Accurate books begin with understanding how financial transactions move through your accounts. While today’s accounting platforms automate much of the double-entry process, knowing the basics of debits and credits can help business owners better understand financial reports, identify potential errors, and have more informed conversations with their accounting advisors.

Start With The Accounting Equation

Assets are items of value that your business owns, such as accounts receivable, inventory, and equipment. Liabilities are debts that your business owes, including accounts payable, credit lines, and commercial loans. What remains after subtracting liabilities from assets is called owner’s equity. The basic accounting equation expresses the relationship: Assets = liabilities + owner’s equity.

T-accounts are a useful way to show how transactions are recorded. Traditionally, debits are recorded on the left side of a T-account and credits on the right. A debit or credit doesn’t inherently represent an increase or decrease; its effect depends on the type of account. Still, increases in assets are generally recorded as debits, while increases in liabilities and owner’s equity are generally recorded as credits. For every transaction, total debits must equal total credits.

Revenue and expenses indirectly affect owner’s equity; these accounts are closed to owner’s equity at the end of the accounting period. Revenue that your business earns is generally recorded as a credit and ultimately increases owner’s equity. Conversely, expenses that your business incurs are generally recorded as debits and ultimately decrease owner’s equity.

See Debits & Credits In Action

Here’s a hypothetical example to illustrate how debits and credits work. An appliance repair shop fixes a washing machine for $500, and the customer pays with cash. This transaction would be recorded by debiting cash (an asset) for $500 and crediting the revenue account for $500.

Continuing with this example, let’s assume the customer already had replacement parts on hand, and the repair shop hires an independent contractor and receives a $100 invoice for the contractor’s labor. The expenses related to this job would be recorded as a $100 debit to the contractor labor expense account and a $100 credit to accounts payable. When the repair shop pays the contractor at the end of the week, the bookkeeper would debit accounts payable for $100 and credit cash for $100.

In the real world, recording transactions is often more complicated. For example, if the contractor had been an employee, accounting for direct labor costs would have required additional recordkeeping for wages, payroll taxes, and other payroll-related costs. Likewise, if the repair required parts from the shop’s warehouse, the journal entries for those expenses would have involved the inventory account.

Turn Bookkeeping Data Into Financial Statements

Day-to-day bookkeeping entries ultimately feed into your business’ financial statements. At the end of each accounting period, they’re used to show your financial position and performance.

The balance sheet reflects the accounting equation above by reporting your business’s assets, liabilities, and owner’s equity. These balances are carried forward to the next accounting period.

The income (or profit and loss) statement shows revenue and expenses. Unlike balance sheet accounts, revenue and expense accounts are closed to owner’s equity and reset to zero at the start of the next accounting period.

The statement of cash flows is another important report. It shows sources and uses of cash. On this report, cash flows are typically categorized as operating, investing, and financing activities. Under U.S. Generally Accepted Accounting Principles, significant noncash investing and financing activities (such as acquiring equipment through financing) are disclosed separately rather than reported as cash flows.

Keep Your Books On Track

Accounting software can automate many bookkeeping tasks, but it can’t always determine how to record and classify transactions properly. Contact us for help maintaining accurate, up-to-date financial records, resolving accounting questions, and producing financial statements that you and your stakeholders can count on.