What it means
In double-entry bookkeeping, every transaction is recorded twice, once as a debit and once as a credit. A credit increases liabilities, equity and revenue, and it decreases assets and expenses.
The side on which an amount appears is a convention, not a judgement of good or bad. The system is built on the rule that total debits must equal total credits.
When a company buys equipment on account, it debits the equipment account and credits accounts payable, so the books stay in balance. A trial balance, which lists every account, checks that this rule still holds at any point in time.
In everyday business use, credit means permission to pay later. A supplier who delivers goods with 30 days to pay is extending trade credit, and a bank that agrees to lend money is extending credit in the form of a loan or an overdraft.
Customers who do this are said to buy on credit. A credit also appears in documents such as a credit note, which reduces the amount a customer owes, for example after returned goods or a pricing error.
A tax credit is different again, because it directly reduces the tax payable. Credit decisions are based on creditworthiness, which is the lender's view of how likely a borrower is to repay.
Lenders look at financial statements, payment history, collateral and the borrower's cash flow, and they set limits and terms to match the risk. Because the same word is used in different ways, context is vital.
In the accounts, a credit is a position in the ledger, and in sales or banking, a credit is a form of financing that creates a receivable for the provider and a payable for the user. Reading the surrounding sentence usually shows which meaning is intended.
In practice
Real-world examples
Example 1
A wholesaler sells $20,000 of goods to a retailer with 45 days to pay. In the wholesaler's books, it credits Sales $20,000 and debits Accounts Receivable $20,000, and the retailer enjoys trade credit. The wholesaler waits 45 days for the cash, so it must have enough funding to cover that gap.
Example 2
A business takes a $100,000 loan from a bank. It debits Cash $100,000 and credits Loans Payable $100,000, which shows that the bank has extended credit to the business.
Example 3
A customer returns damaged goods worth $1,500. The seller issues a credit note for $1,500, which reduces the customer's balance and is recorded by crediting Accounts Receivable and debiting Sales Returns. The customer's next statement shows the lower balance owed.
Think of it
Credits are like the opposite end of a seesaw from debits. When one side goes up, the other must go down to keep everything balanced.
Formula
Calculation
Total debits = total credits
A business buys equipment for $12,000 and agrees to pay the supplier in 30 days. The entry is: debit Equipment $12,000 and credit Accounts Payable $12,000. Debits of $12,000 equal credits of $12,000, so the books balance. When the business pays 30 days later, it debits Accounts Payable $12,000 and credits Cash $12,000, which clears the debt and reduces the cash balance by $12,000.Case study
Seen in the real world
Kestrel Office Supplies is an illustrative, fictional distributor that sold to 300 small businesses. It offered 30 days' credit to every customer, and within a year its receivables had grown to $640,000 while its own bank credit line was nearly used up.
The finance manager reviewed the customer list and found that 40 customers regularly paid 60 days late. She tightened credit for slow payers, required prepayment for the worst five and offered a 1% discount for payment within 10 days.
Within two quarters, receivables fell by $150,000 and the company could reduce its borrowing. In this illustrative case, managing the credit it gave to customers was as important as managing the credit it received from the bank.
Watch out
Common mistakes
- Thinking a credit in bookkeeping always means money coming in, when it simply means an entry on the right-hand side of the account.
- Extending credit to customers without checking their ability to pay, which leads to bad debts and tied-up cash.
- Confusing a credit note with a refund, when a credit note reduces what the customer owes and may be used against later purchases.
Questions
People also ask
Is a credit good or bad on a bank statement?
A credit on your own statement is money coming in, but in your company's ledger a credit may be an increase in a liability or income. The bank's records are a mirror image of your own, which causes the confusion.
What is the difference between a debit and a credit?
They are the two sides of every entry, with debits recording increases in assets and expenses and credits recording increases in liabilities, equity and income.
What is trade credit?
It is the time a supplier gives a customer to pay for goods or services, which acts as a short-term interest-free loan. For the buyer, it is one of the cheapest sources of funding available.
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