Notes and Credits in Accounting: Key Differences and Best Practices
Understand how notes and credits function in accounting to improve clarity, accuracy, and organization in financial documentation.
Businesses rely on accurate financial records to make informed decisions, meet regulatory requirements, and maintain transparency. Within accounting, various tools help track and explain transactions, and understanding their distinct roles is necessary for sound financial management.
Among these tools, notes and credits perform different functions affecting how information is recorded and interpreted. Clarifying their purposes helps ensure they are used effectively.
How Are Notes Used in Documentation
Notes serve as supplements to the main financial statements—the balance sheet, income statement, and statement of cash flows. Often called footnotes, these narrative disclosures provide clarity and detail that the statements alone cannot convey. They are considered an integral part of a complete set of financial statements under frameworks like U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Their primary function is to help readers understand the assumptions, methods, and circumstances affecting the reported figures.
The content of notes is guided by the “full disclosure principle,” which requires financial statements to include relevant information that could influence users’ decisions. This ensures transparency by explaining specific accounting policies, such as the method used for valuing inventory or depreciating assets, as outlined in standards like FASB’s Accounting Standards Codification Topic 235.
Notes also provide detailed breakdowns for specific line items, like components of property, plant, and equipment or terms of long-term debt. They communicate information that doesn’t fit numerical summaries, including details about pending litigation, significant contracts, guarantees, or subsequent events occurring after the balance sheet date but before statement issuance. Standards like ASC Topic 275 address the disclosure of risks and uncertainties.
Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), mandate specific disclosures for public companies, often requiring extensive footnotes detailed in rules like Regulation S-X. These notes provide a comprehensive view, enabling stakeholders to make more informed assessments of a company’s performance and risks.
Where Do Credits Fit in Accounting
Credits are fundamental to the double-entry bookkeeping system. This system operates on the principle that every financial transaction affects at least two accounts, requiring equal debit and credit entries. This ensures the accounting equation (Assets = Liabilities + Equity) remains balanced, enhancing record accuracy.
The effect of a credit depends on the account type. Credits increase accounts on the right side of the accounting equation: Liabilities (like Loans Payable) and Equity (like Retained Earnings). Since revenues increase equity, Revenue accounts (like Sales Revenue) are also increased by credits.
Conversely, credits decrease accounts on the left side of the equation, primarily Asset accounts (like Cash, Accounts Receivable, or Equipment). For example, when a customer pays an invoice, Cash (asset) is debited (increased), and Accounts Receivable (asset) is credited (decreased). Expense accounts, which reduce equity, are typically increased by debits, meaning a credit would decrease an expense balance (an uncommon entry except for corrections or closing entries). Paying rent usually involves crediting Cash (decreasing the asset) and debiting Rent Expense.
Understanding how credits function is necessary for accurately recording transactions. Whether taking out a loan (crediting Loans Payable) or earning revenue (crediting Sales Revenue), the correct application of credits ensures financial records accurately reflect the company’s activities according to frameworks like GAAP.
Differences Between Notes and Credits
While both are parts of financial reporting, notes and credits serve distinct purposes. Notes are narrative disclosures accompanying the main financial statements. They provide context and explanation, guided by the full disclosure principle, enhancing understanding of the numerical data. Notes elaborate on accounting policies, detail balances, and disclose risks.
Credits, however, are mechanical entries within the double-entry bookkeeping system. They represent one side of every transaction (the other being a debit) and are numerical values entered into ledger accounts. Their function is operational: increasing liability, equity, and revenue accounts while decreasing asset and expense accounts. Credits are fundamental to recording financial data.
The core difference lies here: notes are qualitative and explanatory, found appended to financial statements to improve understanding. Credits are quantitative and procedural, existing within the accounting records as part of the process used to create those statements.
Filing and Recordkeeping Essentials
Maintaining organized accounting records is fundamental for monitoring progress, preparing financial statements, identifying income sources, tracking expenses, and substantiating tax filings. The Internal Revenue Service (IRS) requires businesses to support reported income, expenses, and credits, placing the burden of proof on the taxpayer.1Internal Revenue Service. Recordkeeping While no specific system is mandated, the chosen method must clearly reflect income and expenses and include supporting documents.
Record retention periods vary. The IRS generally requires records supporting tax return items to be kept until the period of limitations expires, typically three years from the filing date or tax payment date, whichever is later.2Internal Revenue Service. How Long Should I Keep Records? This extends in certain situations:
- Six years for unreported income exceeding 25% of gross income shown on the return.
- Seven years for claims involving worthless securities or bad debt deductions.
Specific record types have distinct requirements. Employment tax records must be kept for at least four years after the tax is due or paid. Records related to property acquisition and improvements should be maintained until the limitation period expires for the year the property is disposed of, as they are needed to calculate depreciation and gain or loss. The IRS requires records related to unfiled or fraudulent returns to be kept indefinitely.
Other regulations, like the Sarbanes-Oxley Act (SOX), influence retention, requiring audit work papers for public companies to be kept for seven years. Effective recordkeeping involves systems ensuring data integrity, protection, and accessibility, whether physical or electronic. Organized records facilitate compliance, audits, and informed business decisions.