Debits and credits

The debit and credit system can be summarized in two basic rules. Increases in assets are written on the left side of the page. Liabilities and equities are exactly the opposite. That's it, now let's talk about why this marvelous debit and credit system exists. The accounting equation can be used to analyze transactions, to refresh your memory, the accounting equation is assets equal liabilities plus owner's equity. Now although it makes conceptual sense, a row and column spreadsheet analysis format based on the accounting equation can be quite cumbersome. Suppose that a company has 200 accounts, and 10,000 transactions each month. The resulting spreadsheet would quickly grow to unwieldy size, when the process underlying modern bookkeeping was formalized 500 years ago maintaining a 10,000 row by 2,000 column spreadsheet by hand, just not practical. In addition the realities of manual arithmetic made it desirable to have a system based as much as possible on addition rather than on one requiring a constant switching between addition and subtraction. The system devised 500 years ago to deal with these practical realities is elegant in its simplicity. 

Increases are represented by writing transaction amounts on one side of the page, decreases are represented by writing amounts on the other side of the page. Instead of using the terms left and right to indicate which side of a page an amount is written, accountants use their own special terminology. Debit is used to indicate the left side of the page and credit is used to indicate the right side of the page.

One thing missing thus far from this description of debits and credits is a self-checking mechanism analogous to the accounting equation. The simple solution is what has made the debit and credit framework so useful and has survived basically unchanged for 500 years. Again the debit and credit system can be summarized in two basic rules. Increases and assets are written on the left, liabilities and equities are exactly the opposite. The key point here is the following, this is not complicated. This is not a bunch of memorization, just memorize these two simple rules. These two rules can be used to fill out all six of the debit and credit directions for assets, liabilities, and equities in this chart. 

Step one, assets go up on the left. So logic tells us assets go down on the right. Step two for both liabilities and equities. The accounts go up on the right, the opposite of assets and liabilities and equities go down on the other side, the left. When these debit and credit conventions are used maintaining the quality of the accounting equation can be done just by making sure that debits equal credits, thus when accountants analyze even complex transactions they rarely refer to the accounting equation because they know the simple rule of debits equals credits ensures that the accounting equation is always in balance. 

Now, revenues, expenses, and dividends are merely subcategories within the retained earnings equity account. Revenues represent the increase in a company's resources through a business transaction thus revenues are increased in equity. Expenses represent the consumption of company resources through doing business and are decreases in equity. Now because dividends represent the removal of company resources to be paid to owners. Dividends also reduce equity, so how do debits and credits affect revenues, expenses and dividends? Revenues increase owner's equity and so like all owner's equity accounts are increased by credits. Expenses reduce owner's equity and therefore are recoded by debits. Because dividends reduce owner's equity the dividend account is increased by a debit, and decreased by a credit. 

Now just a warning here, individuals who have trouble grasping debits and credits usually get hung up on the revenue and expense accounts. Remember revenues and expenses are sub-categories of the equity account retained earnings. When you credit a revenue account you are essentially increasing retained earnings. When you debit an expense account, you're increasing the amount of expense and that in turn reduces retained earnings. 

Memorize these two rules, assets are increased on the left side, the debit side. Liabilities are the opposite, they are increased on the right side, the credit side. Believe it or not, that's it.