Principles of Financial Accounting: The Accounting Equation and Double Entry - Rules of Debit and Credit for Assets, Liabilities Equity Revenues Expenses

What It Is

In financial accounting, the rules of debit and credit are essential for recording transactions accurately. These rules determine how to increase or decrease various accounts, such as assets, liabilities, equity, revenues, and expenses. If a company buys $10,000 of inventory, the debit to Inventory would be $10,000, while the credit to Cash would be $10,000.

Key Concepts & Formulas

• Asset Accounts: Debit to increase, credit to decrease. Example: If a company buys $5,000 of equipment, the debit to Equipment would be $5,000.
• Liability Accounts: Credit to increase, debit to decrease. Example: If a company borrows $10,000 from a bank, the credit to Notes Payable would be $10,000.
• Equity Accounts: Credit to increase, debit to decrease. Example: If a company issues 1,000 shares of common stock for $10 per share, the credit to Common Stock would be $10,000.
• Revenue Accounts: Credit to increase, debit to decrease. Example: If a company earns $20,000 in sales, the credit to Sales Revenue would be $20,000.
• Expense Accounts: Debit to increase, credit to decrease. Example: If a company incurs $5,000 in salaries expense, the debit to Salaries Expense would be $5,000.
• Gross Profit Formula: Gross Profit = Sales – COGS. Example: If a company has $100,000 in sales and $50,000 in COGS, the gross profit would be $50,000.
• Net Income Formula: Net Income = Gross Profit – Total Expenses. Example: If a company has $50,000 in gross profit and $30,000 in total expenses, the net income would be $20,000.
• Current Ratio Formula: Current Ratio = Current Assets / Current Liabilities. Example: If a company has $100,000 in current assets and $50,000 in current liabilities, the current ratio would be 2:1.

Journal Entry Examples

Example 1: Purchasing Inventory

Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The debit to Inventory increases the asset account, while the credit to Cash decreases the asset account.

Example 2: Issuing Common Stock

Dr. Cash $10,000 Cr. Common Stock $10,000

Explanation: The credit to Common Stock increases the equity account, while the debit to Cash decreases the asset account.

Example 3: Incuring Salaries Expense

Dr. Salaries Expense $5,000 Cr. Cash $5,000

Explanation: The debit to Salaries Expense increases the expense account, while the credit to Cash decreases the asset account.

Common Mistakes

Mistake 1: Confusing Debits and Credits for Expense Accounts

Correction: Expense accounts are debited to increase and credited to decrease. Example: If a company incurs $5,000 in salaries expense, the debit to Salaries Expense would be $5,000.

Mistake 2: Confusing Debits and Credits for Asset Accounts

Correction: Asset accounts are debited to increase and credited to decrease. Example: If a company buys $10,000 of inventory, the debit to Inventory would be $10,000.

Mistake 3: Not Considering Normal Balances

Correction: Remember that asset accounts have normal balances of debit, while liability and equity accounts have normal balances of credit. Example: If a company has a debit balance of $10,000 in Cash, it is a normal balance.

Exam Tips

Tip 1: A Debit Increases Assets AND Expenses – Remember ‘ADE’

This tip helps students remember that debits increase assets and expenses, while credits decrease assets and revenues.

Tip 2: Reversing Normal Balances

This tip warns students to be careful when reversing normal balances, as it can lead to incorrect journal entries.

Tip 3: Dividends Are NOT an Expense – They Go Directly to Retained Earnings

This tip highlights a common trap in accounting exams, where students mistakenly consider dividends as an expense.

Quick Practice

Problem 1: What is the adjusting entry for accrued salaries of $5,000?

Dr. Salaries Expense $5,000 Cr. Salaries Payable $5,000

Explanation: The debit to Salaries Expense increases the expense account, while the credit to Salaries Payable increases the liability account.

Problem 2: What is the journal entry for purchasing $10,000 of equipment?

Dr. Equipment $10,000 Cr. Cash $10,000

Explanation: The debit to Equipment increases the asset account, while the credit to Cash decreases the asset account.

Problem 3: What is the journal entry for issuing 1,000 shares of common stock for $10 per share?

Dr. Cash $10,000 Cr. Common Stock $10,000

Explanation: The credit to Common Stock increases the equity account, while the debit to Cash decreases the asset account.

Last-Minute Cram Sheet

1. Assets have normal balances of debit.
2. Liabilities and equity have normal balances of credit.
3. Revenues have normal balances of credit.
4. Expenses have normal balances of debit.
5. Gross Profit = Sales – COGS.
6. Net Income = Gross Profit – Total Expenses.
7. Current Ratio = Current Assets / Current Liabilities.
8. Dividends are NOT an expense – they go directly to retained earnings.
9. Do not confuse debits and credits for expense accounts.
10. Do not confuse debits and credits for asset accounts.