Debit or credit? The question can confuse most beginner business owners since, to the average person, it can mean the same thing in certain situations. However, debit and credit are far more different than they are similar. This article will help you settle the debits vs. credits question once and for all.
To understand debit and credit, we have to go back to the basics of business finances: money coming in, and money coming out. It is the inevitable truth of business—you can't earn without spending, and you shouldn’t spend money without expecting returns.
This brings us to our main point: the credit and debit difference. It's an ongoing cycle, give and take. Debit and credit just give us a sharper idea of which goes where.
At first glance, the difference between debit and credit seems pretty straightforward. Debit, since it brings in money for the business, is the one that gives, while credit, which connotes loans and payments, takes.
But if you keep track of your financial transactions and look closely enough, you'll realize that debit and credit are not just fancy accounting jargon, and accounting for each can get pretty complicated. So what's the main difference between the two accounts?
Let's go back to give and take. Businesses live off customers' payments in exchange for goods and services and make investments to maintain or even improve their operations. Customers give you money, and you take money from your budget to pay for necessary expenses.
When a customer pays for services, their money becomes the company's money to do with as they see fit. Such payments can be considered “assets”—resources under a company's control. Assets can be anything from hard cash to vehicles or properties.
But when it's the company's turn to make payments to other entities—whether in the form of investments, expenses, or refunds—they relinquish control of the money in their possession, turning them into a “liability”: a resource or amount a business owes to another individual or business.
The main difference between debit and credit lies in assets and liabilities. A debit increases the value of assets while credit accounting increases the value of liabilities. So while the two both give in some areas, they also take in others, depending on the account.
Here are some examples of assets:
Here are some examples of expense accounts or liability accounts:
To better understand debit and credit, here are some examples of how they function in different accounts.
The balances in a bank and cash account are the simplest way to explain debit and credit. When someone deposits an amount into your bank account, you consider that a debit transaction because cash is an asset, and a deposit increases the amount or value of that asset. Essentially, bank debits are transactions wherein the asset account increases.
But when you pay for something, like bills or expenses, then those are considered credit transactions because you owe certain amounts to other individuals or businesses, taking away your control of the asset. Monthly payments on your prepaid debit cards or credit card bill increase your amount owed, making it a credit.
Revenue includes expenses in the equation, making it a liability. So when a client pays a business a certain amount, that amount is entered into the books as a credit, even if it adds to your business's total income after expenses.
Debits in revenue are made when a customer returns an item or asks for a refund, increasing what your business owes to other entities.
Equity is what remains from the revenue after expenses. It is your profit to be divided among shareholders as their portion. Because it takes money from a business, equity accounts are considered liability accounts on the balance sheet. So if someone invests in your business, even if it helps your company financially, that will still be considered credit because the equity accounts increase.
If you're having trouble determining your profit, remember the accounting equation: liabilities minus expenses equals assets. Usually, the profit's dividends will depend on shareholders' equity.
Accounts receivable are simply your business's earned but unpaid sales. Accounts receivable is considered an asset account because when customers pay for the services, the payments turn into cash for your company. Naturally, logging sales into the accounts receivable is considered a debit entry.
Accounts payable keeps track of how much the business owes, making it a liability. So money sent into this account guarantees it will be spent elsewhere, like suppliers or the company's bills, which is considered a credit transaction. This is usually how a credit card company does business.
You probably think that debits and credits complicate the whole accounting process, which is true to some extent. It is complicated, but not without reason. Debits and credits give context to your business's financial health.
For example, in the two account systems, single-entry and double-entry accounting, borrowing money or a bank loan can be interpreted in different ways. In single-entry accounting, the loan is logged as income since it increases your company's funds. But in double-entry accounting, where transactions are labeled as a debit or credit entry, a loan is considered an expense, or a credit that the business will have to pay in the future.
See, if you only logged the loan as additional cash (which it is, but only temporarily), you risk forgetting it in the future and hurting your company's financial health. But if you log it as an expense now, you can better prepare for it in the future.
One of the best decisions you can make in favor of your business's financial health is deciding on an accounting method to use to track your finances.
If you run your business account on a single-entry system, you won’t have much of an issue since it's simpler: separate income and expense accounts; nothing more, nothing less. You can even manage your books with a single journal entry. You log incoming and outgoing money and mark the difference, which will be your profit.
However simple as it may be, single-entry bookkeeping or accounting poses problems for a businessman accounting for their finances using this process. First, single-entry accounting lacks context. Since you only account for income and expenses, you have only a vague idea of your business finances. Second, because of the lack of context, single-entry accounting cannot produce balance sheets, which leads to problems regarding taxes.
So what's a better choice?
Double-entry bookkeeping or accounting fixes the common problems with single-entry bookkeeping. A better financial context in a double-entry system allows you to make more accurate financial predictions. Consequently, you'll have fewer problems with the tax authorities since you'll be able to provide much needed details with a balance sheet.
Double-entry accounting takes assets, liabilities, and equity into consideration when assessing a company's financial situation. It takes asset and expense accounts and marks the debits and credits properly to make an accurate financial assessment.
With double-entry bookkeeping, you won't have to worry about making it to the end of your financial period since your accounting method keeps you up-to-date. Also, accounting software is usually optimized to record debits and credits properly, so it becomes less of a headache to do.
Learning the difference between debit and credit is essential to the survival of your business finances. The average person will have trouble seeing which—they may even label the same transaction as both debit or credit without noticing.If doing your own accounting isn’t optimal, try a bookkeeping service. A good bookkeeping service can keep your books flawless and your business in great financial shape. Unloop can do this for you. Give us a call to find out how.
Unloop is the first and only accounting firm exclusively servicing ecommerce and inventory businesses in the US and Canada. With the power of people and technology, our team dives deep into COGS and inventory accounting. You are paired with a dedicated bookkeeping team that prepares accurate financial statements, financial forecasts, and can also pay bills or run payroll for you. Come tax time, everything is organized and ready to go, so you don't need to worry. Book a call with an ecommerce accountant today to learn more.
