Debits & Credits

Double Entry Accounting System
What are Debits & Credits?

Debits & credits are used to show a flow of money or value from one account to another.

How They Work

Suppose you were keeping the accounting records for a retail store that had just opened.

You could attempt to keep those records by simply recording the business’s sales and costs.
The problem is a business may make many transactions during an accounting period.​
While it is easy to record transactions with a simple system, it is very difficult to check them reliably.
If only some of these transactions are incorrect, your period-end  accounting records will be unreliable and totally useless.
The Double Entry Accounting System

To overcome this problem, businesses use the double-entry accounting system.

​This system wasn’t designed to make recording simple.
Instead, it was designed with checking in mind.
With the double-entry system, you still record sales and costs.
By using a double entry, however, you record a duplicate record of those transactions in other accounts, as well.
This duplicate record is in a convenient format for checking.
It allows for fast, easy, and reliable checking against the records of other businesses.
By checking these accounts alone, you can make sure your entire record of sales and costs is correct.
Accounts

Making all this possible is a system of two-sided accounts.

Each account is divided into two sides.
One sides is the credit side.
You use this side to show money or value came from the account.
The other side is the debit side.
You use this side of the account to show what the money was used for or where it went
How Debits & Credits Work With Cash Transactions

Cash transactions are those transactions the business makes with the bank.

These transactions will be shown on the business’s month end bank statement.
For example, the business will receive cash from sales.
The business will deposit this money in the bank.
In its month-end statement, the bank will show the transaction as a deposit.​
​The business will also pay cash for things.
In doing this, the business will withdraw money from the bank.
The transaction will appear on the month-end bank statement as a withdrawal.
Recording Cash  Transactions

With the double-entry system, you need to record every transaction made with the bank.

For example, to start up, the owner may have put some of their own money into the business.
They would deposit this money in the business’s bank account.
To record this transaction, you credit the capital account.
This shows that the money came from the owner’s capital.
At the same time, you debit the checking account.
This shows the money was deposited in the bank.
The business owner may also borrow additional start-up money from a friend or a relative.
Once received, they will deposit this money in the bank, as well.
To record this transaction, you credit the loan account.
This shows money came from a loan.
​At the same time, you debit the checking account.
​This shows the money was deposited in the bank.
After this, the business owner may rent premises for the store.
​Here, they would take money from the checking account.
Then they send this money to the landlord.
​To record this transaction, you credit the checking account.
​This shows money came from the bank.
Next, you debit the rent account.
​This shows the money was used for rent.
The business owner may buy goods to sell in the store.
Again, they take money from the bank.
​And they use this money for purchases.
​To record the purchase, you credit the checking account.
This shows money came from the bank.
Next, you debit the purchases account.
This shows the money was used for purchases.
​The store will then sell these goods.
If the sales are cash sales, the business will deposit the takings in the bank.
​To record the transaction, you credit the sales account.
This shows the money came from sales.
Next, you debit the checking account.
This shows the takings were deposited in the bank.
Checking Cash Transactions

By month end, you should have a complete record of cash transactions.

You will have one record of them in the general accounts.
Because you use a double entry, you will have a duplicate record of those transactions in the checking account.
​As such,  the checking account  should contain the same transactions as shown in the other accounts.
For your record of transactions to be correct, they should be the same as those shown in the checking account.
This why the checking account is known as a control account.
All you need check is the control account.
​If correct,  because of the double-entry, all the other accounts should be correct, as well.
To check your record of cash transactions, you compare your checking account to the month end bank statement.
​If the records agree, it shows the control account is correct.
This section covered just one of the main control accounts.
There are two others you really need to understand, as well.
To see how these work, sign up for a free tial and read the sections:

1, Recording Customer Transactions

2. Recording Supplier Transactions

Another question many people have is, why does the cash account appear back-to-front to the bank statement?
To find out why this is the case, read the section Cash Account Seems Back to Front
© R.J. Hickman 2020