Why we use Debits and Credits (Balance Sheet)

Check out this weeks video! This is a really important topic I have been waiting to discuss!

VIDEO SUMMARY

This video will tell you why we use Debits and Credits

Almost all accounting classes teach Debits and Credits through memorization. In all your accounting classes, you are going to learn different journal entries and the debits and credits. And you memorize them. And this is great, because you need to memorize them all. However, what I don’t think professors spend enough time on, is why we use debits and credits in the first place. Why? The answer is very important.

Let’s start by looking at a balance sheet. You have two sides. Assets and Liabilities plus Owner’s Equity. And this follows the equation Assets = Liabilities + Owner’s Equity. So you can always look at a Balance Sheet and see that both sides even out. One side will always equal the other side. I am going to explain to you why that is so important.

Let’s look at assets. I think it is pretty common sense why you would want to track a company’s assets. Assets tell you how much property the company owns. So you track cash as it goes up and down. You track inventory as it goes up and down. You track all these things and you can look at the Balance Sheet and say, “this is how much stuff the company owns.”

But accountants don’t stop there. They also watch the other side of the Balance Sheet: Liabilities and Owner’s Equity. The other side of the balance sheet is about understanding who has claims to the company assets. Let’s look at liabilities. You have short term, like Accounts Payable where you might owe a supplier for inventory you bought. That supplier has a claim against a dollar amount of your company’s assets. You might have long term liabilities, like bank debt. That bank has a claim against a dollar amount of your company’s assets. Owner’s Equity follows the same pattern. You might have retained earnings or Additional Paid in Capital, which are the owner’s claims to the assets of the business.

So let’s think big picture. When you set up a company, you just have a blank legal entity. And what happens is all these different parties put things into the business. Owner’s put things in, Banks and Suppliers put things in. And you start accumulating all these assets. Well, it’s important not only to track the assets, in the business, but who owns what assets. And that is the point of double entry bookkeeping. That is why there is always two entries in a journal entry. That is why you always have a debit and a credit that always balances. A single entry bookkeeping system would just keep track of Assets and forget about the other side. But it would be very difficult to run a business that way.

Now, it gets even more complicated. The balance sheet equation we all learn (A = L + O.E.) is not the full equation. The full equation is A = L + E + (Rev – Exp). What you have to realize is that as the company is operating, they are generating either a profit or loss, and that is affecting the balance sheet. You are continually changing the assets and the claims against those assets. So every journal entry you write, you are effecting the balance of your company.

So I’d like to end by just reviewing a couple of journal entries to show you how this works.

• Purchase Inventory – assets go up with the debit. Amount you owe goes up with the credit
• Pay Expense with Cash – Exp goes up with Expense (which reduces the claim from Owner’s), and cash goes down reducing assets
• Bank loan – Cash (assets) go up. But the amount you owe to the bank goes up
• Make a sale – Here we have AR (asset) go up with a debit. And the Rev go up with a credit. Revenue going up increases the claim from owner’s on the balance sheet.
• Purchase equipment with cash. Here you see that these are both asset accounts. One goes up and the other goes down, so there is no net change to the balance sheet.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.