The correct rule of debits and credits, fundamental to the double-entry accounting system, dictates how transactions impact different types of accounts, ensuring the accounting equation remains balanced. Simply put, debits increase asset, expense, and dividend accounts, while credits increase liability, equity, and revenue accounts.
This system ensures that for every transaction, there is at least one debit and one credit, and the total debits always equal the total credits. This foundational principle underpins all financial record-keeping and financial statement preparation.
Understanding Debits and Credits
In accounting, "debit" (Dr) refers to an entry on the left side of a T-account, and "credit" (Cr) refers to an entry on the right side. These terms do not inherently mean "increase" or "decrease"; their effect depends entirely on the type of account being adjusted.
The rules are directly derived from the accounting equation:
Assets = Liabilities + Equity
For the equation to always balance, any change on the left side (Assets) must be offset by a corresponding change on the right side (Liabilities + Equity), or by an opposite change within the asset accounts themselves. Similarly, changes within Liabilities or Equity must be balanced.
The Core Rules of Debits and Credits by Account Type
The following table summarizes the universal rules for increasing and decreasing different types of accounts:
| Account Type | Normal Balance | To Increase Account | To Decrease Account |
|---|---|---|---|
| Assets | Debit | Debit | Credit |
| Liabilities | Credit | Credit | Debit |
| Equity | Credit | Credit | Debit |
| Revenues | Credit | Credit | Debit |
| Expenses | Debit | Debit | Credit |
| Dividends | Debit | Debit | Credit |
Let's break down each type:
1. Assets
Assets are resources owned by the business that have future economic value. Examples include Cash, Accounts Receivable, Inventory, Equipment, and Buildings.
- To increase an Asset account: You debit the account.
- To decrease an Asset account: You credit the account.
Example:
When a company buys new machinery for cash:
- Debit: Machinery (Asset increased)
- Credit: Cash (Asset decreased)
2. Liabilities
Liabilities are obligations a business owes to others. Examples include Accounts Payable, Notes Payable, and Salaries Payable.
- To increase a Liability account: You credit the account.
- To decrease a Liability account: You debit the account.
Example:
When a company takes out a bank loan:
- Debit: Cash (Asset increased)
- Credit: Loans Payable (Liability increased)
3. Equity
Equity (also known as Owner's Equity or Stockholders' Equity) represents the owners' claim on the assets of the business after all liabilities are paid. It is affected by owner investments, revenues, expenses, and dividends/drawings.
- To increase an Equity account: You credit the account.
- To decrease an Equity account: You debit the account.
Example:
When an owner invests personal cash into the business:
- Debit: Cash (Asset increased)
- Credit: Owner's Capital (Equity increased)
4. Revenues
Revenues are increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Examples include Sales Revenue and Service Revenue.
- To increase a Revenue account: You credit the account.
- To decrease a Revenue account: You debit the account.
Example:
When a company performs a service for a customer and receives cash:
- Debit: Cash (Asset increased)
- Credit: Service Revenue (Revenue increased)
5. Expenses
Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Examples include Rent Expense, Salaries Expense, and Utilities Expense. Expenses ultimately reduce equity.
- To increase an Expense account: You debit the account.
- To decrease an Expense account: You credit the account.
Example:
When a company pays its monthly rent:
- Debit: Rent Expense (Expense increased)
- Credit: Cash (Asset decreased)
6. Dividends/Drawings
Dividends (or Owner's Drawings for sole proprietorships/partnerships) are distributions of a company's earnings to its shareholders or owners. They reduce equity.
- To increase a Dividends/Drawings account: You debit the account.
- To decrease a Dividends/Drawings account: You credit the account.
Example:
When a company pays cash dividends to its shareholders:
- Debit: Dividends Declared (Dividends increased)
- Credit: Cash (Asset decreased)
Practical Insights and Importance
- Normal Balance: Each account type has a "normal balance," which is the side (debit or credit) that increases the account. Assets, Expenses, and Dividends have a normal debit balance. Liabilities, Equity, and Revenues have a normal credit balance.
- Balancing Act: Understanding these rules is critical for accurately recording transactions, preparing journal entries, posting to the general ledger, and ultimately creating accurate financial statements like the balance sheet and income statement.
- Foundation of Accounting: The debit and credit rules are the bedrock of the double-entry system, providing a robust framework for financial transparency and accountability. You can learn more about fundamental accounting principles through resources like Investopedia's guide to debits and credits.
