Debits and credits explained

In a ledger, each account has two sides. The left side is the debit side and the right side is the credit side. business.gov.au's glossary uses the same picture: it places a debit on the left and links it to assets and expenses, the accounts a debit increases.

The words carry no judgement. A debit isn't a cost and a credit isn't a gain. Each one simply puts an amount on one side of an account, and the type of account decides whether that side makes its balance bigger or smaller.

Every account in your chart of accounts has a type. business.gov.au's glossary gives asset, liability, owner's equity, income and expense as examples of these types. The type tells you which side increases the account.

• Assets, such as the bank account, money customers owe you and equipment: a debit increases them and a credit reduces them.
• Expenses, such as rent, advertising and bank fees: a debit increases them and a credit reduces them.
• Liabilities, such as unpaid supplier bills, a credit card balance and loans: a credit increases them and a debit reduces them.
• Equity, the owners' share of the business: a credit increases it and a debit reduces it.
• Income, such as sales and interest received: a credit increases it and a debit reduces it.

Because amounts build up on the increasing side, that is also where each account's balance usually ends up: on the debit side for assets and expenses, and on the credit side for liabilities, equity and income.

1. Name the accounts the transaction touches. There will be at least two.
2. Look up each account's type in your chart of accounts.
3. Decide whether each account goes up or down because of the transaction.
4. Apply the rule: an increase goes on the account's usual side, and a decrease goes on the other side.
5. Check that the debits and the credits come to the same total before you record the entry.

When you enter an invoice or code a bank transaction in accounting software, it writes the debit and the credit for you. Choosing the right account is still up to you, so the reasoning above still decides whether the entry is correct.

The table follows one business through some ordinary transactions. It records the sale and the repair cost when they take place, not when they are paid, which is how accrual accounting works: business.gov.au describes it as recording sales and expenses at the time they happen, not when the money moves.

Look at the customer's payment and the supplier payment. Neither touches income or expenses. The payment from the customer swaps one asset for another: money in the bank replaces the amount the customer owed. Paying the supplier reduces the bank account and accounts payable equally. The sale and the repair cost were each recorded once, when the invoice and the bill were entered.

Your bank and your card provider keep books of their own, and their statements show your account from their side. Money paid into your business account is money the bank now owes you, so the bank's statement calls it a credit. In your books the same deposit is a debit, because your bank account, an asset, has gone up.

Credit cards follow the same logic with the roles swapped. To the card provider, your balance is money you owe it, so in its records a purchase is a debit and a repayment is a credit. In your books the card is a liability: a purchase is a credit to the card account and a repayment is a debit.

business.gov.au points out that internet banking shows every transaction, which helps when you are working out debits and credits. Take the amounts and dates from the statement, but take the sides from the account types in your own books.

An overdraft shows the rule at work. business.gov.au describes an overdraft facility as an arrangement under which a lender allows a business to take out more money than its account holds. Once the account is overdrawn, the business owes the bank, and the bank account in your books carries a credit balance until deposits bring it back above nil.

A balance on the side opposite to where it usually sits deserves a look. Some have a plain reason. Others point to an entry posted the wrong way round or to the wrong account.

• A supplier's account showing a debit balance: a bill may have been paid twice, or paid before it was entered.
• A customer's account showing a credit balance: the customer may have paid twice, or paid before being invoiced.
• An expense account with a credit balance: often a customer receipt coded to the expense by mistake.
• An income account with a debit balance: often a supplier payment coded to the income account by mistake.

A trial balance shows the expense and income cases clearly, because it sets every general ledger account's balance in a debit or a credit column, and supplier and customer balances on the wrong side show up on the aged payables and receivables reports.

• Treating every debit on the bank statement as an expense. It only means money left the account, which could be a supplier payment, a card repayment or a transfer to another account.
• Recording a customer's payment as new income when the sale was already recorded on the invoice. The payment clears what the customer owed.
• Booking a credit card repayment as an expense, when the purchases it pays for were already recorded when the card was used.
• Undoing a wrong entry with another entry on the same side, which doubles the error instead of removing it.