What Is Credit?
How do you define credit? This term has many meanings in the financial world, but credit is generally defined as a contract agreement in which a borrower receives a sum of money or something of value and repays the lender at a later date, generally with interest.
Credit also may refer to the creditworthiness or credit history of an individual or a company. To an accountant, it often refers to a bookkeeping entry that either decreases assets or increases liabilities and equity on a company's balance sheet.
- Credit is generally defined as an agreement between a lender and a borrower.
- Credit also refers to an individual's or business's creditworthiness or credit history.
- In accounting, a credit may either decrease assets or increase liabilities as well as decrease expenses or increase revenue.
How Credit Works
Credit is essentially a social relation that forms between a creditor (lender) and a borrower (debtor). The debtor promises to repay the lender, often with interest, or risk financial or legal penalties. Extending credit is a practice that goes back thousands of years, to the dawn of human civilization.
Today, a commonly used definition for credit still refers to an agreement to purchase a product or service with the express promise to pay for it later. This is known as buying on credit. The most common form of buying on credit today is via the use of credit cards. This introduces an intermediary to the credit agreement: The bank that issued the card repays the merchant in full and extends credit to the buyer, who may repay the bank over time while incurring interest charges in the meantime.
The amount of money a consumer or business has available to borrow—or their creditworthiness—is also called credit. For example, someone may say, "They have great credit, so they are not worried about the bank rejecting their mortgage application." Credit rating agencies work to measure and report the credit of individuals as well as businesses (and especially for the bonds that they issue).
In accounting, a credit is an entry that records a decrease in assets or an increase in liability as well as a decrease in expenses or an increase in revenue (as opposed to a debit that does the opposite). So a credit increases net income on the company's income statement, while a debit reduces net income.
Types of Credit
There are many different forms of credit. The most popular form is bank credit or financial credit. This kind of credit includes car loans, mortgages, signature loans, and lines of credit. Essentially, when the bank lends to a consumer, it credits money to the borrower, who must pay it back at a future date.
In other cases, credit can refer to a reduction in the amount one owes. For example, imagine someone owes their credit card company a total of $1,000 but returns one purchase worth $300 to the store. The return will be recorded as a credit on the account, reducing the amount owed to $700.
For example, when a consumer uses a Visa card to make a purchase, the card is considered a form of credit because the consumer is buying goods with the understanding that they will pay the bank back later.
Financial resources are not the only form of credit that may be offered. There may be an exchange of goods and services in exchange for a deferred payment, which is another type of credit.
When suppliers give products or services to an individual but don't require payment until later, that is a form of credit. When a restaurant accepts a truckload of food from a vendor who bills the restaurant a month later, the vendor is offering the restaurant a form of credit.
The credit theory of money argues that all money (whether fiat or backed by something) is a form of credit.
Credit in Financial Accounting
In the context of personal banking or financial accounting, a credit is an entry recording a sum that has been received. Traditionally, credits (deposits) appear on the right-hand side of a checking account register, and debits (money spent) appear on the left.
From a financial accounting perspective, if a company buys something on credit, its accounts must record the transaction in several places in its balance sheet. To explain, imagine that a company buys merchandise on credit.
After the purchase, the company's inventory account increases by the amount of the purchase (via a debit), adding an asset to the company. However, its accounts payable field also increases by the amount of the purchase (via a credit), adding a liability to the company.