Debits and credits are the building blocks of the double entry accounting system. Many accounting students find the usage of these words confusing. Many try to understand them by trying to draw an analogy with something they already know like plus and minus. However, debits and credits are distinctly different from plus and minus. Sometimes a debit entry may make an account balance go up whereas other times it will make an account balance go down. Let’s try and understand how this debit and credit system works.
The debit-credit system can be understood to be a two-layered system. The steps involved in deciding whether an account needs to be debited or credited are as follows:
- Ascertain the type of account
- Ascertain the type of transaction
Ascertaining the Type of Account
Accounts are of two types the debit and the credit types. Here is how they are distinguished
- The 4 Classifications: There are four major classifications of accounts in accounting. They are assets, liabilities, income and expenses. Any item can be classified as exactly one of these classifications. However, the same item may be split into two and be part asset and part expense and so on.
- Divide into Two Groups: We could consolidate these 4 categories into 2 categories. Expenses and assets denote outflow of resources from the firm. Income and Liabilities denote inflow of resources to the firm. Thus accounts can be classified as outflow and inflow
- The outflow accounts i.e. expenses and assets have a by default debit balance
- The inflow accounts i.e. income and sales have a by default credit balance
When you debit an account which has a default debit balance, you increase its value. When you credit an account which has a default debit balance, you decrease its value. The same is true for credit accounts as well.
Ascertain the Type of Transaction
Now you can decide whether to debit or credit an account. Let’s say you have to increase the cash balance. Cash is an asset and therefore has a default debit balance. When you debit it further, you increase its balance. Therefore, you will debit the cash account.
Similarly, you can ascertain whether an item needs to be debited or credited. As a check, you must ensure that the debits in every transaction are equal to the credits. This is like the fundamental principle of accounting.