In the simple ‘worksheet method’, each balance sheet item has their column in an Excel-like accounting worksheet. Transactions are included in the rows, with ‘entries’ in the columns of the items that are affected by the transactions. Increases were added, and decreases subtracted. Even though this method would work (even for large volumes of transactions), this is not how accounting systems are organized.
In practice every balance sheet item has their own record, called a T-account. A T-account, as the name suggests, looks like a capital T, the left side is defined as ‘debit’ (or ‘D’) and the right side as ‘credit’ (or ‘C’). On one side additions are written, and on the other side subtractions. Which side is ‘+’ and which side ‘-’ depends on the type of T-account. See the figure below for the debit-and-credit rules for the different T-accounts.
Increases in assets (assets have a normal debit balance), are written on the debit side (and decreases on the credit side). Increases in liabilities and equity, which normally have a credit balance, are written on the credit side (and decreases on the debit side).
What is a Debit and Credit?
Debit vs credit rules
Important: Debit and credit is not the same as ‘plus’ and ‘minus’ (nor the other way around). It is context dependent: for assets debit is plus (and credit minus), for liabilities and equity it is the other way around.
A straightforward way to remember the debit and credit rules is that T-accounts increase on same side (debit or credit) as the side on where it is normally presented on the balance sheet. Since assets are presented on the balance sheet’s debit side, it is natural to write an increase on the debit side of an asset’s T-account (and decreases in the credit side). Similarly, liabilities and equity are presented on the credit side of the balance sheet. Hence, increases for these T-accounts are included on the credit side of the T-account (and decreases on the debit side).
The value (balance) of a T-account is computed by balancing out the debit and credit side. For example, a T-account with total debits of 100 and total credits of 80 will have a debit balance of 20. A T-account can technically ‘switch’ from one side to another. For example, a credit of 7 to a T-account with a debit balance of 5 will result in a credit balance of 2. This switching can take place for a bank account when the balance of the bank account switches from positive and negative.
Which T-accounts does the firm need? A company is free to chose the number of T-accounts. Depending on the nature of the business detail may be required in different areas. For example, a consultancy firm may have a single T-account ‘vehicles’ to register the cost of the vehicles they own. A car rental firm probably requires more detail when it comes to accounting for the cars they own. Such a company could have T-accounts for different kind of cars such as sedans, SUV’s and trucks.
How transactions enter T-accounts
The journal is a chronological list of all transactions that have occurred. Each transaction enters the journal in a journal entry. The journal entry lists the T-accounts and the amounts that change as a result of the transaction. The journal entry follows the debit and credit rules discussed above. As a result, a journal entry is always balanced (total amount of debits equals the total of credits).
Jan 1: The firm is incorporated on the 1st of January, 20X0. The owner, Betty, pays 40,000 cash for 10,000 shares.
Following the accounting equation:
The following journal entry corresponds with this transaction:
Cash is an asset, which has a normal debit balance. Increases are written on the debit side of its T-account. Therefore, the 40,000 is written in the debit column of the journal entry.
Paid-in capital is part of equity. For equity T-accounts, increases are written on the credit side. Thus, the 40,000 appears in the credit column for Paid-in capital.
– T-accounts are used to register transactions
– T-accounts have a debit side (left) and a credit side (right)
– increases in assets are recorded on the debit side, decreases on the credit side
– increases in liabilities and equity are recorded on the credit side, decreases on the debit side
– the number of T-accounts (i.e., the level of detail that can be provided) differs across firms
– the journal is a list in chronological order of all transactions
– each transaction is posted to the journal in the form of a journal entry
– a journal entry is a list of all T-accounts affected by a transaction, where each T-account has a number added on the debit side, or on the credit side
– a journal entry is balanced: the total of amounts debit equals the total amount of credits