In this essential Accounting A-Level guide, we'll cover the basics of double-entry bookkeeping and recording accurate debit and credit entries to financial statements. Welcome to Debits & Credits 101!
When you think of the Renaissance, what do you think about? Leonardo da Vinci? The Copernican Revolution? What about… accounting? While Michelangelo was sculpting David in Florence, Italy, at the turn of the 16th century, one of the most important financial inventions of the modern era was being quietly perfected in the same city; double-entry bookkeeping. Fast-forward a few hundred years to the 21st century and this method remains the dominant mode of bookkeeping for small businesses and transnational corporations alike. Unsurprisingly then, for A-Level Accounting students, it is a highly examinable part of the syllabus. Getting your debit and credit entries in order isn’t just a neat bonus, it’s critical to scoring the best marks in your exam.
So, with that brief history lesson out of the way, let’s get started!
A Tale of Two Financial Statements
Before we get into the weeds of making journal entries, we need to take a quick step back and consider what we are doing as accountants. After all, these exercises don’t exist in an academic vacuum! One of the key functions of a professional accountant is to record and display financial information in a way that is straightforward and easy to understand for a general user. Typically, our ‘general user’ will be the business owner or shareholders. Of course, there are plenty of other stakeholders who might want to keep an eye on the health of a company; the government, banks, employees… perhaps even yourself! This important information is typically split into a number of ‘financial statements’, each showing a different aspect of a company’s finances.
To use an illustrative example, take the ‘statement of cashflows’. This shows the impact of all the year’s transactions on the company’s bank balance. Why is this important? Having enough liquid assets – those that can be turned into cash at short notice – to cover a firm’s upcoming expenses and debts is vital for the company to continue as a ‘going concern’. This is a fancy way of saying that if we can’t pay for all of our costs – wages, loan interest, utilities, suppliers etc. – then we could face bankruptcy! The reason cashflow is critical is that it is entirely possible to run an otherwise successful company into the ground if finance facilities are not used judiciously. Say we make all of our sales on generous six-month credit terms, but our suppliers demand immediate cash payments, you can see how it wouldn’t take long for us to run out of money to stay afloat. Hence, an accurate cashflow statement – typically paired with a forward-looking cashflow forecast – can help management assess the risk of insolvency.
The two headline financial statements are the ‘statement of profit and loss’ (SPL, also commonly known as the ‘income statement’) and the ‘statement of financial position’ (SFP, otherwise called the ‘balance sheet’). Below I have written up a short summary of each:
- SPL: Shows the company’s profit or loss for a single period of time, typically one year. From top to bottom this is normally expressed as a gross profit (revenue – cost of sales), operating profit (gross profit – operating and administrative expenses), profit before tax (operating profit + other income – finance costs) and profit after tax (profit before tax – corporation tax). Any left-over profit is then taken as ‘retained earnings’, either to be re-invested by the company or paid out as dividends to the shareholders.
- SFP: Shows the company’s assets, liabilities and equity at a single moment in time, typically the final day of a year’s trading. As per the so-called ‘accounting equation’, a properly prepared balance sheet should, as the name suggests, balance such that assets = liabilities + equity. One way of thinking about this is that all the business’ belongings – cash, land, equipment, inventory, patents etc. – has to be funded through a combination of loans (liabilities), third-party investment or retained earnings (equity).
Attention! That final point is particularly pertinent for us. The accounting equation is the foundation of the double-entry bookkeeping system, and keeping it in mind will hold us in good stead as we now progress to the idea of debits and credits.
Debits and Credits in A Level Accounting – The Basics
To debit or not to debit, that is the question. I think. To put it plainly, any asset on the SFP will be a debit balance and any liability or equity balance will be a credit balance. We represent debit balances with a positive number and credit balances with a negative number. On the SPL, things work a little differently to how you might expect. Revenue is a credit, while all expenses are debits. Now, I know what you’re thinking:
“Oscar, why on earth is revenue a negative number?!”
Don’t forget about retained earnings! If the financial year ends in a profit – that is to say, a net credit on the SPL as we understand it – then we’ll transfer it over to retained earnings which exists as equity, a credit balance, on the SFP. If this doesn’t quite make sense right now, don’t panic. Just note the following and you’ll be fine:
- SPL: Revenue is a credit and expenses are a debit
- SFP: Assets are a debit and liabilities and equity are a credit.
DEAD CLIC – A Useful Mnemonic:
If you’re struggling to remember which balance is a debit and which is a credit, there is a helpful mnemonic which you can use. This is especially useful if you forget during your exam! The first word, ‘DEAD’, refers to debits:
Debit:
- Expenses
- Assets
- Dividends
If we debit an expense or an asset, we are increasing those balances. Dividends reduce our retained earnings – part of equity which is a credit balance – so they would also be a debit. ‘CLIC’ then covers our credits:
Credit:
- Liabilities
- Income
- Capital
As before, if we credit a liability or income, we are increasing those balances. Capital refers to equity, so whenever we receive cash from sale of shares, for example, we would credit equity. Of course, if you’re trying to reduce any balances, the reverse operation is required!
Double-Entry Bookkeeping - Worked Example
Now, whenever we make a double-entry, we make debit entries (DR) and corresponding credit entries (CR) which total to the same value. Think of it like Newton’s third law, except instead of dropping apples on Isaac's head we’re selling them to him. In fact, let’s pretend for a moment that we’re doing just that. How would we record such a transaction?
Well, as an independent apple vendor, we’ll first need to fund our little business and buy some inventory. Let’s say we put £10 in, and use £5 of it to buy 50 apples from the wholesaler and keep £5 left over as a rainy-day reserve. That initial £10 cash injection is equity – it’s our 100% stake in the business! – and the 50 apples and £5 cash balance are our company’s assets. We can make a double-entry to record our initial equity and how we used it:
- CR Equity £10
- DR Cash £5
- DR Inventory £5
Notice how the credit entry is the same value as the two debit entries we made: every transaction has an opposite reaction! Next, let’s draft a quick SFP to show our apple company’s initial standing:
Statement of Financial Position (Initial)
Assets
Cash £5.00
Inventory £5.00
Total Assets £10.00
Equity
Ordinary Shares £(10.00)
Retained Earnings £ -
Total Equity £(10.00)
As you can see, given there are no liabilities, the accounting equation holds true: assets = liabilities + equity.
Next, our friend Isaac comes along to buy 10 of our delicious apples, and we sell apples to the general public at £1/apple. So, after the transaction, we’ll have 10 less apples in stock but we’ll have made £10 in cash. Given we bought 50 apples for £5, each apple in our inventory is worth 10p so we’ll need to reduce our inventory balance by £1 (10 x 10p). Let’s record the first part of the two double-entries we’ll need to make:
- DR Cash, £10 (increasing our cash balance)
- CR Inventory, £1 (reducing our inventory balance)
These two entries show the impact on the SFP, so now we must turn to the SPL to close them off. The cash we just made is revenue, while the consumption of inventory is known as a ‘cost of sale’:
- CR Revenue, £10 (increasing our revenue)
- DR Cost of Sales, £1 (recognising the ‘expense’ of the apples sold)
Here, there’s an important accounting principle at play known as the ‘accruals concept’. That is to say, we only recognise revenue and expenses as they are incurred during a transaction. In this instance, even though we bought £5 worth of apples we can’t ‘expense’ them all because we haven’t sold them all yet! Moreover, we would still record revenue even when cash isn’t received for a sale:
Maybe Isaac decides that he wants more apples, but he’s out of cash. “No worries”, we say, “you can pay us back next week”. Isaac agrees, and he buys 20 more apples, promising to pay us back at a later date. Once again, we need to reduce our inventory and recognise a cost of sale in the SPL:
- DR Cost of Sales, £2
- CR Inventory, £2
We’ll also recognise revenue – we did make a sale after all! – but instead of posting the other side of the entry to our cash account we’ll set up a new asset type called ‘trade receivables’ (you might also see this referred to as ‘trade debtors’). Trade receivables are an accountant’s way of saying “Isaac owes us some money”, and that IOU is an asset. Let’s record this transaction too:
- DR Trade Receivables, £20
- CR Revenue, £20
Hey! This apple business is going pretty well! Time to create a short SPL to see our gross profit:
Statement of Profit and Loss (Initial)
Revenue £(30.00)
Cost of Sales £3.00
Gross Profit £(27.00)
Not bad, but of course, HRMC are going to want a slice of that! If we say corporation tax is charged at a flat 25% on profits, we’ll have to pay £6.75 to the taxman. Fortunately, they don’t mind if we pay them until a little later, so we can set-up an IOU of our own and record another double-entry and finish our SPL:
- DR Corporation Tax, £6.75 (adding a tax expense to the SPL)
- CR Tax Payable, £6.75 (this will appear as a liability on the SFP)
Statement of Profit and Loss (Final)
Profit Before Tax £(27.00)
Corporation Tax £6.75
Profit After Tax £(20.25)
We’re almost there! We’ve got a final profit figure of £20.25 (a credit balance, remember), so let’s transfer that from our SPL to our SFP as retained earnings:
- DR Profit After Tax, £20.25
- CR Retained Earnings, £20.25
For good measure, we should probably pay ourselves a dividend, right? We have been working hard after all! Seeing as we paid in £10 at the start, I propose we pay out £10 so we have a full return on our initial investment:
- DR Retained Earnings, £10 (reducing our retained earnings by our dividend amount)
- CR Cash, £10 (using the company bank balance to pay the dividend)
With that done it’s time to see if you’ve been paying attention. After the image below, I have added one final SFP which reflects all of the different transactions we’ve done in this example. Before you look at it, I encourage you to make your own changes to our initial SFP on a scrap piece of paper and see if you can come up with the same final SFP! Don’t forget to make sure it balances!
Statement of Financial Position (Final)
Assets
Cash £5.00
Inventory £2.00
Trade Receivables £20.00
Total Assets £27.00
Liabilities
Tax Payable £(6.75)
Total Liabilities £(6.75)
Equity
Ordinary Shares £(10.00)
Retained Earnings £(10.25)
Total Equity and Liabilities £(27.00)
Closing Thoughts and Next Steps
How did you fare? Did you miss any transactions? If you see any differences between your SPL and mine, I'd recommend going back and writing down all the double entries and then actioning them one-by-one. If yours did match, congratulations! You have now made your first steps towards becoming an accountant proper!
This blog has covered quite a few different topics beyond just debits, credits and double-entry bookkeeping, and all of them are critical to success in Accounting A-Level. If you're feeling a little overwhelmed, it's okay! While Accounting involves many discrete concepts which are simple, the challenge is piecing them all together to handle a variety of different financial transactions and situations. Even after reading an introduction liken this blog though, it's not uncommon to still struggle with debits and credits. If that's the case, Titanium Tutors are well-equipped to provide tailored support and guidance on any areas that need help. Inquire today via the links below this article and we can put you in touch with an Accounting tutor to give you an edge.
That's all from me! Stay tuned for our next Accounting blog which will hone in on how to get the best marks in the AQA Accounting A-Level exam. Until then, keep balancing!
Blog Post Crafted by Oscar
Oscar has been part of the Titanium Tutors team since 2019, when he was a PPE student at the University of Warwick.
For the past two years he has worked at Deloitte LLP, training to become an ICAEW Chartered Accountant within their Audit & Assurance department in Nottingham.
He is now taking a career break, and when he’s not writing on our blog, you can find him touring and gigging as the saxophonist for the jazz collective Mellowmatic, playing at major UK music festivals such as Glastonbury, Isle of Wight and Boomtown.