Sir Isaac Newton’s third law of motion, the law of interactions, states that for every action there is an equal and opposite reaction. The same applies to accounting. There are two sides to every financial transaction. There is a debit and a credit side. For each transaction, these sides must be equal for your books to be balanced.
To understand double-entry bookkeeping, you must first understand what is a debit and what is a credit. Simply put, a charge is something you own or money you are owed, and a credit is money you owe someone else. Let’s look at this in terms of the different types of accounts a company has.
Assets – These are debit items as they are items owned by the company. An increase in wealth is a debit, and a decrease in wealth is a credit.
Payables – These are credit items as they are items that the company owes someone else. An increase in payables is a credit and a decrease in payables is a debit.
Owner Equity – This is a credit account because the balance of the owner’s equity account is the money the company owes the company’s owner. An increase in equity is a credit and a decrease in equity is a debit.
Expenses – These are debit items because the purchase of an expense item reduces an asset item (e.g. bank balance) that represents the credit side of the transaction.
Revenue – These are credits because receiving revenue increases an asset (e.g. bank balance) which is the debit side of the transaction.
Let’s look at a simple example:
Suppose you want to go to the store to buy a bottle of milk that costs $3. Your purchase of the milk is a financial transaction. Before you go to the store you own $3, so this is a debit position offset by the owner’s equity.
If you go to the store and pick up the bottle of milk, you now have a bottle of milk that 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 shopkeeper for the milk bottle, you reduce your cash amount (debit is credited) as well as your cash amount (credit is debited).
Note that at each step of the transaction, the debit and credit sides of the transaction are equal and the balance of all accounts has equal debit and credit sides.
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 worth nothing! That’s why we have expense accounts. Assets that are debits are things that the company owns for a long period of time. Expenses, which are also debit items, are items that the company owns for a short period of time before they are used up.
That’s why we have two separate main reports for a company. The balance sheet is used for the items that are constant in a company. The income statement (or statement of income and expenses) is used for the items that flow in and out of a company on a regular basis. The resulting balance of the profit and loss account is included in the capital part of the balance sheet for balancing purposes.
Another report you may have heard of is the Trial Balance Sheet. This is to ensure you haven’t made a mistake before preparing the balance sheet and income statement. At the end of an accounting period, the closing balance of all your accounts (assets, liabilities, equity, expenses and income) is included in this report to ensure that your debits match your credits. If it doesn’t, you know you made a mistake somewhere, and you need to find your mistake before making the most important reports. The sum of the target columns should equal the sum of the target columns.