Debits and Credits

Debits and Credits: A Clear Explanation


Let's say you are a caveman, and you use rocks for currency. Everything you have can be broken down like this:

5 rocks = 3 borrowed rocks + 2 owned rocks

The two sides of the equal sign must, obviously, be equal at all times. So if you give back some of the rocks you borrowed:

5 rocks = 1 borrowed rock + 2 owned rocks

Then you have to subtract an equal amount from the other side of the equation as well:

3 rocks = 1 borrowed rock + 2 owned rocks

And if, say, you bought a few more rocks, you would have to add more to both sides of the equation:

6 rocks = 1 borrowed rock + 5 owned rocks

Another possibility is to simply replace what you took away. If you give back 1 borrowed rock, but then borrowed 1 more rock, nothing changes so both sides of the equal sign are still equal.

So every rock transaction we make involves two transactions to keep everything equal on both sides of the equal sign.

OK, you ready for it?

An addition on this side is called a DEBIT = An addition on this side is called a CREDIT
A subtraction on this side is called a CREDIT = A subtraction on this side is called a DEBIT

So every transaction will involve one DEBIT and one CREDIT.

Now, how does this apply to real life?

Let's say you have:

$1000 cash = credit card debt of $1000 + $0

Now let's say you want to pay off $100 of this credit card debt. You would subtract $100 from cash, which throws the equal sign out of balance:

$900 cash = credit card debt of $1000 + $0

So, you would also subtract $100 from your credit card debt:

$900 cash = credit card debt of $900 + $0

Now both sides of the equal sign are equal. So what did you just do there? You subtracted $100 from the left side, and $100 from the right side; you CREDITED cash and DEBITED credit card debt, because:

An addition on this side is called a DEBIT = An addition on this side is called a CREDIT
A subtraction on this side is called a CREDIT = A subtraction on this side is called a DEBIT

Why is your bank card called a debit card? Because when you spend money from it, the money that the bank is borrowing from you (your checking account), is decreasing, or DEBITING:

bank's total cash = customer checking accounts + bank's own money

And your credit card is usually used to pay for things, and thus increases (for some of us, this is all it does). You are increasing the amount of money you are borrowing. So an increase on the right side of the equation, if you remember, is a CREDIT. Thus, a credit card!

Now, let's divide one of these items up further. Remember the amount you actually own? Two rocks?

5 rocks = 3 borrowed rocks + 2 owned rocks

Anything that increases these owned rocks is income, and anything that decreases it is an expense.

Let's say you need to spend your rocks on cave rent. You rent your cave from a local Neanderthal. He needs 2 rocks for rent. You aren't gaining anything for this; you are just having to spend your rocks to keep a roof over your head. So you subtract 2 rocks, an expense. And you need to subtract this from both sides:

3 rocks = 3 borrowed rocks + 0 owned rocks

Real life? You need to spend $500 rent on your apartment:

$1000 cash = $0 credit card debt + $1000

Obviously you'll need to subtract $500 in cash, but what is the other balancing transaction? You aren't paying off money you've borrowed; you are just paying an expense. So you need to subtract it from the amount you own:

$500 cash = $0 credit card debt + $500

Can you explain what we just did in DEBITS and CREDITS? Again, to drive the point home:

An addition on this side is called a DEBIT = An addition on this side is called a CREDIT
A subtraction on this side is called a CREDIT = A subtraction on this side is called a DEBIT

So you've CREDITED cash, and DEBITED rent, an expense. How about if you then receive your whopping $1000 paycheck?

$1500 cash = $0 credit card debt + $1500

Your income increases your cash, and it obviously doesn't increase your debts, so you have to add it to the amount you actually own. You've just DEBITED cash, and CREDITED income.

Now let's look at the technical terms for these:

Assets: cash or stuff that can be sold for cash
Liabilities: debt
Equity: what you actually own, whatever's left over after you pay off your debt

Arranged like this:

Assets = Liabilities + Equity

So think about what category your transaction falls under. If it's cash or a physical item or anything that can be converted to cash, it's an asset. If it's debt or loan, it's a liability. If it's an expense or income, it's equity.

An increase in an asset is called a DEBIT, and an increase in a liability or equity is called a CREDIT.

A decrease in an asset is called a CREDIT, and a decrease in a liability or equity is called a DEBIT.

That's it!