Debits and Credits Explained

Every transaction you make will lead to (at least) two entries in your accounts, a debit and a credit. More complex transactions may lead to a larger number of postings, but the total of the debits for that transaction will always be equal to the total of the credits.

Easy way to understand where to put your debits and credits

• A Debit to the balance sheet is good (increasing an asset or reducing a liability)
• A Debit to the profit and loss is bad (increasing an expense or reducing income)
• A Credit to the balance sheet is bad (reducing an asset or increasing a liability)
• A Credit to the profit and loss is good (increasing income or reducing an expense)

Take The Example Of A Simple Cash Sale

The two entries are:

• Debit cash on the balance sheet (cash balance has increased)
• Credit sales on the profit & loss (a sale has been made)

These are both good for the business.

What About A Sale On Credit, With VAT?

This simple situation is complicated slightly if the business is VAT registered. Say a sale is made for £100 excluding VAT with credit terms given to the customer. Here the double entries are:

• £120 Debit to debtors on the balance sheet
• £100 Credit to sales on the profit & loss
• £20 Credit to the VAT creditor on the balance sheet

Note that although there are three transactions, the total of all the debits and credits still agrees.

The “T” Account

This is often shown in a “T” account, where debits are always shown on the left, and credits on the right (if you live in the UK this is because you DRive on the left, and CRash on the right (debits and credits are often abbreviated to Dr & Cr)

Again, using the good/bad analysis:

• the customer owes the business £120 (good, DR balance sheet)
• there has been a net sale of £100 (good, CR profit & loss)
• the business owes HMRC £20 (bad, CR balance sheet)

At a later point the customer will hopefully pay for their purchase. At this point you credit debtors (to remove the amount owed) and debit your bank balance. Of course at the end of your VAT quarter part of that cash will go to HMRC to clear the VAT creditor.

More Complex Transactions

For more complex transactions it is not always easy to tell where the debits and credits will go. Typically if you can work out where one side goes, and you know whether it is a debit or a credit (use the patronising but useful good/bad system above!), you can then figure out where the other side will end up.

But What’s The Point?

If double entry bookkeeping is done properly, you’ll know where every penny comes from and goes. Every single transaction will be explained properly, and there won’t be any “unknown differences” written off. Of course, this is in an ideal world, and is based on everything always being posted to the correct place.

The combination of all the various debits and credits to date can be summed up in the trial balance. This shows all the different balance sheet and profit and loss items in a big list with the debit or credit balance of each one. Of course, when you sum all the credits together, and all the debits together, the total of each column will be the same. If not you’ve got a real problem!

Banks

By now you should know that having a positive balance in your current account will be a debit (a positive balance is a good thing!). Increasing that balance would be a debit, and decreasing it would be a credit.

So why when you look at your bank statement is it the wrong way around?

It isn’t…for the bank. The bank produces the statements from their point of view. If you have a positive bank balance, that means the bank owes you money, so to them it is a credit.

Maslins offer a complete accountancy solution for freelancer/contractor businesses for just £99+VAT/month.