We hear the terms “debit” and “credit” used on a daily basis. In the context of a conversation they can mean a different thing each time that we use them. In the context of accounting practices, debits and credits actually mean the opposite of what we would expect.
What do you think of when you hear the word “debit”? For most people today, they think of a debit card. The card is used to take money out of our account. We use it at ATM machines and in the store. For us, a debit means that we have less money in our account.
Switching to credits, a credit is seen as something that we get. Finance companies give us credit cards and we go crazy. It’s money that we didn’t work for but can use to buy other things. In our eyes, a credit is a positive thing.
Now, let’s pretend that we are sitting in an accounting class. The teacher asks us to explain debits and credits. Most likely, the explanation above is what the teacher will hear. However, this answer is wrong – at least partially.
According to accounting textbooks, any transaction that we make has a debit side and a credit side. This is neither good nor bad but a simple fact. If we take a second to think about it, the reasoning does make sense.
You go to the store and buy a pair of pants. You use your debit card to pay for it. The money is deducted from your account for the transaction. We understand that. Now, the money is being deposited as a transaction into the account of the store. This we also understand. As such, a type of transaction has taken place in each situation.
A debit is what was received by someone. A credit is what was used to get the thing that you received. If you’re still with me, then applaud! Accounting is not an easy thing to understand.
When you buy something and use a credit card, you receive the item that you wanted to buy. That is a debit even though you received something. We think of receiving something as a credit, but not to an accountant. The credit card company pays the bill, but this decreases their liability to you so it is a credit for them.
Liabilities are credit accounts. Putting money in the bank is a credit because it increases their liability. That is money that they must keep track of for you. When you remove money, it reduces their liability because your money is back in your hands. This is debit for them. We have come to use the bank’s terms for their transactions as our own, but it doesn’t always work that way.
Debits and credits are interesting if not a bit confusing. Suffice it to say, any transaction is made up of someone getting something and someone losing something.