Debits, credits, and journal entries
Double-entry bookkeeping records every transaction with equal debits and credits, a system used for over 500 years.
Double-entry bookkeeping
In double-entry bookkeeping, every transaction is recorded in at least two accounts, with total debits equal to total credits. Luca Pacioli described the system in 1494, though Italian merchants used it earlier. It provides a built-in check: if debits do not equal credits, there is an error.
Accounts and the T-account
An account records increases and decreases in one item, such as cash or rent expense. A T-account is a simple diagram: the left side is the debit side, the right side the credit side. 'Debit' and 'credit' simply mean left and right; they do not mean good or bad.
Debit and credit rules
Assets, expenses, and drawings increase with debits and decrease with credits. Liabilities, equity (capital), and revenues increase with credits and decrease with debits. A common memory aid is DEALER: Dividends (or Drawings), Expenses, and Assets increase with debits; Liabilities, Equity, and Revenue increase with credits.
Normal balances
Each account has a normal balance on its increase side: assets, expenses, and drawings normally have debit balances; liabilities, equity, and revenues normally have credit balances. A cash account with a credit balance, for example, would signal an overdraft or an error.
Journal entries
Transactions are first recorded in the journal in date order, showing the accounts debited and credited, the amounts, and a brief explanation. By convention, debits are listed first and credits are indented below. For example, receiving 4,000 dollars cash for services: debit Cash 4,000; credit Service Revenue 4,000.
Posting to the ledger
Journal entries are then posted to the general ledger, the collection of all accounts, so each account shows its running balance. The chart of accounts lists all accounts with numbers, often assets in the 100s, liabilities in the 200s, equity in the 300s, revenues in the 400s, and expenses in the 500s and beyond.
The trial balance
A trial balance lists all ledger accounts and their balances to check that total debits equal total credits. A balanced trial balance does not prove the records are correct: errors such as recording a transaction in the wrong account, or omitting it entirely, will not show up.
Worked example
Paying 1,200 dollars cash for a one-year insurance policy: debit Prepaid Insurance (an asset increases) 1,200; credit Cash (an asset decreases) 1,200. Borrowing 10,000 dollars from a bank: debit Cash 10,000; credit Notes Payable (a liability increases) 10,000. In each entry, debits equal credits.
Key takeaways
Double-entry bookkeeping records equal debits and credits, described by Pacioli in 1494. Debit means left and credit means right. Assets, expenses, and drawings increase with debits; liabilities, equity, and revenues increase with credits (DEALER). Normal balances follow the increase side. Transactions are journalised, then posted to the ledger, organised by a chart of accounts. A trial balance checks that debits equal credits but cannot catch every error.
Flashcard
Every transaction has equal debits and credits
Check your understanding
A business pays 500 dollars cash for electricity. Which journal entry records this?