You didn’t go into business to become an accountant, so it’s understandable that you’d have questions like: “are expenses debit or credit?”
In short, because expenses cause stockholder equity to decrease, they are an accounting debit.
It’s helpful to understand why.
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Understanding Debits and Credits
Let’s start with some basic Accounting 101. We may have moved away from “managing the books” in an actual paper ledger and painstakingly entering each journal entry with a quill pen, but the premises of accounting remain untouched through time.
There are five primary account types you have:
- Assets: Cash or things like land, equipment, or business vehicles that could be converted into cash.
- Expenses: What you spend money on to operate the business.
- Liabilities: Debts you owe an individual or other business (your accounts payable).
- Equity: Take the value of your liabilities from the value of your assets to get this.
- Revenue: Cash earned through sales.
Going further, each of these types of accounts falls into two primary types of accounting entries:
Debits: money taken from your account to cover expenses. Liability, expense.
Credits: money coming into your account. Asset accounts, equity, revenue.
These two entries must balance each other out. If, for example, you have a debit of $1,000 from the purchase of a new computer, you would then create an equal credit for the asset of the computer. This system of having a balance is called double-entry accounting and has been around since 1494 when Franciscan friar Luca Pacioli (the Father of Accounting) first published a book using this system.
The terms ‘debt’ and ‘credit’ actually can be attributed to him. In Latin, debere means to owe and credere means to entrust. Makes sense, right?
Key Financial Statements
Debits and credits come into play on several important financial statements that you need to be familiar with.
This is a snapshot of the profitability of your business. At the top are listed all your revenues. Below are all expenses or losses, including accounts payable accounts. At the bottom, you’ll find your net income: revenues minus expenses. This is the amount you have left after you’ve paid all debts.
If you ever apply for a small business loan or line of credit, you may be asked to provide your income statement.
The focus of this report is on assets and liabilities. It’s a financial snapshot of how your business is doing. Investors care about your balance sheet because they can see whether there is enough cash for them to take a dividend. If you’re considering selling your business, a potential buyer will want to see what assets you have on the balance sheet.
Statement of Cash Flows
Cash flow is hugely important for any business. It provides information about your cash payments and cash receipts, as well as the net change of cash after all financing and operating activities during a set period.
If you take out a loan, for example, you’ll have cash in the bank, but that’s not revenue. It does, however, impact the available funds you have to operate your business.
But Wait, What About Equity Accounts?
Accounting can be quite the rabbit hole to go down, but in the long run, you’ll be glad you took the journey!
Equity, as we first discussed, is a credit.
Shareholders’ equity is the net amount of your company’s total assets and liabilities.
Here’s an example:
200,000 operating expenses
$500,000 – $200,000= $300,000
With this scenario, your shareholders’ equity would be $300,000.
This number is important to potential investors because it helps them understand your net worth. If they see steady growth in your shareholders’ equity through increased retained earnings, your company may be an appealing investment.
On to Expenses
Yes, we took the circuitous route to get back to the question about debits and credits, but understanding how your business account works, and how an asset or liability affects an accounting entry was important before we got back to the question of whether expenses are a debit or credit.
Again, because expenses cause stockholder equity to decrease, they are an accounting debit.
While it might sound like expenses are a negative (they are, after all, cutting into your profit margin), they actually aren’t. First of all, any expense you have is (hopefully) for the betterment of your business. Your salaries expense allows you to bring in the brightest people in your industry to help you grow the company. Raw materials expenses allow you to create finished goods you can then sell for a profit. Even the accounting software you pay for each month helps you stay organized with each accounting transaction.
Expenses also reduce your credit accounts, which means you are taxed on a lower annual revenue number. Let’s say you earned $300,000 last year. You had $280,000 in deductible business expenses. So you will generally be taxed on $20,000, not $300,000, and that tax bill will be lower, thanks to those expenses.
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The Key to Smartly Managing Expenses
Even if your accounting software automatically downloads each liability transaction and invoice, you still should be involved with your accounts, adjusting entries when needed.
Come tax time, each expense transaction will need to be appropriately categorized. Yes, your software may download each debit card transaction, but it won’t necessarily choose the right category for the expense. And if you pay for services with your business credit card, you’ll have to note what those expenses were for. These categories include things like:
- Office supplies
- Employee benefits
- Bank fees
Set a reminder each month to go into your software to ensure that each transaction is appropriately categorized. Then, tax time will be a lot easier.
And as you start to explore your business financing options, the more organized you are with your ledger, as well as accounts payable and receivable, the easier it will be for potential lenders or investors to understand your company’s financial health. Simply having lots of sales and earnings doesn’t give a true understanding of whether you are financially solvent or not.
Another good idea to ensure you’re a low-risk investment is to take a look at your business credit report to understand how creditors see your company. That, along with checking your free business credit scores, can help you have a good handle on your finances.
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