Most people (without knowing it) use a system of accounting known as single-entry accounting when they record transactions relating to their checking or savings accounts. For each transaction, one entry is made (either an increase or decrease in the balance of cash in the account).
Likely the single most important aspect of GAAP is the use of double-entry accounting, and the accompanying system of debits and credits. With double-entry accounting, each transaction results in two entries being made. (These two entries collectively make up what is known as a “journal entry.”)
This is actually fairly intuitive when you think back to the accounting equation:
Assets = Liabilities + Owners’ Equity.
If each transaction resulted in only one entry, the equation would no longer balance. That’s why, with each transaction, entries will be recorded to two accounts.
EXAMPLE: A company uses $40,000 cash to purchase a new piece of equipment. In the journal entry to record this transaction, Cash will decrease by $40,000 and Equipment will increase by $40,000. As a result, the “Assets” side of the equation will have a net change of zero, and nothing changes at all on the
“Liabilities + Owners’ Equity” side of the equation.
Assets = Liabilities + Owners’ Equity
-40,000 (no change) (no change)
Alternatively, if the company had purchased the equipment with a loan, the journal entry would be an increase to Equipment of $40,000 and an increase to Notes Payable of $40,000. In this case, each side of the equation would have increased by $40,000.
Assets = Liabilities + Owners’ Equity
+40,000 +40,000 no change
So, what are Debits and Credits?
Debits and credits are simply the terms used for the two halves of each transaction. That is, each of these two-entry transactions involves a debit and a credit.
Now, if you’ve been using a bank account for any period of time, you likely have an idea that debit means decrease while credit means increase. That is, however, not exactly true. A debit (or credit) to an account may increase it or decrease it, depending upon what type of account it is:
A debit entry will increase an asset account, and it will decrease a liability or owners’ equity account.
A credit entry will decrease an asset account, and it will increase a liability or owners’ equity account.
From the perspective of your bank, your checking account is a liability—that is, it’s money that they owe you. Because it’s a liability, your bank credits the account to increase the balance and debits the account to decrease the balance.
EXAMPLE: A company uses $40,000 cash to purchase a new piece of equipment. Cash will decrease by $40,000 and Equipment will increase by $40,000. To record this decrease to Cash (an asset account) we need to credit Cash for $40,000. To record this increase to Equipment (an asset account), we need to debit Equipment for $40,000.
This transaction could be recorded as a journal entry as follows:
Dr. Equipment 40,000
Cr. Cash 40,000
As you can see, when recording a journal entry, the account that is debited is listed first, and the account that is credited is listed second, with an indentation to the right. Also, debit is conventionally abbreviated as “DR” and credit is abbreviated as “CR.” (Often, these abbreviations are omitted, and credits are signified entirely by the fact that they are indented to the right.)
An easy way to keep everything straight is to think of “debit” as meaning “left,” and “credit” as meaning “right.” In other words, debits increase accounts on the left side of the accounting equation, and credits increase accounts on the right side. Also, this helps you to remember that the debit half of a journal entry is on the left, while the credit half is indented to the right.
Let’s take a look at a few more example transactions and see how they would be recorded as journal entries.
- Chris’ Construction takes out a $50,000 loan with a local bank. Cash will increase by $50,000, and Notes Payable will increase by $50,000. To increase Cash (an asset account), we will debit it. To increase Notes Payable (a liability account), we will credit it.
Cr. Notes Payable 50,000
- Last month, Chris’ Construction purchased $10,000 worth of building supplies, using credit to do so. Building Supplies (asset) and Accounts Payable (liability) each need to be increased by $10,000. To do so, we’ll debit Building Supplies, and credit Accounts Payable.
Dr. Building Supplies 10,000
Cr. Accounts Payable 10,000
Eventually, Chris’s Construction will pay the vendor for the supplies. When they do so, we’ll need to decrease Accounts Payable and Cash by $10,000 each. To decrease a liability, we debit it, and to decrease an asset, we credit it.
Dr. Accounts Payable 10,000
Cr. Cash 10,000
Revenue and Expense Accounts
So far, we’ve only discussed journal entries that deal exclusively with balance sheet accounts. Naturally, journal entries need to be made for income statement transactions as well.
For the most part, when making a journal entry to a revenue account, we use a credit, and when making an entry to an expense account, we use a debit. This makes sense when we consider that revenues increase owners’ equity (and thus, like owners’ equity, should be increased with a credit) and that expenses decrease owners’ equity (and therefore, unlike owners’ equity, should be increased with a debit)
EXAMPLE: Darla’s Dresses writes a check for their monthly rent: $4,500. We need to decrease Cash and increase Rent Expense.
Dr. Rent Expense 4,500
Cr. Cash 4,500
EXAMPLE: Connie, a software consultant, makes a sale for $10,000 and is paid in cash. We’ll need to increase both Cash and Sales by $10,000 each.
Dr. Cash 10,000
Cr. Sales 10,000
The General Ledger
The general ledger is the place where all of a company’s journal entries get recorded. Of course, hardly anybody uses an actual paper document for a general ledger anymore. Instead, journal entries are entered into the company’s accounting software, whether it’s a high-end customized program, a more affordable program like QuickBooks, or even something as simple as a series of Excel spreadsheets.
The general ledger is a company’s most important financial document, as it is from the general ledger’s information that a company’s financial statements are created.
In many situations, it can be useful to look at all the activity that has occurred in a single account over a given time period. The tool most frequently used to provide this one-account view of activity is known as the “T-Account.” One look at an example T-account and you’ll know where it gets its name:
The Trial Balance
A trial balance is simply a list indicating the balances of every single general ledger account at a given point in time. The trial balance is typically prepared at the end of a period, prior to preparing the primary financial statements.
The purpose of the trial balance is to check that debits—in total—are equal to the total amount of credits. If debits do not equal credits, you know that an erroneous journal entry must have been posted. While a trial balance is a helpful check, it’s far from perfect, as there are numerous types of errors that a trial balance doesn’t catch. (For example, a trial balance wouldn’t alert you if the wrong asset account had been debited for a given transaction, as the error wouldn’t throw off the total amount of debits.)