Making Sense of Debits and Credits

Overview

The intent of this article is to provide a basic understanding of accounting, especially debits and credits, to business owners who are using software such as Quickbooks Pro (QBP). Today's accounting software appears simple to use, but it is easy to set up accounts incorrectly or debit and credit the wrong accounts. It is confusing for someone trying to learn accounting to read a phrase like: “debits always go on the left, and credits always go on the right.” This information is meaningless to us because we never kept books manually and we never will! We need to understand what debits and credits are, how they work, and how to apply them properly in software like Quickbooks Pro. I am explaining debits and credits in a new and novel way - how I had to view them before they made any sense. If you are confused, I hope this article will help you. There are many examples included in the the separate article QBP Sample Transactions

Debits and Credits

Whenever you record an accounting transaction, one account is debited and another account is credited.  And the amount of the debit must equal the amount of the credit. (This is called double-entry bookkeeping.) From a math perspective, we can think of a debit as adding to an account, while a credit is subtracting from an account. (This is the OPPOSITE of what you probably believe!) Or you might say a debit is adding a positive number to an account balance, while a credit is adding a negative number to an account balance. Please note that in Quickbooks Pro, you NEVER enter a negative number. And another tidbit: accountants often use DR (debit record) to indicate a debit, and CR (credit record) to indicate a credit.

Change Your Paradigm

You may be confused now because you always thought a credit was a good thing! Well, debits and credits are neither good nor bad. We are confused because we’ve learned these terms from dealing with banks and stores, but they use these terms from their perspective, not ours! When a bank gives you a credit, it is their Cash they are crediting (or subtracting from). So that’s bad for the bank, but good for you, the customer. We really have it backwards. As a business owner you must think of debits and credits from your company’s standpoint.

Review of Positive and Negative

Do you remember the math number line from junior high? What do you see? Zero is in the middle. The numbers to the right of zero are positive and the numbers get bigger as they go to the right. The numbers to the left of zero are negative and the numbers get bigger as they go to the left.

Whenever I add a positive number (debit), I move to the RIGHT on the number line. Examples:
(1) If I add $100 to $400, my answer is $500 (the balance increases)
(2) If I add $100 to -$400, my answer is -$300 (if you owe your Dad $400 and then pay him $100, your debt decreases to $300.)

And whenever I add a negative number (credit), I move to the LEFT on the number line. Examples:
(1) If I add -$200 to $700, my answer is $500 (the balance decreases)
(2) If I add -$100 to -$200, my answer is -$300 (if you owe your Dad $200 and borrow another $100, your debt increases to $300.)

[Remember: A debit adds a positive number and a credit adds a negative number. But you NEVER put a minus sign on a number you enter into QBP.]

Debit and Credit Accounts

Concentrate now. Some of our company’s accounts maintain positive (debit) balances and some maintain negative (credit) balances. This makes sense if you think about it. We already said that for every transaction, we debit one account and credit another. That means there are as many negative numbers being added to balances as positive numbers. If an account begins with a negative balance and only receives credits, that account’s balance will stay negative! And vice versa.

For instance, when you make a cash sale, the checking account - Cash - is debited, and a revenue account - let’s call it Sales - is credited. Revenue account almost always receives credits. However, we do not say “I have negative $1000 in Sales.” And on your QBP reports, Sales will have a positive value. Whether an account maintains a negative or positive balance is “under the covers” as it were; it is for accounting purposes. But since the rule of bookkeeping is “for every debit there is a credit,” some accounts will “play” on the negative side of the number line and others will “play” on the positive side of the number line.

The balance of an account always increases if the number increases, regardless of the + or - sign. Likewise, the balance of an account always decreases if the number decreases, regardless of the + or - sign

The five types of accounts:

  • Assets: what the company owns of value (Cash, Accounts Receivable, furniture, vehicles)
  • Liabilities: what the company owes to others (loans, Accounts Payable)
  • Equity: the company’s net worth. Equity equals Assets minus Liabilities
  • Revenue: money the company is earning
  • Expenses: money the company is spending

Assets and Expenses

Two of the 5 accounts maintain a positive balance. They are Assets and Expenses. Because they maintain a positive balance, they are called debit accounts. You will read this in Accounting books: “Accounts that normally have a positive balance are increased with a Debit and decreased with a Credit.” Of course they are! Look at the number line. If you add a positive number (debit) to a positive number, you get a bigger positive number. But if you start with a positive number and add a negative number to it (credit), you will get a smaller positive number (you are moving left on the number line). A quick note about the Asset account called Cash. This account does get both debits (you deposit money) and credits (you write checks); but its goal is to maintain a positive balance!

Liabilities, Equity, and Revenue

The other 3 types of accounts primarily receive credits, so naturally they tend to maintain a negative balance. They are Liabilities, Equity, and Revenue. They are called credit accounts. You will read this in Accounting books: “Accounts that normally maintain a negative balance are increased with a Credit and decreased with a Debit.” Again, look at the number line. If you add a negative number (credit) to a negative number, you get a larger negative number! (you’ve moved to the left on the number line). But if you start with a negative number and add a positive number to it (debit), you get a smaller negative number because you’ve moved to the right on the number line. Some of you might be thinking: if I start off with -200 and add 600 to it, I get 400 - a positive number. In accounting, balances seldom cross over zero. A negative account might eventually reach zero - such as a loan account. As you debit this account each month with your loan payment, the negative balance will get smaller and smaller until it reaches zero with your final payment. But credit accounts seldom have a positive balance, and debit accounts seldom have a negative balance.

[Remember: A debit adds a positive number and a credit adds a negative number. But you NEVER put a minus sign on a number you enter into QBP.]

Debit and Credit Accounts Logic

There is logic behind which accounts maintain a negative balance. It makes sense that the liability accounts maintain a negative balance because they track company debt. But what about Equity and Revenue? Again, you need to look at it from the company’s viewpoint. Having lots of Revenue is good for you - the business owner. But from the company’s viewpoint, the money being tracked by Equity and Revenue accounts is money the company owes you - the owner.

What about the accounts that maintain a positive balance? It’s easy to understand why an Asset account is positive since it tracks your company’s Cash and other valuable possessions. But what about Expenses? Well, the services and supplies required to run the business do cause a decrease in owner’s equity, so they could be looked upon as positive from the company’s standpoint.

Three Unique QBP Accounts

There are 3 other accounts you may use in transactions. Inventory and COGS (cost of goods sold) normally maintain positive balances, as they are expenses required to run the company and, as such, reduce owner’s equity.  And the Owner/Shareholder Draw account (often called Distributions), which tracks money the owner(s) take out of the business, maintains a positive balance as it also reduces the owner’s equity.

Debit and Credit Wrap-Up

If you fully understand the above, you will find it much easier to determine which accounts need to be debited or credited in your transactions. The good news is that QBP helps you when it comes to Cash! When you make a deposit, QBP automatically debits Cash so you just need to indicate which account should receive the credit. And when you write a check, QBP automatically credits Cash (takes money out of the account) and you just need to indicate which account should receive the debit (perhaps an expense account).

You can look for yourself in QBP and see which accounts are debit accounts and which are credit accounts. Right-click on an account and click Find. On the next window, click Find. You will then see all the postings QBP has done to that account from the beginning. Do not be confused, however. When you look at the Balance Sheet, a user-friendly report, you’ll see that it lists the negative balances as positive numbers and subtracts the positive balances in order to calculate its totals.

Once in a while, a debit or credit may be split and posted against several accounts. For example, you might credit Cash $100 to make a loan payment, but then debit a Loan account $95 and a debit an Interest Expense account $5. But the total amount of the credit must always equal the total amount of the debit.

[Remember: A debit adds a positive number and a credit adds a negative number. But you NEVER put a minus sign on a number you enter into QBP.]

The Item List: Items for Income

QBP uses Items so you need to understand what they are and how to use them properly. An Item is an entity that points to an account. Each Item must be associated with an account and multiple items may be associated with the same account. Let’s look at how QBP handles invoices as an example. QBP forces you to specify an Item for every individual charge on an invoice. Any Item you specify on an invoice should be associated with an income/revenue account because these accounts are crebited when you create an invoice (and A/R is debited). If you provide Consulting, you may only need to create one Item: you could name it Consulting and associate it with an income account such as Sales. If you wanted to break down how you spent your consulting time, you could create multiple Items, i.e. Financial consulting, PC consulting, and Sales Consulting, etc.; but each Item would be associated with a revenue account such as Sales. If you resell parts, you would create an Item and call it Parts for Resale; or perhaps create a separate Item for each unique part.  It depends on your business. An Item for use on an invoice is a descriptive entity - of a part or service - that points to a revenue account.

Items for COGS (cost of good sold)

The other use for Items is for COGS (cost of goods sold). The money you make on a product or service is seldom 100% profit because you usually have some direct costs. If you resell parts, your profit is the difference between what you paid, and what you charged, for the part. The cost of the part is a COGS. To qualify for a COGS, the part or supply must be used up in the sale or service. If you need pads of flipchart paper for your customer planning sessions, they are a COGS.  If you pay a subcontractor for a particular job, his cost is a COGS. On the other hand, a flipchart stand is an expense, not a COGS, because you will use it for many projects. And a tool is an expense - unless you bought it for a particular job and will never use it again.

Costs that are directly related to a customer job - parts or labor - should be posted to a COGS account, not an expense account, so that a business owner can determine his or her net profit on the Profit and Loss report. In QBP you can post COGS expenses directly to a COGS account, or to an Item you created that is associated with a COGS account. When you enter a check, bill, or credit card payment in QBP, you must select the "Expenses" tab or the “Items” tab. If you select the Expenses tab, you are asked to choose an account (to debit) and you would choose a COGS account. If you select the Items tab, you would choose an Item that you created which is associated with a COGS account. (And the COGS account would be debited.)

In QBP 2006 and newer, there is a check box on the edit screen that says, “This item is used in assemblies or is purchased for a specific customer job.” When checked, QBP allows you to choose both an income account and a COGS account. When you enter a bill or write a check in QBP, you select the Item under the Items tab and you choose the customer job the purchase pertains to in the Customer:Job column. Then when you create the invoice for that customer job, you click the Time/Costs icon and the product you purchased for the job should be listed. Select it. I suggest you create a sample QBP company and test this feature.

Sales Tax and Shipping

An additional Item you may require is Sales Tax. When you enter the Item you can mark it as taxable and enter the agency and tax percentage. Or you can create the Item but not specify that it is taxable until invoice time. QBP will calculate the sales tax automatically. When you submit the invoice, QBP debits Accounts Receivable, and credits both the revenue account that the revenue Item points to, and Sales Tax Payable (a liability account) with their respective amounts. Do not confuse this with Sales Tax you pay. Sales tax you pay for a purchase is just part of the expense or COGS to your company.

If you charge for shipping on your invoice, you will need to setup a revenue Item called Shipping. If you resell shipping, you will want to associate this Item with a COGS account as well to use when you pay to ship to a customer.

For more information, see the separate article QBP Sample Transactions