Personal Finance: The Importance of a Clean Credit History

n accounting theory, the financial aspects of an entity, stated in terms of units of currency, are calculated using the accounting equation which is that Capital (or Equity or Net Worth) equals the value of your Assets (things you own) less the value of your Liabilities (things you owe); this is more often rearranged as: Assets equal Liabilities plus Capital. Each Asset, Liability and Capital account contains debit and credit transactions that allow for the calculation of values for these accounts.

Debits and credits are a system of notation used in accounting to keep track of money movements (transactions) into and out of an account: money paid into an account is a debit, money taken out of an account is a credit. Traditionally, an account's transactions are recorded in two columns of numbers: debits in the left hand column, credits in the right. Keeping the debits and credits in separate columns allows each to be added up independently so that the total debits and credits can be calculated; the smaller of the two totals is then subtracted from the larger to get the account balance. If an account has a debit balance then it owes money (to someone) because more money has been paid into it than has been drawn out, if it has a credit balance then it is owed money. Some accounts would normally have a credit balance because money usually only ever comes out of them (a salary account for instance), some normally a debit balance (a weekly shopping expense account, car fuel account).

What is often confusing is that the notion of debit and credit will depend on the perspective of the person preparing the accounts, even though they may be essentially the same account. Take your bank account for example. In your accounts when you pay money into your bank account it is recorded as a debit, your bank account is in debt to you - the bank owes you money. The bank's perspective is different however, their job is to keep track of where all the money in their 'vault' has come from and where it goes. To do this, they create an account for each customer so when you pay money into the bank, from their perspective, it has come out of your account (a credit) into their vault: your account is in credit - your account is owed money. When you receive a statement from your bank, it will give the state of your account from the bank's point of view, which is why people are used to the term 'your account is in credit' to mean that they have money in that account, when technically it means the opposite.

The two column system was developed in the days when accounts were done manually, and it is simpler and less error prone to add all the numbers in a column and then take the difference between the two results; but that is not the only reason it is used. In the double entry bookkeeping system, transactions never occur in isolation; money always moves from one account (credit) to another (debit): from your salary account to your bank account, from your bank account to your mortgage account, from your credit card account to your car fuel account, ... This means that each credit transaction must have a balancing debit transaction and that the sum of all credits in the accounts must equal the sum of all debits, if not, an error has been made; keeping separate debit and credit columns makes it much easier to check this. It is also very useful to analyse the cashflow of an account (where money came from and where it went), and again, the two column system makes it much easier to see this.

Computer accounts systems also normally use the double entry bookkeeping system and often present the accounts in the same two column system or a bank statement type format, do cashflow analysis, etc. Internally though, they would not usually use a two column system for an account but positive and negative numbers instead. Indeed, that is a convention (debits are positive, credits are negative) that goes back to the computer programming language COBOL.

The accounts are collectively referred to as the ledger. A journal is a place where entries (debits and credits) are written before they are written in the ledger. Modern computer systems generally have you make entries directly to the ledger and then produce printouts that are designed to look as if they were journals, which they may not be in reality. Of course, the computer software you are using will have a built-in feature to make sure your debits equal your credits, which is one of the chief benefits of old-fashioned journals anyway. For each transaction, one or more accounts are debited, and one or more accounts are credited. The total value of the debits must equal the total value of the credits. A debit journal increases the balance on a debit value account and reduces the balance on a credit value account. A credit journal increases the balance on a credit value account and reduces the balance on a debit value account.

In an asset account, a debit entry signifies the receipt of new assets, and thus represents an increase in assets. In a liability account, a debit entry represents a sum to be applied toward the satisfaction of the liability, and therefore decreases the liability.

There are different types of accounts and these accounts are expected to hold either a debit balance or a credit balance. Asset accounts and expense accounts are expected to always have a debit balance. Gain, Income and Liability Accounts are expected to always have a credit balance.