What is Debit Credit Analysis?
Accountants perform debit credit analysis at all times as part of their responsibilities. Business transactions occur on a daily basis, and it is the role of the accountant to record the transactions appropriately to determine their impact on the business. The transactions are recorded in either the debit or credit side of an account, where the debit is on the left side, and the credit is on the right side.
Debit and credits are accounting entries that are used to monitor money going out of or coming into the business. Debit and credit form the backbone of the double-entry system, where every transaction comprises two parts – for every debit transaction, there is a corresponding credit of equal amount.
- Credit and debit entries are the cornerstones of the double-entry system, which requires every business transaction to be recorded in at least two accounts.
- Credit and debit entries are used to monitor the money that is coming into and going out of the company.
- When the balance increases, the accounting rule is to debit the asset/expense account and credit the liability/income account.
How Debit and Credit are Used
When a new business transaction is created, you need to identify at least two accounts that are impacted by the transaction and whether they increase or decrease. A debit entry of one account should come with a corresponding credit entry. There is no limit on the number of accounts in one transaction, but the minimum number of accounts should be two.
For each transaction, the total dollar amount in the debit and credit columns must always be equal to be considered balanced. For example, when you debit account A with $100, there must be a corresponding entry of $100 in the credit column of B. If the accounts do not balance, then it would be impossible to create key financial statements such as bank statements and income statements.
The Classical Approach to Debit and Credit
The classical approach comprises three different rules for three types of accounts, i.e., real accounts, personal accounts, and nominal accounts. The groups of accounts help users determine whether to debit or credit an account.
Real accounts include all tangible and intangible assets such as building, machinery, furniture, land, goodwill, and patents. The debit/credit rule for real accounts is to debit items that come in and credit items that go out.
For example, if the business purchases office equipment, you should debit the appropriate account with the purchase price. When the business sells an asset, you should credit the business with an amount equal to the value or selling price of the asset.
Personal accounts relate to the owner(s), partners, customers, suppliers, shareholders, etc. The debit/credit rule for personal accounts is to debit the receiver of the payment and credit the giver.
When you pay for a service or good, you should debit the receiver of the payment and credit bank or cash, depending on whether you paid with cash or a cheque. When you receive a payment, debit the bank or cash account, and credit the person who is paying you.
Nominal accounts are related to incomes, expenses, profits, or losses. The accounting rule for nominal accounts is to debit expense and loss, and credit income and profit accounts.
If you incurred an expense, debit the expenditure account and credit the income account. The income account can be interest received, rent received, etc. while the expenses may include rent paid, travel, bank charges, stationery, electricity, postage, etc.
Debits and Credits in the Balance Sheet
When recording transactions on the balance sheet, you should take note of the items that you will debit or credit. A debit entry increases the balance in the asset side, while a credit entry reduces the balance. For example, if the company purchases equipment worth $10,000 using a check, it will increase the asset balance by $10,000. Similarly, if the company sells an item in its stock (asset) at $100, it will decrease the asset balance by $100 since it is a credit transaction.
On the liability side of the balance sheet, a debit entry decreases the balance while a credit entry increases the balance. For example, if the company takes a loan of $200,000 to purchase a factory, the transaction will be credited in the long-term debt section, which increases the liabilities account balance. The transaction will also be debited in the cash-on-hand, which increases the asset balance. The debit and credit transactions will balance the equation.
Debits and Credits in the Income Statement
Most of the time, transactions on the balance sheet correspond to items on the income statement. Therefore, understanding how each transaction impacts the balance sheet can help you determine whether to credit or debit the transaction in the income statement.
For example, a company gives a salary of $10,000 to its employees. The transaction is credited in the balance sheet to reduce the cash balance on the asset side of the balance sheet. The credit transaction on the balance sheet should include a corresponding debit entry of $10,000 to the salary expense on the income statement.
Similarly, when the company sells an item worth $500, the transaction is debited in the company’s cash account on the balance sheet, and a corresponding credit entry of $500 is made on the company’s revenues on the income statement.
Thank you for reading CFI’s guide to Debit Credit Analysis. CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: