Finance Definitions: Credit Vs. Debit

Finance Definitions: Credit Vs. Debit

Hi y’ all! Please join MomVesting as we welcome Mitchell Pauly, a guest blogger who loves to discuss finance in fun, funny and informative ways. We look forward to his continued definition contributions while he builds his own site; so put on your spectacles and get ready to learn and laugh!

Debits and Credits

Remember learning punctuation in grammar school? If you were like me you didn’t understand what the big deal was — like, who cares, right?** In hindsight, probably not our proudest educational moment; alas, we understand that punctuation is an essential part of communicating with language. Since most of my friends’ eyes glaze over like a redneck in a foreign film theatre when I talk about finance, I know that finance has a language unto itself. To learn that language it helps to begin with some of its most basic concepts: debit and credits.

You’ve read this far so I guess now I can let you know that you got here under false pretenses. I have to explain Double Entry Bookkeeping in order to fully flush out debits and credits. Sorry I snuck that one in here…

Double Entry Bookkeeping

In double entry bookkeeping two entries are made for every single transaction. Think about it: money has to move from one place to another; so it makes sense that it would require two entries. It’s these entries that are called either a debit or credit.

In business, a debit is an increase to expenses and a decrease to revenue, and a credit is a decrease to expenses and an increase to revenue. Read that again. The trick to knowing which is which is to identify the two components of a transaction: which is the debit and which is the credit?

Debits and Credits

If I transfer money from my checking account to yours, I am debiting my account and crediting yours (two entries, one transaction). So you know that in this case a debit is a decrease while a credit is an increase (now you know how a debit card got its name). For most people, this is as simple as it need be, but humor me.

Let’s now think about a paycheck and then a single purchase made with the paycheck. Think of your entire paycheck as revenue because, in the business of your life, it is. Taxes would then be debits on your paycheck because they work to reduce your revenue.

Now let’s say your employer pays you a non-salary bonus (because nothing has caught fire recently ); that would be an increase in revenue and thus a credit. Let’s move on from that transaction: feeling good because of your bonus you go out and buy a pair of Dutch wooden clogs. The cost of these shoes would be a debit to your checking account because it’s an increase in expense. Oh no! The clogs broke (now you know why they went out of style), so you return them; the money you get back would be a credit to your account.

The concept of debits and credits is linked arm in arm with that of double entry bookkeeping. In day-to-day life it’s probably hard to imagine thinking about things specifically in that light — you probably won’t. But you may wish to take the general concept (two entries, a debit and a credit, for every single transaction) and apply it to the peripheral financial concepts you will learn on this site; to perhaps some of the most important transactions you make regularly. After a while you will be using the terms fluently, I promise you. As for my friends; well, they might as well start growing mullets.

**If you weren’t like me, cut me a break and roll with the intro, all right?

Mitchell Pauly is a Financial Professional with experience working for Fortune 500 companies and small businesses. He enjoys investing and personal finance, comedy and sports. In his spare time he writes for various publications about personal finance, with a mind towards young adults and parents of young adults.

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MoneyCone's picture

MoneyCone wrote:

Mon, 09/12/2011 - 14:59 Comment #: 1

Very nice intro to finance basics Mitchell!

Alex | Perfecting Dad's picture

Alex | Perfecting Dad wrote:

Mon, 09/12/2011 - 20:23 Comment #: 2

I always hated the terms debit/credit. Credit always felt like a good word, but it's only good for income. When it comes to an asset, a credit means the value goes down. You want debits on your assets, which hopefully are created from credits in the income. Avoid debits in the expenses and credits to the liabilities.

So your checking account and clogs examples are a bit incomplete. If you consider the accounts as assets, then the one giving the money would experience a credit to the asset and the one getting would experience it as a debit to their asset. Here is how the double-entry transaction works in detail for the Giver and Getter of the money.

Bank Liability to Giver: Debit
Asset of Giver: Credit
Expenses of Giver: Debit
Revenue of Getter: Credit
Asset of Getter: Debit
Bank Liability to Getter: Credit

Equal Debits and Credits means it is in balance and no money has been "lost".

I believe most regular people don't need double-entry and don't think of income, expense, assets and liabilities as being different. They therefore won't have all the accounts needed to do the double-entry.

Detailed Clogs Example

Paycheck: Credit to income and debit to bank account
Buy the clogs: Debit to expense and credit to bank account.

- or with a credit card -

Paycheck: Credit to income and debit to bank account
Buy the clogs: Debit to expense and credit to credit card loan
Pay the credit card: Credit to bank account debit to credit card loan

Again, it seems like taking money out of the bank account should be a debit, but it's a debit from the BANK'S point of view because the bank owes you less money meaning that their liability has been reduced. To the owner of the account it's a credit.

Christa Palm's picture

Christa Palm wrote:

Wed, 09/14/2011 - 19:03 Comment #: 5

On behalf of Mitchell: thank you both for your kudos and clarifications! We try to keep things simple for definitions posts, but we definitely appreciate any additional clarification feedback!

Financial Definitions - Glossary for Understanding Finances 's picture

Financial Definitions - Glossary for Understanding Finances wrote:

Thu, 01/19/2012 - 21:46 Comment #: 6

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