Debits and credits are the backbone of double-entry accounting system. In double-entry accounting, a company’s assets are equal to its liabilities plus owner’s equity.
This is known as the accounting equation (Assets = Liabilities + Equity). Each transaction has to be recorded in at least two accounts and the sum of all debits must equal to the sum of all credits. This is an elegant mechanism to ensure the accounting equation is not violated.
Depending on what type of account you are working with, a debit or credit will either increase or decrease the account balance. Debit and credit are abbreviated as Dr and Cr, respectively.
For example, when you pay down a bank loan for $500, the transaction will be recorded as:
Dr. Loan Payable $500
Cr. Cash $500
Account Cash, which is an asset account, is decreased by a credit of $500. To hold the accounting equation, we have to debit account Loan Payable, which is a liability account, for the same amount of $500. In other words, the company’s liability is decreased by a debit of $500.
Whether an account is increased or decreased by a debit or credit depends on the type of account. Many people feel confused about which account to debit and which account to credit when they are recording a transaction. Here is the simple rule:
Debits increase assets; debits decrease liabilities and equity
Credits decrease assets; credits increase liabilities and equity
Armed with the above rule and some practice, you should have no trouble in discerning which account to debit and which account to credit.