In accounting, every financial transaction is recorded by two entries on the company's books. These two transactions are called a "debit" and a "credit," and together, they form the foundation of modern accounting. Debits and credits will always balance, or equal each other; this ensures that the company's balance sheet and income statement are always in balance as well, accurately reflecting the income, expenses, assets, liabilities, and equity in the business for each period of time.
The rules for debits and credits for the balance sheet
When an accountant is executing a transaction on the balance sheet of a company, debits and credits are used to record which accounts are increasing and which are decreasing. For example, if a company takes out a loan, that loan transaction would be recorded by both a debit and a credit, which would simultaneously increase its liabilities (the loan) and its assets (the cash on hand funded by the loan).
On the asset side of the balance sheet, a debit increases the balance of an account, while a credit decreases the balance of that account. When the company sells an item from its inventory account, the resulting decrease in inventory is a credit. In the example of the loan transaction above, the increase in cash would be recorded as a debit to the company's cash on hand, increasing it by the loan amount.
On the liabilities side of the balance sheet, the rule is reversed. A credit increases the balance of a liabilities account, and a debit decreases it. In this way, the loan transaction would credit the long-term debt account, increasing it by the exact same amount as the debit increased the cash on hand account. The debit to cash and credit to long-term debt are equal, balancing the transaction.
The final component of the balance sheet -- the shareholder's equity section -- contains some accounts that behave like the asset accounts, where debits increase the balance and other accounts that behave like liability accounts. Retained earnings, for example, increase when credited. Dividends, on the other hand, increase when debited. This is due to how shareholders' equity interacts with the income statement (more on this next) and how some accounts within shareholders' equity interact with each other.
The rules for debits and credits on the income statement
To me, the easiest way to understand debits and credits on the income statement is to consider first how each transaction is impacting the balance sheet. Consider, for example, how a company pays its payroll.
Every two weeks, the company must pay its employees' salaries with cash, reducing its cash balance on the asset side of the balance sheet. A decrease on the asset side of the balance sheet is a credit. If the balance sheet entry is a credit, then the company must show the salaries expense as a debit on the income statement. Remember, every credit must be balanced by an equal debit -- in this case a credit to cash and a debit to salaries expense.
The same logic holds true for revenue. When a customer pays cash to buy a good from a store, the money increases the company's cash on the balance sheet. To increase the balance of an asset, we debit that account. Therefore the revenue equal to that increase in cash must be shown as a credit on the income statement.
The bottom line on the income statement is net income, which interacts with the balance sheet's retained earnings account within shareholders' equity. At the end of each period, a company's net income -- its profit or loss -- is transferred to the balance sheet's retained earnings account. Retained earnings increase when there is a profit, which appears as a credit. Therefore, net income is debited when there is a profit in order to balance the increase in retained earnings. If there is a loss, the opposite happens, with retained earnings decreasing with a debit and being balanced by a credit to net income.
Here's your cheat sheet
Debits and credits can be a bit confusing. Sometimes a debit causes an account to increase, and other times it leads to a decrease. Credits are equally flexible. The first time you're exposed to these concepts, the only thing that's easy to remember is that every debit must be balanced by an equal credit. To help keep it all sorted out, there's an easy trick to help you remember which accounts increase with either a debit or a credit. It's the DEALS and GIRLS mnemonic.
- Accounts that increase with a debit are the DEALS accounts: dividends, expenses, assets, and losses.
- Accounts that increase with a credit are the GIRLS accounts: gains, income, revenues, liabilities, and stockholders' equity.
Use this mnemonic to help you as you're getting started, and pretty soon debits and credits will come to you naturally. With this solid foundation, understanding how the income statement and balance sheet interact and reflect the realities of a business will be much easier and will make you a far better investor and financial analyst.
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