Ryan Hiebert
They don't just mean left and right. That's a useful oversimplification.
Types of accounts
In double-entry bookkeeping, there are five different types of accounts, as the most basic taxonomy that all accounting talks about.
- Assets are what you own.
- Liabilities are what you owe.
- Equity is what you are worth.
- Revenue is what you earn.
- Expenses are what you spend.
Assets are Debits
The word debit comes through Latin debitum, "what is owed," from debere, "to owe." It shares that root with the word debt. This can be confusing, because the quintessential example of a debit account is an asset, which is what we own, not what we owe.
But this is because we're thinking about the accounts backward from how they came to exist. Accounts aren't about us, they're about someone else's relationship to us.
An asset account would originally have been tracking something that somebody else owes us. For a modern example, a bank account is an asset, because it belongs to us. But it's a debit account, because that money is owed to us.
That becomes more obvious when we think of another common type of asset account, an Account Receivable. These represent amounts that have been billed to somebody else, such as a school bill or an invoice.
Assets extend this category sometimes by also including physical property, or cash we have on hand. This stretches the definition a bit because there's not another real person on the other end of the account. But if we anthropomorphize a bit we can make the analogy work. Pocket money is money that our pocket owes us. A building is money (value) that the building itself owes us.
A debit is a debt that somebody owes us.
Liabilities are Credit
The word credit comes through Latin creditum, "something entrusted or loaned," from credere, "to believe, trust, entrust." In other words, a credit is something that is entrusted to us. Once we realize this, it can be a little more intuitive that the relationship is oriented around someone else, not around us.
It's easier to see that we are entrusted with some money when we have a liability account, the premier example of a credit account. If we take out a loan from the bank, they are entrusting us with some money that we have agreed to pay back at a later date.
A common type of liability account is an Account Payable. When we receive an invoice, we owe a debt to somebody else, which means for that (hopefully short) amount of time, they have entrusted us with money they expect us to pay.
A credit is what someone has entrusted us with.
Owner's Equity
Equity, sometimes called "owner's equity", is how you track what belongs to the owner when all the assets and liabilities are settled. The common formula is
Assets - Liabilities = Owner's Equity
So is owner's equity a credit or a debit? The trick to figuring this out is that equity thinks of the owner as another party, rather than as ourselves. So owner's equity is something that has been entrusted to the business as capital. It's not just a liability, because liabilities have to be settled before any of the assets can be distributed to the owner. But the similarity is what helps us identify that owner's equity is credit.
Equity is what the owner has entrusted us with.
Transaction entries
When we think about individual changes to these accounts, we can apply the same names, debit and credit.
When we have an asset account receivable (a debt someone owes us) and someone hands us cash to pay it, they entrust us with the cash, and in exchange we are reducing the debt that they owe us. If we perform some additional good or service, that would increase the account receivable, as they now owe us for what we provided.
Conversely, when we have a liability account payable (an entrusted amount we have the responsibility to pay), by handing someone else some cash they owe us a reduction in our bill because of what we paid. If we buy something else from them, they again entrust us with the responsibility to pay them for what we bought.
So, a debit increases a debit account and reduces a credit account, where a credit increases a credit account and reduces a debit account.
Revenues and Expenses
Revenues and expenses take another step to rationalize their names. These are temporary accounts that keep track of changes to owner's equity. They are periodically rolled into the owner's equity by closing the books at the end of a period.
We do this by aligning the account's type with how a transaction would impact owner's equity. By separating them into two accounts, it allows us to accumulate them for the period. From there we can squint a bit and see a rationalization.
A balance in owner's equity is a credit, because it is what the owner has entrusted us with.
Expenses are a debit, because the owner owes us a reduction in their equity.
Revenues are a credit, because the owner entrusts us with an increase in their equity.
It's not about us
So that's the crux of why debits and credits are confusing. Unlike our standard account taxonomy, they aren't referring to us as the object, they're referring to the other party that we're in a relationship with.
But figuring out who is "us" and who is "someone else" is confusing. We're usually thinking about how we interact with other people, rather than how other people interact with us, which is how these terms came about. This confusion only compounds when you start to consider owner's equity, revenues, and expenses, which aren't so directly about relationships to other people in the first place.
So, we simplify. Debits are traditionally on the left side of a transaction journal. Credits are traditionally on the right side. And we just memorize which side each type of account belongs on. After a little while, this useful simplification sticks, and we stop thinking about what the words mean anymore, and care more about what they do.