In this chapter, we are going to talk about Debits and Credits. I believe that debits and credits are a powerful tool in teaching and learning accounting. My students who mastered this powerful tool have made significant improvements in cracking a problem they are trying to solve. So let us get started.
Generally, when we think about the word credit, we recall things like credit my account, credit card, credit to people. Moreover, the word debit reminds us of a debit card, debit my account, etc. However, those are connotations in the real world. In the world of accounting, debit means left, and credit means right. Based on the type of transaction, debit could be useful, or it could be bad — the same idea applies to credit.
There are several rules for debits and credits that we must keep in mind moving forward.
Rule #1: Every transaction must have at least one debit and at least one credit.
Rule #2: Debits must equal credits for all transactions. If we want our debits to equal credits, we have to have at least one on each side in a transaction, as mentioned before.
Rule #3: There are no negative numbers allowed, which means that we are either going to debit a positive number, or credit a positive number.
Now let us talk about different accounts concerning debits and credits.
Every account has a normal balance, which it carries under normal circumstances. In T-Accounts, we are going to put debits on the left side and credits on the right side. Assets and Expenses have a normal debit balance, which means they sit on the left side of the T-Account.
Problem 1:
At the beginning of the year, Addison Company's account receivable had a balance of $3,820. On March 9, Addison company completes a $7,500 project for a client, who must pay within 30 days. On March 12, Addison company received $3,500 cash as partial payment for the work completed on March 9.
Step 1: The beginning balance goes on the left side of the T-Account since it is a debit balance account.
Step 2: On March 9, We increase accounts receivable because it increases the amount of cash that our client owes us. Accounts receivable has a normal debit balance, and we show that increase with a debit.
Step3: On March 12, we collect cash from the client, which reduces accounts receivable, and the client does not owe us the cash anymore because they paid us. We reduce a debit balance account with a credit entry. Therefore, we reduce accounts receivable with a credit.
Step 4: In order to find our ending balance, we add up our debits and subtract them from the sum of the credits.
Again it is important to remember that debits will sometimes increase an account and sometimes decrease an account. It all depends on the type of account. Liabilities, Equity, and revenue have a normal credit balance which goes on the right side of the T-account.
Let's look at an example of a liability account like accounts payable, which is the amount a company owes for items or services purchased on credit. Let's say...
Problem 2:
On January 1, 2019, Michael and Jim form Michael Scarn, Inc. ("MSI"), a consulting business. Michael Scarn, Inc. ("MSI") had a beginning balance of $20,000 in their accounts payable. On April 10, 2019, MSI receives an invoice from a consultant that MSI hired, Big Tuna, Inc. ("BTI"). The invoice is for $12,000. On September 1, 2019, MSI pays the balance owed to BTI from April 10.
Step 1: The beginning balance is on the credit side because it is a credit balance account.
Step 2: On April 10, 2019, we are going to increase the liability because we have an obligation to pay BTI for providing services to us. We increase the liability with credit; a credit entry increases accounts payable with a normal credit balance.
Step 3: On September 1, 2019, we pay the remaining balance owed to BTI, which reduces the liability. We show a decrease to liability with a debit, so a debit entry reduces accounts payable (a normal credit balance).
Step 4: The end of the period we add up the credits, subtract the sum of the debits, get an ending balance of $20,000 which we write on the credit side because it is a credit balance account.
Now you probably think what the corresponding accounts are in these examples. As we mentioned earlier, every transaction must have at least one debit and at least one credit. We are going to cover that in the next chapters, so see you later!
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