Accounting Basics: Understanding Debits and Credits
Understanding debits and credits is helpful for anyone working with accounting software like QuickBooks Online. In this guide, we'll cover the basics of debits and credits, accounts, and how they work in various QuickBooks transactions.
Introduction to Double Entry Accounting
Double entry accounting, also known as the Venetian accounting system, was invented over 500 years ago. This system is based on the idea that every transaction has two sides: the payer and the payee. Within a company's books, each transaction has both debits and credits, which always balance out.
Accounts: The Building Blocks
An account is a group of related transactions. In a traditional paper-based bookkeeping system, each account would have its own page with the account name at the top, such as Rental Income, Interest Expense, or Bank Account.
There are five main types of accounts types:
| Account Type | Description |
|---|---|
| Asset | What you own |
| Liability | What you owe |
| Equity | Money invested in the business or value retained from profit |
| Income | Money you made |
| Expenses | Money you spent |
Let's consider an example of a company that only has one account of each type.
Jon starts a business, opens a bank account, and makes an initial investment of $5,000. Since money in the bank is an asset and the initial investment is equity, the first transaction looks like this:
| Account | Debits | Credits |
|---|---|---|
| Assets | $5,000 | |
| Equity | $5,000 |
Now, Jon buys $3,000 worth of gizmos to sell. The transaction for this purchase looks like:
| Account | Debits | Credits |
|---|---|---|
| Expenses | $3,000 | |
| Assets | $3,000 |
When Jon sells all his gizmos for $5,000, the transaction appears as:
| Account | Debits | Credits | Description |
|---|---|---|---|
| Assets | $5,000 | The money going into the bank account from the sale | |
| Income | $5,000 | The money coming from the sale |
After these three transactions, Jon's account balances look like this:
| Account | Balance | Description |
|---|---|---|
| Assets | $7,000 | |
| Equity | $7,000 | Net income (Income - Expenses) also counts as equity; this is how profit is accounted for. |
| Income | $5,000 | |
| Expenses | $3,000 |
Why Debits and Credits Matter
The above example is more abstract than typical QuickBooks usage. Now, let's examine some examples of how debits and credits work within QuickBooks transactions.
If you want to see the debits and credits for any transaction click More > Transaction journal
Invoice
When you create an invoice, this is what that looks like on the backend:
| Account | Debits | Credits | Description |
|---|---|---|---|
| Accounts Receivable | $200 | The Accounts Receivable tracks how much is owed to you on invoices. A/R is an asset so a debit increases A/R | |
| Sales | $200 | When you create an invoice that is when your sale is recorded. A credit to a sales account increases that account |
Receive payment
When you receive a payment in QuickBooks, the transaction appears as follows:
| Account | Debits | Credits | Descrition |
|---|---|---|---|
| Bank Account | $200 | Money is received and deposited into the bank account. A debit increases the bank account balance. | |
| Accounts Receivable | $200 | The outstanding amount owed on the invoice is reduced. A credit decreases Accounts Receivable. |
By understanding the basics of debits and credits, you'll have a better grasp of how QuickBooks Online records transactions. This knowledge will help you manage your business's finances more effectively.