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Sunday, October 24, 2010

What is Debit and Credit in Accounting?

Though simple terms in themselves, the use of "debit" and "credit" can be confusing. This confusion arises because of the way the two terms, debit and credit are used in everyday life: one assumes that if a bank has given me credit in the form of a credit card, the money at my disposal increases, and hence the conclusion that credit means "increase." This is awfully mistaken. Similarly, people think that when a bank debits their accounts, the money in the account decreases, and hence the conclusion that debit means "decrease."

So, if debit is not decrease and credit is not increase, what exactly is debit and credit in accounting?

In actual, there is no one-to-one mapping between debit/ credit and increase/ decrease. The actual affect on an account for a debit or credit entry is dependent on the "type of the account." Certain accounts are considered debit accounts, and others are considered credit accounts.

What are Debit and Credit?

A debit entry in a debit account reflects an increase; on the other hand, a debit entry in a credit account reflects a decrease, and vice versa. For example, cash is a debit account. It's increase is mentioned by a debit entry. When you receive cash, you debit it. When you pay out, you credit cash.

With the above understanding, the only thing you need to know to decide between debit and credit is the type of the account, discussed next:

Rule of Thumb

A general rule of thumb to differentiate between the different types of accounts (Expense, Asset, Dividend, Revenue and Liabilities) is to remember the word "DEAD." It indicates that Debit means increase in Expenses or Assets or Dividends. The rest, Revenue and Liabilities, are credit accounts, and a credit entry in these types of accounts indicates an increase.

Of course, this is not an exhaustive list; one needs to understand nature of each account to classify it as debit or credit.

Understanding the Nature of Accounts

While some say that "memorization usually precedes comprehension," I find it easier to memorize by comprehending at least some part of the puzzle. To comprehend the rules, we have to look at the basic accounting equation:

Assets = Liabilities + Equity

So, first make sure that you
  1. Memorize and understand the above equation
  2. Understand that in the modern accounting system, each transaction has a debit against a credit and vice versa

So, if one thing increases by a transaction and the other one decreases, it's for sure that both of them are the same type of accounts (either both debit or both credit).

For example, if you pay cash to buy furniture, one account is increasing (asset) and the other one is decreasing (cash). Thus, both of these accounts (cash and furniture) are of the same type (debit type accounts, in actual).

But if both of them increase (or decrease) at the same time then they are opposite type of accounts. For example, if you pay cash to settle some loan (accounts payable) then both accounts have decreased. In this case, cash is a debit account and accounts payable (a liability) is a credit account.

Combine the understanding developed by the two paragraphs above with the DEAD keyword, and hopefully you will never have problem settling transactions.

Useful reference: Principles of Accounting, Chapter 2

It's an awesome free online book. Individual chapters can be downloaded in the form of PDF's. There are exercise questions in the form of filling the blanks, multiple-choice questions as well as detailed working using MS Excel. A must for any one interested in learning basic accounting!

Since I scored miserably in the Finance and Accounting course during my undergraduate program, comments and criticism are highly welcomed to improve the above text.