A Jargon-Free Explanation of Debits and Credits

As with any technical field, accounting has its own jargon with meanings that often elude outsiders. This can be particularly frustrating to small-business owners who lack an understanding of the key terminology used in an area that is so very important to their businesses.

An accountant is somewhat like a sports referee conveying an infraction to coaches. That is, describing an observation with shortcut expressions that should efficiently reveal the consequences.

So when you hear, “every transaction entails equal offsetting amounts,” you should understand that the total of all debits must equal the sum of all credits. Once you get the meaning of these words in accounting, you’ll be better able to comprehend and resolve errors. The following may help demystify debits and credits:

Double-entry system

You probably think of debits and credits as two separate actions. For example, your bank statement has credits for deposited funds, and debits for checks and other withdrawals. In accounting, however, each transaction creates both a debit and a credit. Deposits to your bank account are usually offset by increases in revenue. Most withdrawals are offset by increases in expenses. Recording these increases and decreases is the function of debits and credits.

Increasing revenue with a credit and increasing expenses with debits makes sense: more revenue seems like a credit for working, and more expense seems like a debit (or deduction) from your output. So the impact on your bank account from revenue and expenses is an offsetting debit or credit respectively.

When you pay a bill – which debits an expense – the offset is a credit on your bank account ledger. Thus, credits on your bookkeeping for a bank account lower the cash balance; debits increase it.

Asset accounts

Bank accounts in your bookkeeping are assets. Since debits increase the balance on your accounting for a bank account, and credits lower the balance, other assets work the same way. Debits increase the ledger balance for an asset, and credits reduce it. For example, if you buy a new computer, you’ll debit the asset account for equipment. The check you write to the computer store is an equal amount of credit to the bank account ledger on your books.

Liability accounts

What about purchases with borrowed money? You still debit an expense or asset, but the offsetting credit is to a liability account instead of a bank account. So a credit to liabilities – such as a credit card or loan – increases the balance on the ledger. Why are those credits increases but the credits to a bank account, decreases? Remember, the bank account is an asset. Credits decrease assets, but increase liabilities.

And the reverse: debits increase assets but decrease liabilities. So what happens when you pay off a credit card by writing a check? Simple. Debit the credit card liability account (which decreases the balance) and credit your bank account (it’s decreased too).

Two decreases? That’s why it helps to start thinking of offsetting double entries as debits and credits instead of increases and decreases.

Plan For the Future by Tracking New Project Outlays Now

Adding a new business offering is a path to supplementary revenue, but it also may come with unforeseen costs. As a result, innovations and improvements are often derailed by hidden expenses. To avoid last-minute panic, improve your planning by tracking your outlays on new projects and learning what may wreck your budget.

Consider up-front cash outlays

It’s only after you make up-front cash outlays for a new service or an extra feature that you’ll see the resulting increase in income. Each new project requires its own set of calibrations, so create a timeline of necessary expenditures: A new offering to customers calls for changes to your website, printed materials, and advertising copy; you might need new supplies or special products; perhaps some extra training or certification is required.

Unexpected costs happen with just about any new commercial offering in practically any type of business. Even a solo operation, which is unlikely to add new employees as part of a new project, may still need to hire outside assistance for non-recurring steps involved in implementing a change.

Track now; benefit in the future

Create a budget for these project-specific costs at the start of a project and track them. You may find you’ve under-budgeted – not accounting for the little things that arise or not considering items that cost more than you expected.

After some experience in these matters, you’ll learn to anticipate every cost, and to budget for those hidden extras. The result is better planning for new initiatives in the future.