Debit and credit are the two sides of every entry in double-entry bookkeeping. The debit side records what came into an account or what benefited from the transaction, and the credit side records what went out of it or the source of that value. Put more simply, every financial transaction affects at least two accounts: one is debited and the other is credited with the same amount, so total debits always equal total credits. Outside the books, a debtor is the person or entity that owes a debt, and a creditor is the party entitled to collect it.
Two different meanings: debtor and creditor in business, debit and credit in the books
Many business owners confuse the everyday meaning with the accounting meaning, and telling the two apart clears up most of the confusion:
- In business dealings: the debtor is the party that owes an amount it has not yet paid, such as a customer who bought on credit, and the creditor is the party that is owed the amount, such as a supplier waiting to be paid.
- In the accounting books: debit and credit are directions of recording within an account, not a statement that anyone owes anyone. The cash balance in the till, for example, is a debit balance, and that does not mean there is a debt.
That is why a customer who buys on credit appears in the business’s books under debtors (accounts receivable), because the customer owes the business, and a supplier appears under creditors (accounts payable), because the business owes the supplier.
Debit and credit rules for each type of account
Accounts fall into main groups, and each group has a side that increases it and a side that decreases it. This is the rule every entry is built on:
- Assets, such as cash, bank, customers, inventory and equipment: increase with a debit and decrease with a credit, and their normal balance is a debit.
- Expenses, such as salaries, rent, electricity and maintenance: increase with a debit and decrease with a credit, and their normal balance is a debit.
- Liabilities, such as suppliers, loans and accrued expenses: increase with a credit and decrease with a debit, and their normal balance is a credit.
- Equity, such as capital and retained earnings: increases with a credit and decreases with a debit, and its normal balance is a credit.
- Revenue, such as sales and service income: increases with a credit and decreases with a debit, and its normal balance is a credit.
These rules rest on the accounting equation: assets equal liabilities plus equity. Every correct entry keeps this equation in balance, whatever the type of transaction.
How to record a journal entry step by step
- Identify the transaction: what actually happened? A sale, a purchase, a payment, a collection or a salary payment.
- Identify the affected accounts: find the accounts whose balances changed because of the transaction.
- Classify each account: is it an asset, a liability, equity, revenue or an expense?
- Determine the direction of change: did the account increase or decrease? Then apply the rule to see whether it is recorded as a debit or a credit.
- Check the balance: total debits must equal total credits in the entry.
- Write a clear description and attach the document: such as the invoice, receipt voucher or bank advice, so the entry can be reviewed later.
In the traditional Arabic format, the entry is written with “from account” before the name of the debited account and “to account” before the name of the credited account.
After the entries are posted to the general ledger, a trial balance is extracted: a list of the debit and credit account balances at a given date. Total debit balances should equal total credit balances. If they differ, there is an error in an entry or in posting that must be traced before the financial statements are prepared.
Practical examples from a business
Depositing capital in the bank
When a partner deposits capital in the business’s bank account, the bank account, an asset, increases and is debited, and capital, an equity account, increases and is credited: debit Bank, credit Capital, or in the Arabic format, from Bank account, to Capital account.
Selling goods on credit, then collecting
On the sale, the customers account, an asset, increases and is debited, and sales, a revenue account, increase and are credited. When the customer pays later, the bank is debited and the customer’s account is credited, which closes its balance.
Buying supplies from a supplier with VAT
The purchases or expense account is debited with the value of the supplies before tax, the input VAT account is debited with the tax amount where it is deductible under the regulations, and the supplier’s account is credited with the total. On sales, output VAT is recorded on the credit side, because it is an amount payable to the Zakat, Tax and Customs Authority (ZATCA).
Paying office rent in advance
If rent is paid for a coming period, the prepaid rent account, an asset, is debited and the bank is credited. The portion whose period has passed is then transferred to rent expense: the expense is debited and prepaid rent is credited.
Paying employee salaries
Salaries expense increases and is debited, and the bank balance decreases and is credited. If there are deductions from salaries, they are recorded in separate accounts according to their nature.
Common debit and credit mistakes
- Reversing the two sides of an entry: recording a collection from a customer as a debit to their account instead of a credit, so the balance doubles instead of closing.
- Confusing an expense with an asset: recording equipment that will be used over a long period as an immediate expense, or recording an ordinary expense as an asset.
- Unbalanced entries: these usually happen in compound entries that involve tax, a discount or more than one account.
- Neglecting documents: an entry that is not backed by an invoice or voucher is hard to defend in an audit or examination.
- Mixing the owner’s personal accounts with the business’s accounts: drawings get mixed up with expenses and the profit figure is distorted.
- Relying on a balanced trial balance alone: a trial balance that balances does not mean the books are free of errors, because the right amount may have been recorded in the wrong account.
How to keep your books sound and compliant
Well-kept books are the basis for everything a business submits to official bodies, from zakat and VAT returns filed with ZATCA to the financial statements uploaded on Qawaem as the Ministry of Commerce requires. To achieve this:
- Adopt a clear chart of accounts that suits your activity, and do not create new accounts at random.
- Use an accounting system that will not post an unbalanced entry and that keeps documents with the entries.
- Reconcile bank statements with the books regularly.
- Review customer and supplier balances periodically, and contact them to confirm the balances.
- Follow the accounting standards endorsed by the Saudi Organization for Chartered and Professional Accountants (SOCPA) when preparing financial statements.
The Innovant team can help organize your chart of accounts, review your entries and prepare your books before the financial statements are drawn up.
