Sir Isaac Newton’s third law of motion, the law of reciprocal actions, states that for every action there is an equal and opposite reaction. The same can be said for accounting. For every financial transaction, there are two sides. There is a debit side and a credit side. For each transaction, these sides must be equal for your books to balance.
To understand double-entry bookkeeping, you must first understand what a debit is and what a credit is. Simply put, a debit is something you own or money is owed to you and a credit is money you owe someone else. Let’s look at this in terms of the different types of account a business has.
Assets – These are debit items as they are items that are owned by the business. An increase in assets is a debit and a decrease in assets is a credit.
Liabilities – These are credit items, as they are items that the business owes to someone else. An increase in liabilities is a credit and a decrease in liabilities is a debit.
Owner’s Equity – This is a credit account because the owner’s equity account balance is money the business owes the business owner. An increase in owner’s equity is a credit and a decrease in owner’s equity is a debit.
Expenses: These are debit items because the purchase of an expense item reduces an asset item (for example, cash in the bank) that is the credit site of the transaction.
Revenue – These are credit items because receipt of revenue raises an asset item (for example, cash in the bank) that is the debit side of the transaction.
Let’s look at a simple example:
Let’s say you want to go to the store to buy a bottle of milk, which costs $3. Your purchase of milk is a financial transaction. Before you go to the store, you own $3, so this is a debit item, balancing with the owner’s equity.
When you go to the store and pick up the bottle of milk, you now have a bottle of milk, which is worth $3, and you owe the store owner $3. So the bottle of milk is a debit and the $3 you owe is a credit.
When you pay the store owner for the bottle of milk, you are reducing the amount of money you have (the debit item will be credited) and you reduce the amount of money you owe (the credit item will be debited).
Please note that at each step of the transaction, the debit and credit of the transaction are the same and the balance of all accounts has the same debit and credit.
So what happens when you drink the bottle of milk? You no longer have a $3 bottle of milk; you have an empty bottle that is worthless! That’s why we have expense accounts. Assets, which are debit items, are things that the business owns over a long period of time. Expenses, which are also debit items, are things the business owns for a short period of time before they run out.
This is why we have two separate main reports for a company. The balance sheet is used for those items that are constant in a business. The Profit and Loss Statement (or Income and Expense Statement) is used for items that enter and leave a business on a regular basis. The resulting balance from the profit and loss statement is placed in the equity section of the balance sheet to balance things out.
Another report you may have heard of is the trial balance. This is used to make sure you haven’t made a mistake before preparing your balance sheet and profit and loss statement. At the end of an accounting period, the closing balance of all your accounts (assets, liabilities, owner’s equity, expenses, and income) is included in this report to make sure your debits equal your credits. If they don’t, you’ll know you’ve made a mistake somewhere and you’ll need to find your mistake before preparing the main reports. The flow column total should equal the flow column total.
