports - dummies

How Debits and Credits Impact Your Financial Reports

By Lita Epstein

For the purpose of financial reporting, you probably think of the word debit as a reduction in your cash. Most nonaccountants see debits only when they’re taken out of their banking account. Credits likely have a more positive connotation in your mind. You see them most frequently when you’ve returned an item and your account is credited.

Forget everything you think you know about debits and credits! You’re going to have to erase these assumptions from your mind to understand double-entry accounting, which is the basis of most accounting done in the business world.

Both cash-basis and accrual accounting use this method, in which a credit may be added to or subtracted from an account, depending on the type of account. The same is true with debits; sometimes they add to an account, and sometimes they subtract from an account.

Double-entry accounting

When you buy something, you do two things: You get something new (say, a chair) and you have to give up something to get it (most likely, cash or your credit line). Companies that use double-entry accounting show both sides of every transaction in their books, and those sides must be equal.

Probably at least 95 percent of businesses in the U.S. use double-entry accounting, whether they use the cash-basis or accrual accounting method. It’s the only way a business can be certain that it has considered both sides of every transaction.

For example, if a company buys office supplies with cash, the value of the office supplies account increases, while the value of the cash account decreases. If the company purchases $100 in office supplies, here’s how it records the transaction on its books:

Account Debit Credit
Office supplies $100
Cash $100

In this case, the debit increases the value of the Office supplies account and decreases the value of the Cash account. Both accounts are asset accounts, which means both accounts represent things the company owns that are shown on the balance sheet. (The balance sheet is the financial statement that gives you a snapshot of the assets, liabilities, and shareholders’ equity as of a particular date.)

The assets are balanced or offset by the liabilities (claims made against the company’s assets by creditors, such as loans) and the equity (claims made against the company’s assets, such as shares of stock held by shareholders). Double-entry accounting seeks to balance these assets and claims. In fact, the balance sheet of a company is developed using this formula:

Assets = Liabilities + Owner’s equity

Profit and loss statements

In addition to establishing accounts to develop the balance sheet and make entries in the double-entry accounting system, companies must set up accounts that they use to develop the income statement (also known as the profit and loss statement, or P&L), which shows a company’s revenue and expenses over a set period of time.

The double-entry accounting method impacts not only the way assets and liabilities (balance sheet accounts) are entered, but also the way revenue and expenses (income statement accounts) are entered.

The effect of debits and credits on sales

If you’re a sales manager tracking how your department is doing for the year, you want to be able to decipher debits and credits. If you think you’ve found an error, your ability to read reports and understand the impact of debits and credits is critical.

For example, anytime you think the income statement doesn’t accurately reflect your department’s success, you have to dig into the debits and credits to be sure your sales are being booked correctly. You also need to be aware of the other accounts — especially revenue and expense accounts — that are used to book transactions that impact your department.

A common entry that impacts both the balance sheet and the income statement is one that keeps track of the amount of cash customers pay to buy the company’s product. If the customers pay $100, here’s how the entry looks:

Account Debit Credit
Cash $100
Sales revenue $100

In this case, both the Cash account and the Sales revenue account increase. One increases using a debit, and the other increases using a credit. Yikes — accounting can be so confusing!

Whether an account increases or decreases from a debit or a credit depends on the type of account it is. Make a copy of this table, and tack it up where you review your department’s accounts until you become familiar with the differences:

Account Debits Credits
Assets Increases Decreases
Liabilities Decreases Increases
Income Decreases Increases
Expenses Increases Decreases