You have completely missed the point, which is that the way in which accountants use these words is unnecessarily confusing because it does not align with the common English definitions of the words "credit" and "debit".
Yes, sorry, I was defending the established terminology without making clear why.
My problem is that your alternatives don't just change the words, they change the logic. The invariant of debit/credit is that they need to balance out.
If you choose words that can occur on both sides of the equation then this is no longer true and you're throwing out a lot more than just the admittedly unintuitive meanings of these words.
> My problem is that your alternatives don't just change the words, they change the logic.
No, they don't. They just change the words you need to express the logic.
> The invariant of debit/credit is that they need to balance out.
Sure. So? If I give you a dollar, that's going to balance whether we call that a debit to me and a credit to you or a credit to me and a debit to you. The labels don't matter.
What matters is that the labels are different on each side of the equation.
That contradicts your suggestion that we should use the intuitive meaning of the words and it contradicts your suggestion to 'just use "credit" for any increase, and "debit" for any decrease'.
Let's say a company raises equity (i.e it issues new shares), money comes into the bank account. In traditional terminology that would result in:
debit bank
credit equity
According to your suggestions, however, raising equity would result in
increase bank
increase equity
This violates the principle that the sum of labelAs need to cancel out (or balance out) the sum of labelBs. And this is why I said that you're changing the logic.
It doesn't matter whether you encode the signs in the terminology or in the equation. If you say X + Y = 0 i.e. X = - Y and stipulate that a transaction adds to X and subtracts from Y, that is completely equivalent to saying X - Y = 0 i.e. X = Y and stipulating that a transaction adds to both X and Y.
Sure, but if you want to keep your terminology consistent with the math, you would then have to make a distinction based on the types of the accounts involved in a journal entry.
E.g, this would be correct:
increase bank
increase equity
but this would be incorrect:
increase bank
increase receivables
If all numbers are positive then there would be no way to check whether the journal entries balance out without considering the account types.
If, on the other hand, you encode the sign in the amounts then the sign would disagree with the semantics of the label and you would have to flip signs based on the account type at the time of recording the entries:
> you would then have to make a distinction based on the types of the accounts involved in a journal entry
That's right. The distinction is based on whether the account represents an asset or a liability.
> increase bank
> increase receivables
You would have to define what you mean by "bank" in order for this to make sense. But in general, receivables represent money that a company is owed from orders that have not yet been paid for, i.e. they are a effectively a loan from the company to its customer, and like all loans they are an asset to the creditor, which in this case is the company. When a payment is made against an outstanding receivable, the receivable is debited (the loan balance is reduced) and the company's cash balance is credited. Because cash and receivables are both assets, these add together and cancel out just as you would expect.
The rules under my system are still very simple:
1. Every financial asset is someone else's liability, and vice versa. Cash is an asset to its owner and a liability to society at large. Loans are assets to the creditor and a liability to the debtor. Purchase orders are a liability to the purchaser and an asset to the supplier. Etc. etc.
2. Every financial transaction is a change in someone's liability coupled with a change of equal magnitude in someone else's assets.
3. The absolute value of your assets minus the absolute value of your liabilities is your net worth.
A completely equivalent formulation is that liabilities have negative signs attached to them, and then your net worth is the sum of your assets and liabilities, but this is just a question of where you hide the negative sign. A - B is the same as A + (- B). It really doesn't matter except insofar as one convention might make it easier to think about things. Most people are used to seeing their liabilities expressed as positive numbers, i.e. if you owe money on your credit card bill, the balance due is positive, and if you have a credit balance, the balance due is negative. But it's all just a shell game with where you hide the signs.
Instead of grouping together accounts into credit-normal and debit-normal, to make things balance, I think it’s more intuitive to group accounts by usage and use negative numbers.
Asset and Liability accounts appear on a Balance Sheet and are called State accounts. State accounts track the current state of your net worth.
Income and expense accounts appear on an Income Statement and are called Change accounts. Change accounts since they track why your net worth changed.
>You would have to define what you mean by "bank" in order for this to make sense.
Bank means bank ledger account. The bank balance and receivables cannot both increase because they are both assets.
>That's right. The distinction is based on whether the account represents an asset or a liability. ... A completely equivalent formulation is that liabilities have negative signs attached to them
Understood. My point was merely that you cannot just change the labels.
The downside of this approach is that you would no longer be able to see whether a journal entry balances out based on the labels alone.
> The downside of this approach is that you would no longer be able to see whether a journal entry balances out based on the labels alone.
Yeah, well, there is this cool new invention called a "digital computer" that can help a lot with that. You don't have to keep the ledger on paper using quill and ink any more.
Absolutely, but digital documents are not accounting software either. Communication would definitely get harder if we lose debit/credit and with it the left/right visualisation of T accounts.
Perhaps some simple convention would help, like attaching +/- to account names. We do have account numbers and accountants know their meaning but most people don't.
> It would be very confusing to label expense accounts as "liability".
Why?
> expenses do not necessarily increase liability.
That depends on what you mean by "expenses". If you give someone an expense account, that is a commitment to make payments for expenses, i.e. debt, so it's a liability. When you actually pay for those expenses (or reimburse someone for incurring those expenses) you are paying off debt and reducing your liabilities. Why is that confusing?
> And then there are accounts that can be assets or liabilities depending on their balance.
Sure. So? An asset account is one which represents assets when its balance is positive, and a liability account is one which represents liabilities when its balance is positive. A negative balance in an asset account is a liability, and a negative balance in a liability account (like a credit card, for example) is an asset.
You could do away with this convention and just represent all assets as positive values and all liabilities as negative, but people are used to distinguishing "money that you have" from "money that you owe" and having both of those represented by positive numbers in the usual case.
>That depends on what you mean by "expenses". If you give someone an expense account, that is a commitment to make payments for expenses, i.e. debt, so it's a liability.
This is not what expense account means in accounting. An expense account is an account that records expenses incurred such as your AWS bill, rent payments or salaries paid.
These are not liabilities and labelling them as such is more than confusing.
>Sure. So? An asset account is one which represents assets when its balance is positive, and a liability account is one which represents liabilities when its balance is positive.
Exactly, so how do you label it if it can be either? The only way I see is to label it according to its main purpose and accept that it's sometimes semantically wrong. That's effectively what the chart of accounts does.
> An expense account is an account that records expenses incurred such as your AWS bill, rent payments or salaries paid.
Ah.
> These are not liabilities
Well, that depends.
Every expense that involves an invoice or purchase order that is not paid immediately in cash must be recorded as two transactions. The first transaction is the issuing of the invoice or the PO. That transaction is a liability to the buyer, an asset to the seller. The second transaction is the payment of the invoice. That transaction involves a decrease in the buyer's cash reserves (asset) and a discharge (decrease) of the the buyer's liability, and an increase in the seller's cash reserves (asset) and a decrease in the seller's accounts receivable (asset).
When I look in "accounting for dummies" type web sites, they all give examples of expense accounting as a single transaction. That is deeply broken. If you try to record an expense as a single transaction then your balance sheet is going to be wrong if you have any unpaid invoices, either payable or receivable. In fact, recording an expense as a single transaction doesn't even work if you're paying cash in a brick-and-mortar store unless you literally keep all your cash as physical cash in a safe because ATM withdrawals are transactions that need to be recorded too.
In a situation like an employee being reimbursed for a travel expense there are at least four transactions:
1. The employee using their credit card to buy something (liability to the employee, asset to the merchant)
2. The merchant getting paid by the credit card company (converting a receivable into cash, i.e. trading one asset type for another)
3. The employee submitting their expense report (invoice) to the company for reimbursement (liability to the company, asset to the employee)
4. The employee getting paid by the company for the incurred expense (company converts asset into a discharge of liability, employee converting receivable into cash)
I say "at least" because if there is a credit card involved then step 2 actually involves a bank issuing a loan to the credit card holder, so there is an additional entity involved, and more transactions on their end. And of course when I say "cash" I actually mean "demand deposit" which is not quite the same thing, though people tend to conflate the two.
I think you’re missing the balancing that needs to happen that’s internal to each party’s books. That’s where an expense account would come in, using the accounting equation:
∆ State = ∆ Change
↓
Assets - Liabilities = Income - Expense
For example you had:
> 3. The employee submitting their expense report (invoice) to the company for reimbursement (liability to the company, asset to the employee)
So looking just at the company’s books:
$0 Asset - $100 Liability = $0 Income - $100 Expense
-$100 State = -$100 Change
Then in step 4:
> The employee getting paid by the company for the incurred expense (company converts asset into a discharge of liability, employee converting receivable into cash)
The company’s books would be:
-$100 Asset + $100 Liability = $0 Income - $0 Expense
$0 State = $0 Change
So the net impact on the ledger would be (putting these entries together):
-$100 Asset - $100 Liability + $100 Liability = $0 Income - $100 Expense
-$100 Asset - $0 Liability = $0 Income - $100 Expense
-$100 State = -$100 Change
Which is exactly what the company’s books would have recorded if they were using cash accounting instead of accrual. They spent $100 on an Expense.
So I think it’s super important to make a distinction between Liability and Expense Accounts because they’re on different sides of the accounting equation - State and Change. The same distinction applies to Asset and Income Accounts. [1]
You're right, I did leave that out. But you also left something out: equity. The real equation is that ∆ State = ∆ Change = ∆ Equity. So there are really three things that need to balance (or four or six if you consider the counterparty's books and depending on how you count). But the income/expense really has nothing to do with the actual transactions, they have to do with the arcane rules around paying your taxes as a business entity, where you can be taxed on income you haven't actually received yet, and deduct expenses you haven't actually paid yet, or not be allowed to deduct expenses you have paid until long after you've actually paid them (depreciation). This is generally not applicable to individuals running lemonade stands. This is (and I know you know this) the difference between cash and accrual accounting. Those terms hide the fact that the difference between these two is mostly a reflection of tax law.
Accrual is also a way of doing implicit projections into the future, which made sense back when accounting was done with pen and paper, and payments could not be initiated by the payee. In that world, there was no such thing as (for example) an automatically renewable subscription. Today there is. How would you account for signing up for such a subscription? Theoretically, an open-ended automtically renewable subscription is an infinite liability (unless you start taking interest rates into account, but of course no one does that because no one knows what interest rates are going to be in the future). The Right Way to do this is to keep track of it as an infinite series of transactions with time stamps, which would be impossible to do with pen and ink, but is trivial for a computer.
> The common English use of 'credit' and 'debit' is correct,
Yes, by definition.
> The mistake is that we talk about them as "our" accounts.
No. The mistake is the failure to recognize that every account is actually two different accounts, one for each party to a transaction. A bank account looks different to the bank than it does to a depositor or to a borrower. To a depositor, a positive balance is an asset -- quite literally "money in the bank". To the bank, a positive balance in a deposit account is a liability, a loan that it has taken from the depositor on which it must pay interest (at least sometimes) and which it must eventually pay back. To a borrower, a positive balance on a loan is a liability, to the bank it's an asset. Every financial asset is a liability to some counterparty. Even cash is a liability to society at large. So whether something is an asset or a liability depends entirely on your point of view, and so if both parties are going to use the same number to represent an account balance, it is an arbitrary choice what the sign represents. A positive number is always going to be an asset to one party and a liability to the other. Which is which is totally arbitrary, except that there are some deeply entrenched conventions: a positive balance on a deposit account at a bank represents an asset to the depositor, a liability to the bank. A positive balance on a loan represents an asset to the lender, a liability to the borrower. A positive balance on an invoice represents an asset to the seller and a liability to the buyer. But there is no inherent reason why it has to be that way, it's just tradition.
Likewise, whether "credit" means "increase" or "decrease" is also simply a matter of convention. A "credit" to a deposit account means the balance goes up. A "credit" to a loan account (i.e. a loan payment) means the balance goes down. The thing that unifies these things is that a "credit" is either an increase in an asset or a decrease in a liability since both assets and liabilities are recorded by convention as positive numbers. So in isolation (i.e. without a balancing double-entry transaction), a (positive) credit increases your net worth and a (positive) debit decreases it.
