What is a Credit in Accounting?
Credit means different things depending on its context. For example, the amount available to borrow from a vendor. A credit in accounting is a journal entry with the ability to decrease an asset or expense, while increasing capital, liability or revenue. When using double-entry bookkeeping, these entries are recorded on the right-hand side.
Credits are one half of a fundamental accounting standard, opposite debits. Together, they make up the core of double-entry accounting practices, showing the movement of capital from one account to another, in and out of a business.
To better-understand credits in accounting, it’s best to explore them in context. Here’s a look at how they work as journal entries and their role in the accounting process.
Credits vs. Debits in Double-Entry Accounting
Credits and debits operate opposite one another in double-entry accounting. Every credit recorded requires an equal, offsetting debit somewhere else. Accountants will always record transactions in two accounts: credit to one, debit to the other.
For example, if ABC Company buys a new company car with $20,000 cash, it will need to record this transaction as follows:
- Credit the cash account for $20,000
- Debit the asset account for a vehicle worth $20,000
While a simple example, this showcases the importance of double-entry accounting and the purpose of credits and debits. When reviewing the company’s finances, an accountant will be able to match up these two transactions, bringing transparency and traceability to cash flows.
How Credits Affect Different Accounts
Credits have different meanings depending on which account they’re attributed to. It comes down to economic benefit: the flow of capital from a source to a destination. Here’s a look at how credits affect different accounts when applied as part of an economically beneficial transaction:
- Dividends. When a company issues a dividend, it reduces equity and increases liabilities. Credits represent a decrease to this account.
- Expenses. Crediting an expense account involves a decrease to the balance, usually offset by an increase in liability, revenue or equity.
- Assets. A credit to asset accounts will decrease the balance. For example, as inventory decreases, assets decrease while revenue increases.
- Liabilities. Credits increase the balance of liabilities accounts. The best example is a bank loan, which represents a borrowed source of capital.
- Equity. Credits to an equity account will increase the value, since they represent less of an obligation to pay back shareholders.
- Revenue. A credit to revenue is equivalent to an increase, since it records money coming into the business.
This breakdown of how they affect different accounts boils down to economic benefit. In fact, credits are the source of economic benefit. They represent where capital flows from. Accountants need to always keep this in mind when recording transactions. This is because the offsetting debit needs to represent the destination of economic benefit. Getting them correct across each type of account is the fundamental nature of double-entry accounting.
Common Accounting Actions
There are some common, everyday accounting actions that every business will record. Here’s a look at how they’re credited (and debited) based on the nature of the transaction and the accounts affected by the double-entry standard:
- Sale for cash: Debit cash, credit revenue
- Sale on credit: Debit accounts receivable, credit revenue
- Accounts receivable: Debit cash, credit accounts receivable
- Accounts payable: Debit accounts payable, credit cash
- Pay employees: Debit wages and payroll, credit cash
Accountants will always credit the account the money comes from and debit the account it moves to. Note that while there are always two accounts, many transactions involve more.
What Happens When Credits Outweigh Debits?
The purpose of double-entry accounting is to ensure balance between all credits and debits. At any point in a financial accounting period, debits should equal credits. If they don’t there’s a problem. When credits outweigh debits, it can mean one of several mistakes.
- There may be a debit misrepresented as a credit. Doubling up on credits can quickly throw the balance sheet into disarray. Thankfully, this mistake is less common in accounting software, since offsetting debits are automatically applied.
- Clerical error can create imbalance. A missed or moved decimal point, or mistyped number can mix up the credit. For example, entering $1,005 as $1,050 or $100,050 will both cause an excessive credit.
- Misattributing credits to the wrong account can also throw off the balance sheet. For example, crediting liabilities instead of expenses can skew the account balance and the offsetting debit.
An excess of credits on the balance sheet—no matter the reason—is a credit balance. Accountants will need to comb the balance sheet to identify misattributed transactions or where clerical error resulted in the excessive crediting. The purpose of auditing and trial balance generation is to spot and remedy these errors before the end of an accounting period, so the company can close its books.
A Cornerstone of Accounting
Credits make up one half of fundamental accounting practices, opposite debits. Credits (and debits) are neither good nor bad in terms of financial accounting—rather, they’re transacting variables. Without them, it wouldn’t be possible to see cash flows within a company or trace capital from one account to the next.
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Always remember that credits in accounting decrease assets and expenses, while increasing liabilities, revenues and equity. Understanding this relationship and double-entry accounting fundamentals makes it easier to read balance sheets and income statements. And this will help you better-understand the financial health and operations of a company.