In accounting, revenues are recorded as credit balances, while expenses are recorded as debit balances. This is because of the fundamental principle of double-entry bookkeeping, which requires every transaction to have an equal and opposite effect on the accounting equation.
The accounting equation states that assets equal liabilities plus owner’s equity. Revenues increase owner’s equity, while expenses decrease it.
To understand why revenues have credit balances and expenses have debit balances, let’s dive a bit deeper into the accounting equation.
Owner’s equity represents the owner’s claim on the assets of the business. It is the residual interest in the assets of the entity after deducting liabilities.
When a business generates revenue, it increases its assets or decreases its liabilities, which in turn increases owner’s equity. For example, when a company sells a product or provides a service, it earns revenue, which increases its cash or accounts receivable (assets), and also increases owner’s equity.
To record this transaction, we follow the double-entry system. We credit the revenue account to increase its balance, reflecting the increase in owner’s equity. By crediting the revenue account, we are saying that the owner’s equity is increasing due to the revenue earned.
On the other hand, expenses are costs incurred by a business to generate revenue. They decrease owner’s equity because they reduce the amount of profits or increase the amount of losses.
When an expense is incurred, assets or liabilities of the business decrease, which in turn decreases owner’s equity. For instance, when a company pays for rent or employee wages, its cash decreases (an asset), and owner’s equity decreases as well.
To record this transaction, we debit the expense account to increase its balance, indicating the decrease in owner’s equity. By debiting the expense account, we are saying that the owner’s equity is decreasing due to the expense incurred.
Revenues are credited because they increase owner’s equity, while expenses are debited because they decrease owner’s equity. This aligns with the double-entry system of accounting, where every transaction affects at least two accounts and maintains the balance in the accounting equation.
It is important to note that while revenues and expenses have different effects on owner’s equity, they both contribute to the determination of net income or net loss. Net income is calculated as revenues minus expenses, and it ultimately impacts the overall financial performance of the business.