What Are Debits and Credits?

Debits and credits form the basis of the double-entry accounting system of a business. Debits represent money that is paid out of an account and credits represent money that is paid into an account. Each financial transaction made by a business firm must have at least one debit and credit recorded to the business’s accounting ledger in equal, but opposite, amounts.

Bookkeepers and accountants use debits and credits to balance each recorded financial transaction for certain accounts on the company’s balance sheet and income statement. Debits and credits, used in a double-entry accounting system, allow the business to more easily balance its books at the end of each time period.

What Are Debits and Credits?

Debits, abbreviated as Dr, are one side of a financial transaction that is recorded on the left-hand side of the accounting journal. Credits, abbreviated as Cr, are the other side of a financial transaction and they are recorded on the right-hand side of the accounting journal. There must be a minimum of one debit and one credit for each financial transaction, but there is no maximum number of debits and credits for each financial transaction.

The business’s Chart of Accounts helps the firm’s management determine which account is debited and which is credited for each financial transaction. There are five main accounts, at least two of which must be debited and credited in a financial transaction. Those accounts are the Asset, Liability, Shareholder’s Equity, Revenue, and Expense accounts along with their sub-accounts.

A debit increases both the asset and expense accounts. The asset accounts are on the balance sheet and the expense accounts are on the income statement. A credit increases a revenue, liability, or equity account. The revenue account is on the income statement. The liability and equity accounts are on the balance sheet.

 

Concept of Double Entry

Every transaction has two effects. For example, if someone transacts a purchase of a drink from a local store, he pays cash to the shopkeeper and in return, he gets a bottle of dink. This simple transaction has two effects from the perspective of both, the buyer as well as the seller. The buyer’s cash balance would decrease by the amount of the cost of purchase while on the other hand he will acquire a bottle of drink. Conversely, the seller will be one drink short though his cash balance would increase by the price of the drink.

Accounting attempts to record both effects of a transaction or event on the entity’s financial statements. This is the application of double entry concept. Without applying double entry concept, accounting records would only reflect a partial view of the company’s affairs. Imagine if an entity purchased a machine during a year, but the accounting records do not show whether the machine was purchased for cash or on credit. Perhaps the machine was bought in exchange of another machine. Such information can only be gained from accounting records if both effects of a transaction are accounted for.

Traditionally, the two effects of an accounting entry are known as Debit (Dr) and Credit (Cr). Accounting system is based on the principal that for every Debit entry, there will always be an equal Credit entry. This is known as the Duality Principal.

Debit entries are ones that account for the following effects:

• Increase in assets
• Increase in expense
• Decrease in liability
• Decrease in equity
• Decrease in income

Credit entries are ones that account for the following effects:

• Decrease in assets
• Decrease in expense
• Increase in liability
• Increase in equity
• Increase in income

 

Accounting entries

In the double-entry accounting system, at least two accounting entries are required to record each financial transaction. These entries may occur in asset, liability, equity, expense, or revenue accounts. Recording of a debit amount to one or more accounts and an equal credit amount to one or more accounts results in total debits being equal to total credits when considering all accounts in the general ledger. If the accounting entries are recorded without error, the aggregate balance of all accounts having Debit balances will be equal to the aggregate balance of all accounts having Credit balances. Accounting entries that debit and credit related accounts typically include the same date and identifying code in both accounts, so that in case of error, each debit and credit can be traced back to a journal and transaction source document, thus preserving an audit trail. The accounting entries are recorded in the “Books of Accounts”. Regardless of which accounts and how many are involved by a given transaction, the fundamental accounting equation of assets equal liabilities plus equity will hold.

 

What is a T-account?

A T-account is a visual way of displaying the transactions occurring within a single account. Any transaction a business makes will need to be recorded in the company’s general ledger. The general ledger is divided up into individual accounts which categorise similar transaction types together.

The reason it’s called a T-account is simply that it is shaped like a T.

• When you debit an asset or expense account, you increase its value.
• When you debit a liability, equity or revenue account, you decrease its value.
• When you credit an asset or expense account, you reduce its value.
• When you credit a liability, equity or revenue account, you increase its value.
• When a company records a transaction, at least one account will always be debited, whilst at least one other will always be credited, hence the name “double-entry”. These entries show the movement of value around the business.

 

Accounting equation approach

This approach is also called the American approach. Under this approach transactions are recorded based on the accounting equation, i.e., Assets = Liabilities + Capital.[18] The accounting equation is a statement of equality between the debits and the credits. The rules of debit and credit depend on the nature of an account. For the purpose of the accounting equation approach, all the accounts are classified into the following five types: assets, capital, liabilities, revenues/incomes, or expenses/losses.

If there is an increase or decrease in a set of accounts, there will be equal decrease or increase in another set of accounts. Accordingly, the following rules of debit and credit hold for the various categories of accounts:

• Assets Accounts: debit entry represents an increase in assets and a credit entry represents a decrease in assets.
• Capital Account: credit entry represents an increase in capital and a debit entry represents a decrease in capital.
• Liabilities Accounts: credit entry represents an increase in liabilities and a debit entry represents a decrease in liabilities.
• Revenues or Incomes Accounts: credit entry represents an increase in incomes and gains, and debit entry represents a decrease in incomes and gains.
• Expenses or Losses Accounts: debit entry represents an increase in expenses and losses, and credit entry represents a decrease in expenses and losses.

These five rules help learning about accounting entries and also are comparable with traditional (British) accounting rules.

How do I set up bookkeeping for my small business?

The IRS requires all businesses to keep basic financial records in order to accurately track gross receipts, purchases, expenses, and other transactions. The exact nature of your record-keeping system is up to you, but a well-designed small-business bookkeeping system will keep your financial information in good order, facilitate reporting, and scale with your business as you grow.

Choose Cash or Accrual Accounting

Businesses with revenues under $5 million per year may use either cash accounting or accrual accounting to track how money flows into and out of the business.

• Cash accounting records revenues when the money is received by the business, and expenses when they are paid by the business. This is the same kind of accounting that individuals use when balancing their checkbooks.
• Accrual accounting records revenues when they are earned, which may be long before the customer actually pays the business. Similarly, expenses are recorded when the business incurs them, not when it pays for them.

Set Up a Business Bank Account

A separate bank account for your business is a must-have for businesses of all sizes. Make sure that all business transactions flow into and out of this account, not your personal bank accounts. Similarly, never make personal transactions using your business bank account. We’ve written before about how mixing business and personal accounts can get you into trouble.

Having a dedicated business bank account solves a lot of problems:

• First, you’ll know every transaction in that account is a business-related transaction.
• Second, you can automatically import transaction information from your business bank account straight into your bookkeeping software. Separating your business and personal accounts means you won’t have to waste time separating business- from non-business expenses.
• Third, keeping your business funds siloed away from your personal funds shows the IRS and other authorities that you are serious about maintaining your financial records in a businesslike manner.

Pick a Bookkeeping Software Package for Small Businesses

Technically, a business can manage its books using Excel. Theoretically, they could even do it with pen and paper. But, practically speaking, bookkeeping software is a must for all businesses. Manually typing or writing transactions day after day is a tremendous waste of time and energy, and such a manual approach is also highly error-prone. A basic bookkeeping software package is not terribly expensive and can more than pay for itself in the time you’ll save and the capabilities you’ll gain.

Create a Chart of Accounts

The chart of accounts is a list of the accounts you have set up in your bookkeeping system to track all financial activities. This chart forms the skeletal structure that holds your entire bookkeeping system together. Most bookkeeping software packages will set up a basic chart of accounts for you, based on your entity type. But you’ll likely need to tweak this chart to better match your business’s specific needs. Each account should have an account name, a type (asset, liability, expense, and so on), a description, and a number.

Set Up an Expense Tracking System

If you want to keep accurate records, tracking your business expenses is a must. Transaction receipts generally come in either paper or electronic form. Paper receipts can be stored in something as simple as a shoebox, but it’s much better to keep those receipts organized — whether by date, in alphabetical order, or with some other system. Electronic receipts can live on your computer or in an online storage system, such as Expensify.

Prepare Your Bank Reconciliation Process

Having your transactions automatically imported from your bank is a wonderful time-saver, but it doesn’t eliminate the need for bank reconciliation. This is the process of comparing your monthly bank statement with your business’s Cash account in your chart of accounts, to confirm that both are accurate.

A typical reconciliation process goes as follows:

• Take the bank statement and add any outstanding items, such as checks that haven’t cashed yet. Write the new total at the bottom of the statement.
• Review the bank statement’s transactions to check for any errors. If you find an error, contact the bank immediately.
• Adjust the Cash account within your bookkeeping software to reflect bank-generated transactions, such as service charges and interest payments.
• Ideally, the corrected bank-statement balance and the corrected Cash account balance will now be identical. If not, you’ll need to dig into both the bank statement and the bookkeeping account transactions to figure out what’s causing the discrepancy.

Set Up Your Reporting System

Reports help you assess your business’s overall financial health. Most bookkeeping systems have dozens of reporting options, but most of them won’t be important to your particular business. There are three basic reports that you’ll definitely want to generate and review on a regular basis.

• Balance sheet

The balance sheet takes a snapshot of what your business owns and owes at any particular time. Balance sheets list a business’s assets, liabilities, and equity.

• Income statement

Also known as the profit and loss (P&L) statement, the income statement shows how profitable your business was over a certain period. This statement compares your business’s revenues (the money you made from selling your products or services) to your business’s expenses. If your business had more revenues than it had expenses, it was profitable; if not, it took a loss.

• Cash-flow statement

The statement of cash flows tells you how much actual cash your business received over a certain period. This differs from the income statement because income statements are generally prepared using accrual accounting, so the revenues listed on the statement may still be unpaid. Your business might have enormous income, yet be chronically short of cash to pay the bills.

 

Determine your tax obligations

Tax obligations vary depending on the legal structure of the business. If you’re self employed (sole proprietorship, LLC, partnership), you’ll claim business income on your personal tax return. Corporations, on the other hand, are separate tax entities and are taxed independently from owners. Your income from the corporation is taxed as an employee.

Self-employed people need to withhold taxes from their income and remit them to the government in lieu of the withholding that an employer would normally conduct. For American store owners, you’ll need to pay estimated quarterly taxes if you’ll owe more than $1,000 in taxes this year. Canadians have it a little easier; if your net tax owing is more than $3,000, you’ll be required to pay your income tax in installments.

Calculate gross margin

Improving your store’s gross margin is the first step toward earning more income overall. In order to calculate gross margin, you need to know the costs incurred to produce your product. To understand this better, let’s quickly define both cost of goods sold (COGS) and gross margin.

COGS. These are the direct costs incurred in producing products sold by a company. This includes both materials and direct labor costs.

Gross margin. This number represents the total sales revenue that’s kept after the business incurs all direct costs to produce the product or service.

 

Reconciling Your Accounts

Keep ledgers for all financial accounts. You may have several business bank accounts. For example, small businesses usually have a checking account to pay bills and a savings account to save up money to pay self-employment tax. You should also create a ledger or spreadsheet for each of your major accounts.

Keeping this ledger will allow you to monitor the current state of your business. You won’t have to wait for the monthly bank statement to see if your business is insolvent or thriving.

Reconcile your books. You need to make sure that your monthly recording of expenses is the same that shows up on your bank records. This means analyzing your bank statement and your accounts to make sure the same transactions appear on each.

• Reconciliation is a good way to catch mistakes—yours or the bank’s. If the bank makes a mistake, you can contact them. Share whatever documentation you have (receipts, cancelled checks).
• You can also catch fraudulent activity with reconciliation. For example, an employee might have withdrawn money from the checking account without telling you.
• Perform reconciliation monthly. If you wait too long, it will be harder to reconcile. Also, you won’t catch fraudulent transactions in a timely manner.

 

Maintaining Cash Flow & Improved Financial Management

As a responsible small business owner or bookkeeper, you should be aware of your company’s revenue streams. With accurate bookkeeping, you can tell how much your business is making in terms of income and track your spending to ensure that you have enough cash on hand to cover your business expenses. Proper financial records make it easier for you to analyze the financial state of your firm and determine areas that need improvement.

 

Be prepared for major expenses.

Even with your carefully maintained balance sheet and cash flow reports, it’s hard to predict what will happen in the future. That’s why it’s always a good idea to plan for significant or surprise—or significantly surprising—expenses with a cushion of savings.

Keep a separate emergency fund for your business. Save separate emergency funds for your business and personal life. Both should give you enough cash to cover your expenses for three to six months. For your business, that extra cash can help you cover unplanned large expenses that can’t wait. For example, if you own a copy shop, what would happen if your printer broke down and you had to wait until you saved enough for a new one? Imagine all the business you would lose! But if you had the cash on hand, you could replace the printer and be back to normal in no time.

Don’t go into debt for your business—always pay cash! You’ll have less risk and your business will be profitable faster when you operate without debt. Put whatever you make back in the business, especially in the beginning, and live lean in both your business and personal life. A future without debt is worth it!

Do You Need To Outsource Payroll Service?

Millions of U.S. businesses outsource their payroll processing. Why do they do it, and what benefits does it bring them?

How common is outsourcing payroll? In a recent survey conducted by Robert Half and the Financial Executives Research Foundation1, 39 percent of U.S. companies — more than 10 million businesses — claimed they outsource their payroll processing. And 43 percent outsource their payroll tax responsibilities.

While some businesses opt to handle running payroll functions in-house through manual bookkeeping or do-it-yourself payroll apps, small business owners have increasingly come to prefer the expertise of professional payroll providers.

 

But why do so many business owners decide to outsource payroll? Here are main reasons:

1. Outsourced payroll saves time

If you handle your payroll in-house, you know that it requires a lot of time and attention to detail. That demand on your time increases as your staff grows. Each pay period becomes a series of checks and balances to ensure no errors are made while handling a considerable amount of data that varies from employee to employee.

The inability to relinquish control, and the failure to delegate tasks to better manage your time is a bad business habit you need to give up.

2. Overhead costs are reduced

As a business owner, your time has a dollar value that’s linked to the revenue you generate from the tasks you handle at any given time. The time you are able to save each day is money earned.

If you look at the total time you spend on payroll each pay period compared to the costs of outsourcing, you’ll see a great deal of cost savings when you take those tasks off of your plate.

3. Improved data security

There’s a fair amount of risk that comes with in-house payroll. The door is wide open for identity theft. Employee records can be viewed by those who handle payroll. Employees can tamper with records for personal gain, and there’s also the risk of embezzlement.

Aside from these employee risks, you’ll need to consider the security of your payroll software. While the software itself could be relatively secure, you may house your data on a server or network with security flaws that could leave you open to data theft.

4. Guaranteed government compliance

Payroll firms understand tax law. It’s their business to keep up with the rules, regulations, and changes in tax law. They guarantee accuracy and compliance. If there are mistakes, they’ll make corrections while handling the liability of any errors they may make.

5. Access to a variety of services

Aside from the standard payroll and tax calculation, some platforms offer additional value-added services like contract generation, contractor services, labor law compliance, access to health benefits, workers’ compensation payments, and bookkeeping services.

A worry-free payroll

A professional payroll provider employs people who know payroll processing–professionals who specialize in the complexities of regulations, government compliance, taxes, and human resources. It’s what they’re trained to do and the core of their service guarantee. You can save yourself a lot of time, money, and he

 

Why Payroll Is One Function You Should Outsource

But the question business owners and managers want answered is:  what do you actually gain from outsourcing payroll? Is it worth all the time and effort just to investigate and identify appropriate outsourced service providers?  Then there’s the work involved to transition the function outside to the third party service.  Do the benefits of outsourcing outweigh that effort? chose to outsource the functions to reduce the risk of the payroll not being processed, to manage growth by anticipating the increased payroll responsibilities that will be required as the firm grows and hires more employees, and to keep up with technology, such as pay cards and direct deposit.”

Ideally, outsourcing achieves three main goals:

• It frees up time and resources to focus more on your core business.
• It gives you access to more technology and expertise to perform payroll well.
• It reduces costs and risks.

 

Payroll Software vs. Payroll Service

There are two basic ways a business can carry out payroll:

Option 1: You can do it yourself using payroll software. Online payroll software applications work in a similar way to tax software. They give you a handful of prompts and information, but you—or someone in your business—must do all the input. The software company can offer online support, by phone, chat, or FAQs.

Option 2: You can outsource your process by giving a payroll service the basic information on employees and letting them run payroll, send out paychecks, do all of the reporting, and sending all the payroll tax payments out

 

Outsource payroll the right way

With payroll outsourcing, it often comes down to what’s most efficient and cost-effective for your business. It pays to do your homework and assess your business needs before making a decision. If you get the right provider, you’ll spend less time thinking about payroll and more time doing what you do best – running and growing your business.