System of debits and credits to increase and decrease account balances in the ledger

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All transactions could be recorded in columnar fashion as increases or decreases to elements of the accounting equation. However, even for a very small company with few transactions, this would become cumbersome. So, most companies use a process called the double-entry system . The term double-entry refers to the dual effect that each transaction has on the accounting equation.
Elements of the accounting equation are represented by accounts which are contained in a general ledger . Increases and decreases in each element of a company’s financial position are recorded in these accounts. A separate account is maintained for individual assets and liabilities, retained earnings, and paid-in capital. Also, to accumulate information needed for the income statement, we use separate accounts to keep track of the changes in retained earnings caused by revenues, expenses, gains, and losses. The number of accounts depends on the complexity of the company’s operations.

An account includes the account title, an account number to aid the processing task, and columns or fields for increases, decreases, the cumulative balance, and the date. For instructional purposes we use T-accounts instead of formal ledger accounts. A T-account has space at the top for the account title and two sides for recording increases and decreases.

For centuries, accountants have effectively used a system of debits and credits to increase and decrease account balances in the ledger. Debits merely represent the left side of the account and credits the right side, as shown below

Whether a debit or a credit represents an increase or a decrease depends on the type of account. Accounts on the left side of the accounting equation (assets) are increased ( + ) by debit entries and decreased ( − ) by credit entries. Accounts on the right side of the accounting equation (liabilities and shareholders’ equity) are increased ( + ) by credit entries and decreased ( − ) by debit entries. This arbitrary, but effective, procedure ensures that for each transaction the net impact on the left sides of accounts always equals the net impact on the right sides of accounts. For example, consider the bank loan in our earlier illustration. An asset, cash, increased by $40,000. Increases in assets are debits. Liabilities also increased by $40,000. Increases in liabilities are credits

The debits equal the credits in every transaction (dual effect), so both before and after a transaction the accounting equation is in balance. Prior exposure to the terms debit and credit probably comes from your experience with a bank account. For example, when a bank debits your checking account for service charges, it decreases your account balance. When you make a deposit, the bank credits your account, increasing your account balance. You must remember that from the bank’s perspective, your bank account balance is a liability it represents the amount that the bank owes you. Therefore, when the bank debits your account, it is decreasing its liability. When the bank credits your account, its liability increases.
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