We all know Debit and Credit are two most common words in finance and accounting. For any newbie, it's important to understand what is Debit and Credit in accounting, and in this article we will learn all the basics.
What is debit and credit
Understanding what are debits and credits
I decided to write on these terms because I think everyone knows what is debit and credit in terms of your bank account, but not in other transactions.
Wait, let me explain. Finance terms are based on accounting and when we see double entry book system, every debit must have a corresponding credit entry. This is how total assets always equal total liabilities.
There are three simple rules of accounting.
I call them three golden rules of accounting.
These rules are set for three categories of accounts—Personal, Real and Nominal account.
Difference between debit and credit in accounting
Rules of Debits and Credits
Rule: Debit the receiver, credit the giver.
Personal accounts are of a person or an organization.
Rule: Debit what comes in, credit what goes out
Rule: Debit all expenses and losses, Credit all incomes and revenues.
Well, I don’t want to confuse you with all these rules, they are simple rules and accountants in organizations take care of the preparation of final accounts.
As an investor/analyst, you don’t need to worry about it. What you need to know is the final balances/accounts of Balance Sheet and Profit & Loss account of a company.
The purpose of this post is to understand the process of preparing final accounts and what is Debit and Credit in accounting terms.
Look at this figure for the process.
A journal entry is recording of a transaction. A transaction can involve several items and they are recorded as debits and credits. The total of debits should equal credits to balance the journal entry.
For example, you purchased some machinery for Rs.25,000. The journal entry for this transaction would be:
Furniture A/c - Debit - Rs.25,000
and Cash A/c - Credit - Rs.25,000.
After recording a journal entry, the next step is to give effects of debit and credit to each account. So, such individual accounts are called Ledger accounts. Such accounts are categorized into asset accounts such as cash, accounts receivable, inventory and liability accounts such as accounts payable, notes payable etc.
After general ledger step, the next thing is to take final balance of each account. It can be debit or credit balance. Trial balance will have two parts - Debit and Credit. So the debit balance of all accounts are listed under debit column and credit balance of all accounts are listed under credit column.
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P&L Account, Balance Sheet
Profit & Loss account statement and Balance Sheet and other financial reports are produced after taking the ledger balances in trial balance.
This is how the financial statements are created.
Now, I am sure you know how Profit & Loss account and Balance Sheets are prepared.
I hope this article helped you to understand the basics of Debit and Credit in accounting and the difference between debit and credit in accounting.
If you still have any queries or doubt, feel free to ask via comments.