One of my passions is helping people understand that accounting is really not that difficult. When presenting financial information during board meetings, or to a CEO, or to one of my small business clients, I get one of two reactions. First is one of fear that what is being presented comes from numbers that they won’t understand. Second, is a response of wishing that they had paid attention in accounting courses back in college. AskCPASam blogs are designed to make all of this understandable.
After a recent “Payroll Accounting” workshop, I was approached by one of the attendees who described her confusion over the words debit and credit. She explained that the use of those two words by her bank made it confusing to keep track of which one goes to which side in accounting. This entire post came out of that discussion. I don’t have the name of that aspiring payroll professional in Minnesota, but this blog is for you.
First, let’s lay some ground rules. In accounting, like algebra, everything must balance. In case any of my readers are unfamiliar with it, this is a “T” account. Values in both sides of the “T” accounts used in a transaction must add up to the same number.
Debit simply means “left.” Anytime something is debited or has a debit balance, you are dealing with the left side of the accounting equation or the left side of a “T” account.
Credit simply means “right.” Anytime something is credited or has a credit balance, you are dealing with the right side of the accounting equation or the right side of a “T” account.
In order to speak the language of accounting, these two words are the most fundamental. The accounting equation looks like this: Assets = Liabilities + Equity. That equates to what you own = how you paid for it. Notice there are two sides to that equation, a left side and a right side? The left side is always debit and the right side is always credit. Assets are debit balance. Liabilities and equity is always a credit balance.
Here is where the confusion arises. The bank always says they will debit your account when they are taking money away. They also say they are crediting your account when they add money. This leads people to believe that debit and credit must mean increase and decrease. Banks have a different view of your money than you do. All of your assets are actually liabilities to them. Any loans you have with them are actually assets to them since it is future money coming in. The conclusion is that banks are making us confused in accounting! To help de-fog the situation in my attendee’s mind, I came up with the following solution.
1. Debit card – a debit card has stored value. While the bank says they are debiting your account, remember that a debit card is always backed by the asset of a bank account. Your bank account may be tiny, but it still has some value. It is an asset. It is on the left. It is a debit!
2. Credit card – a credit card is a promise to pay or a liability after purchasing something. Liabilities come from the action of buying something. Liabilities are part of how you paid for something. It is the right side of the equation. It is a credit!
So the next time you are taking an accounting test or exam remember: assets = liabilities + equity OR debits = credits.
In closing, you know that all accounting jokes are only funny to accountants. One of my good accountant friends always says, “If you can’t make it balance, don’t worry! There’s always the Crebit!” For those non-accountants out there, he just combined debits and credits because after all, most people think accountants make all of this up anyway, especially if it won’t balance.