Debits and Credits aren’t new and cloud accounting innovations have absolutely no impact. Assets, & expenses, are still increased by debits, and liabilities, equity, and revenue are still increased by credits.
Accounting software is software. If you don’t understand what the software is supposed to be able to do, then you’ll never master how to use it. Accounting software should not be teaching you accounting. You should be teaching the accounting software what you need it to do, in order to get the accounting right. Does that give you some perspective on how this should work?
For the non-accountant / business owner this will begin to make more sense in the next lesson. For now let’s look at a simple example of a real world transaction, and what it looks like in debit and credit form. I always like to translate from what happens in real life, to what happens in accounting.
In real life, you start a business and you open up a bank account. Let’s say you open that account with $1,000 cash of your own money. This does two things. You just increased cash in the business (Debit Cash). This sounds backwards, because the banks have you trained to think debits mean they are taking money away from you. It doesn’t work that way in accounting. Your bank account, and more specifically the cash in it, is an asset. Assets are increased by debits. Where did this money come from? It wasn’t income was it? No you as the owner are contributing money into the business. In other words, you are increasing the equity, or book value of the business, by contributing the asset, cash. If the debit increases the asset, cash, then it follows that the equity (the other side of this transaction) is increased by a credit.
In every transaction, debits and credits always must balance.
The entry in this example is:
Debit Cash $1,000
Credit Owner’s Equity $1,000
There are five account types in every set of books. Anything else you can name is a subset of one of these five types:
1 – 3 make up your Balance Sheet
4 – 5 make up your profit and loss
To illustrate my point above. Regardless of what accounting software you’re using, the bottom line is that it had better make it easy for you to capture this transaction, in your bank account, and show it on your balance sheet with $1,000 in the bank, and $1,000 in owner’s equity.
Here’s a summary of what is increased by debits vs credits. Then in lesson 3, we’ll see what this looks like in all 4 cloud accounting applications covered in this course.
Credits Increase everything else
There are some videos on YouTube that give you clever ways of remembering this. My way is simple. Remember that cash is increased by a debit. Always start with cash, and then you can figure the rest out from there. Going back to the example above, I know that my deposit increases my cash $1,000, so that means Debit Cash. I now have an unidentified flying credit.
Now I just think in terms of where the money came from. It has to be one of three things:
- Income (payment from a customer)
- Loan (a bank or individual loaned us money)
- Owner contribution to the company
Whatever it is, it’s a credit. It’s just a question of WHAT we are crediting.
- If it’s #1, it’s a credit to sales or some income account.
- If it’s # 2, it’s a credit to a loan. Look above, credits increase liabilities. A loan payable to a bank is a liability.
- If it’s #3 then, that’s what we were talking about in the beginning. Credit Owners Equity.
Other complexities can (and will) be introduced, like, what if it’s a payment on an invoice? We’ll get into that later. For this purpose, and at this stage I want to keep it very simple.