Lesson 7: Debits and Credits for Equity Accounts
We covered assets last lesson so you may think this one would be about liabilities. However, it makes more sense to cover income and expense accounts at this point.
Equity accounts are broken down into two different groups based on the two primary financial statements: Balance-Sheet-only accounts and Income Statement accounts. It is important to note that the Balance Sheet tracks all financial activity of a business/individual, whereas the Income Statement only tracks income and expenses. I will cover the distinction in great detail in later lessons. For this lesson, you just need to know that income and expense accounts are equity accounts on the Balance Sheet.
For the most part, income and expense accounts are the most used equity accounts in personal finance. There is really only one Balance-Sheet-only equity account used in personal finance and there is a later lesson covering it. First things first, let's discuss the debit and credit mechanics of equity accounts; they are a little trickier than that of assets andlLiabilities.
Credit = Up
Debit = Up
Please note: In Figure 7A, the down arrows in the income and expense accounts were removed to make the concept easier to follow. There can be debit entries in an income account or credit entries in expense accounts but they are rare, especially for personal finance. You generally only use an income account when you receive money or use an expense account when you spend money, so entering a transaction to decrease those accounts is uncommon (unless you return purchases often).
Now, let's take a look at some examples to see how income and expenses affect your Balance Sheet and Net Worth:
Since income naturally increases equity, the income accounts act in the same manner as the Balance-Sheet-only equity accounts; credits increase them. Expense accounts are the opposite however; they are increased by debit entries. Expense accounts are known as a contra accounts, meaning the debit and credit mechanics work in reverse of the other accounts in the same section:
The higher an income account, the higher the overall equity (ie more money on hand = higher net worth)
The higher an expense account, the lower the overall equity; it's the reverse of its neighboring accounts
Example 7-1: You get paid $1,000 from your job, direct deposit to your Checking Account:
Left (Asset) Side: Since your Checking Account increased, a debit entry of $1,000 is entered into the account.
Right Side: A paycheck for wages or salary increases an income account (increasing equity/Net Worth).
Assets = Liabilities + Equity
$1,000 = $0 + $1,000
$1,000 = $1,000
With this example, your Net Worth (equity) has increased by $1,000, therefore an equity account must be involved in the transaction. I know that "Net Worth = Assets - Liabilities" sounds like a transaction simply increases an asset account and your Net Worth increases by default. The logic there is sound but double-entry mechanics does not work like that. Since the transaction increases equity, an equity account must be increased.
Example 7-2: You pay for $250 worth of expenses (such as groceries, entertainment, gas, etc.) with your Checking Account:
Left (Asset) Side: Since your Checking Account decreased, a credit entry of $250 is entered into the account.
Right Side: Again, expense accounts are contra accounts. Therefore, the offsetting debit entry increases the expense which decreases equity.
Assets = Liabilities + Equity
($250) = $0 + ($250)
($250) = ($250)
Important Note: This example shows why contra (reverse) accounts are necessary. A debit entry is needed on the equity side since a credit entry was used on the asset side. If the contra effect was missing, the debit entry would decrease the expense account (like a debit entry decreases the Balance-Sheet-only equity accounts and Income accounts). Decreasing an expense would increase equity, which obviously would be incorrect. The contra mechanics allow expense accounts to be increased (debited) when equity losses need to be recorded.
Click here to continue to the next lesson on income transactions.