A tutorial to help you understand the bookkeeping/accounting concepts of Debits and Credits
Most people don’t find the math of Accounting as difficult as understanding the concepts of accounting, and for many there is no more difficult concept to grasp than that of Debits and Credits. Now the concept of Debits and Credits is actually more than 500 years old, being used extensively by the Venetian merchants of Italy in the 15th century Renaissance period. The concepts were first documented in Latin in the 1400’s and were later translated into English in the 16th century. Is it any wonder then, with the passage 500 years, that we may have become a little confused about the original meaning and concepts, particularly with the English language adopting new legal and everyday meanings for these age old words. So it may be beneficial then, as we try to understand the concept of Debits and Credits, to go back to where it all begun … but first some background.
Basic accounting concepts – for bookkeeping students
This training session is targeted at students who have a desire to learn more about bookkeeping. While specifically developed for students other people interested in understanding more fully the accounting concepts, may also find this training session beneficial.
Keywords
Credits, debits, firm, accounts, accounting concepts, bookkeeping, financial transaction, accounting system, Luca Pacioli, account group, double entry bookkeeping, duality of financial transactions.
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Learning outcomes
- What is the origin of Debits and Credits?
- Why was it called Debit and Credit?
- What are the underpinning concepts for Debits and Credits?
- How would they have applied Credits and Debits in the 1400’s?
- Is there another way to look at applying Debits and Credits?
Introduction – Debits and Credits
- What accounts are involved? (There must be a minimum of 2)
- What account group do they each belong? (They must belong to one of the five)
- Has the financial transaction increased or decreased the $ amounts in this account?
- Apply the table logic.
- Make sure that the total amount $ of the debits = the total $ amount of the credits.
Session – Debits and Credits
PART 1 – What is the origin of Debits and Credits?
In more primitive trading times, bookkeeping was not such a big issue because the person who manufactured or produced the goods was usually the person selling or trading the goods in the market place. However, the Renaissance period saw a huge increase in both trade and banking systems brought about by the Roman-built transport systems and the growth of more sophisticated societies like those in Italy (particularly Venice). So, the merchants of Venice in the 1400’s, developed an accounting system to accurately record these more complex financial dealings that were prevalent of the time.
- The accounting cycle
- The use of journals and ledgers
- Debits equalled credits – ‘double entry bookkeeping’
- The account groups of assets (including receivables and inventories), liabilities, capital, income, and expenses
- Year-end closing entries
- The trial balance, which he believed should be used to prove a balanced ledger.
PART 2 – Why was it called Debit and Credit?
Now remember, Luca was more a mathematician than an accountant, so his mind would have been trained to look for the key principles, concepts and symmetry that underpinned the Venetian merchant’s financial recording system.
Note: The English translators used the Latin roots for these concepts and so named them Debits and Credits. It is highly probable that we also got the abbreviated forms of these terms (Dr and Cr) from the Latin roots as well, because there is no ‘r’ in the English word Debit but there is one in its Latin form ‘Debere’.
PART 3 – What are the underpinning concepts for Debits and Credits?
To properly understand Debits and Credits you will need to first understand the concepts that underpin the whole accounting process. Some of these are called Accounting Conventions and others are simply re-enforcing the way that the accounting systems looks at and records financial transactions.
In simple terms, the legal system defines an entity as a person or non-person that is capable of suing or being sued under the laws of the land. In most countries of the world, companies are given this ‘non-person’ entity status and are given the same rights and obligations of individual persons. Accounting takes this concept a step further by stating that every firm (including sole traders and partnerships), creates its own ‘accounting entity’ and that the income and net worth of each entity must be calculated based on its own financial transactions.
A firm, while it has ‘legal’ control over items of value, it is not the ultimate owner of those things. In other words, if the firm sold everything it had, it would be obliged to distribute all those monies to meet the claims made by other people or entities. The firms first obligation is to pay the claims made by external people (i.e. loans and creditors) with the balance being given to meet the claims made by the owner(s). The business would then return to how it all began, as a blank sheet without obligations or the control of any items of value.
While this a not a strict accounting concept, it is an important one to understand when getting the right perspective on financial transactions. Just like one person can be a parent, sibling, cousin or an offspring, so too a person can be an investor in a firm, a creditor/debtor of a firm, the manager of a firm or a director of a company that controls the operations of a firm. The important thing to remember is, that in accounting the financial transactions are always analysed and recorded from the firm’s point of view with you as the manager (not owner).
The financial world is a closed system. That is, money does not just arrive from nowhere and it is not just paid into thin air. If money is received by one person or entity, it must have been given by another person or entity and that in every traction involving financial resources there must be a source and a destination. This gives us our first insight into the Debits and Credits system that we use in accounting today.
As understood from Concept 2, the firm does not really own anything, from an accounting perspective. It may have legal rights of ‘ownership’ or control, but fundamentally in accounting terms it is an accounting entity set up by the owners to manage their affairs. So, when a firm makes a profit it does so for the owner’s benefit, not for the firm’s. Remember, if everything was sold off the firm would be left with nothing because everything of value would be used to first pay off liabilities with the remainder going to the owners.Summary
- The business or firm is an entity.
- The business (firm) is a separate entity distinct from the owners
- People can wear multiple hats and operate in multiple capacities.
- Every financial transaction has two sides to it. (a source and a destination)
- The profit from the firm’s activities belongs to the owners.
PART 4 – How would they have applied Credits and Debits in the 1400’s?
As Lucia pointed out, the accounting system he documented was being widely used by the Venetian merchants. These people seem to be the 15th century entrepreneurs. Let’s say that a Venetian entrepreneur named Antonio asked Lucia to record the financial transactions of his new business (firm) prior to Luca completing his famous ‘Summa’ book in 1494.
- The source of the economic resources was the Italian olive producer whom the firm now owed $100,000 – Credit (Cr) Accounts payable
and
- The destination of the transfer of economic resources was the olives that the firm now had as inventory – Debit (Dr) Inventory
Asset – Inventory (increase) $100,000 DrLiability – Accounts Payable – Olive Provider (increase) $100,000 Cr
- One source of economic resources was the bank who the firm now owed $20,000 in the form of a loan – Credit (Cr) Bank loan
and
- Another source of economic resources was the $30,000 from the owner Antonio who the firm treated as a separated entity to itself – Credit (Cr) Capital
and
- The destination of the economic resources sourced from the bank and the owner was a ship that was purchased for $50,000 – Debit (Dr) Ship
Asset – Ship (increase) $50,000 DrLiability – Bank Loan (increase) $20,000 CrOwners Equity – Capital – Antonio (increase) $30,000 Cr
PART 5 – Is there another way to look at applying Debits and Credits?
Part 1 – The sale of the olives for $200,000 cashPart 2 – The Olive provider was paid for his outstanding account.Part 3 – The use of $30,000 of cash proceeds to pay for the trip costs and interest expensePart 4 – The withdrawal and use of $10,000 by Antonio (as owner)
All the account groups have been affected in this transaction, yet you can see that we still achieve the same outcome using the ‘source and destination’ approach as the learned-Table 1 approach, but there is an underlying meaning to the questions and they are in keeping with Luca’s original Latin meaning.
Additional resources
- Chapter 21 of the ‘Tao of Financial Information” http://taofinancial.blogspot.com/
- Articles on bookkeeping and accounting
Conclusion – Debits and Credits
- To understand the origins of the terms Debits and Credits
- To understand the reason it called Debits and Credits
- To identify and comprehend the underpinning accounting concepts for Debits and Credits
- To see how would they have applied Credits and Debits back in the 1400’s.
- To find a meaningful way to apply Debits and Credits to financial transactions.
We set out at the start of this article to understand more fully the basic accounting concepts of Debits and Credits. We know that we can be a successful bookkeeper by simply applying the learned Table 1 approach, but some people want to understanding the ‘why’? By going back to the time of its conception, and looking at the original meanings we have been able to give meaning and a new approach to determining the Debits and Credits of financial transactions.
- Image Source #1 – by closelyobserved.com CC Atrtribution 2.0 ttp://www.flickr.com/photos/soylentgreen23/155041332/
- Image source #2 – DivulgaMAT: Centro Virtual de Divulgación de las Matemáticas de la Real Sociedad Matemática Española www.divulgamat.ehu.es
- Image source #3 – CC Atrtribution 2.0 wikimedia.org_Luca_Pacioli
- Image source #4 – CC Atrtribution 2.0 http://en.wikipedia.org/wiki/File:Leonardo_polyhedra.png
- Image source #5 – CC Atrtribution 2.0 http://www.bestwebbuys.com/Accounting-ISBN_9780324376159.html?isrc=b-search
- Image source #6 -CC Atrtribution 2.0 http://www.luc.edu/classicalstudies/academics.shtml
About the author
Peter Baskerville is a lecturer, educational resource developer and entrepreneur. He has authored courses in post graduate education in entrepreneurship for the Queensland Education Department TAFE and developed teaching resources for IBSA the Commonwealth Government’s vocational skill authority. He has lectured at Southbank Institute of Technology, private RTO’s and been a guest lecturer with indigenous organisations as well as mentoring Brisbane City Council multi-cultural scholarship winners. He hold interests in businesses operating in the hospitality and educational resource development sectors. |
By Peter Baskerville
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I’d like to thank you for this very helpful article. It is much less ambiguous than the home study course I am doing.
James
yeah!!!!!
Even though I actually like this post, I think there was an spelling error near towards the end of your 3rd section.
i think, it will be helpfull for both the students and teachers of accounting….it is really a Good work.
A really well written, and original article explaining accounting basics.
I am an Engineer. When I was as nominated as treasurer of a our Church, I had the need to learn accounting in a hurry. This article, together with the pages on wiki were the ones that really put me on the path of understanding accounting concepts. A big Thank You, Peter!
This article is very well written and informative. Thank you for writing it.
This has been invaluable to me, thank you. I have been struggling with my home study course and finally the penny has dropped!
this guideline is very use full for us thanks for circulation for every body.
Thanks Peter
thanks for everything, this is my first time to enroll my self in this class, i need to learn many things as basics , so once a gain i thanks i got some things form your side
Hello Peter,
Thank you very much for this very interesting article. I can apply the rule Source of Value = Credit and Desitination of Value = Debit to most of the financial transactions I am confronted to. However I struggle with the following case.
If my company receives a sales order, ultimately, the accountant in my company credits the stock and debits the cost of goods sold. It makes sense to me that the stock is credited (because it is the source of the value). But cost of goods sold doesn’t sound to me like the “destination of the value”. Could you kindly explain how you would apply your rule in this case (to determine that it’s cost of goods sold that has to be debited) ? If I apply the rule you gave I would have thought cash or bank account would be debited (they sound more like a destination to me).
Your help on this would be much appreciated.
Thanks in advance,
Mic
Yeah Mic the concept that all financial transactions have a source and destination of economic value explains the first principles of the debit and credit system in accounting. While it is very easy to identify this concept taking place in most financial transactions, others are less clear like the one you describe. But economic value is still being transferred from (credit) the asset account – stock on hand to (debit) the expense account – cost of good sold. When the customer purchases the goods, economic value is transferred from (credit) the customer by way of sales to (debit) the bank account in the form of cash. Did this help?
Hello Peter,
Thanks again for your response. I understand the example you give about a customer purchasing goods, however I admit I’m still a bit lost regarding the example I gave (sales order received and stock credited and cost of goods sold debited). Maybe there’s no easy explanation for this one ? Well, if you or anyone has a nice easy way of explaining this one I would be very interested.
Kr,
Mic
The Inventory Stock (asset–store of value) is relieved/CR, and the reason for that relief is debited, on the other side. The right side of the equation interprets DR as “reasons for spending or consuming or using” wealth/assets.
That “right-reason” side interprets DR as a current benefit when it is sold (not a stored benefit); the current benefit is to allow the revenue sale in the first place. All expenses can be viewed as “current” or consumed benefits. Whereas DR on the other-LEFT side are stored or future benefits.
So the CR to stock inventory is the source of the benefit that is given up to the customer. The customer receives that value (he bought the goods!). He effectively bought the wealth DR. But of course will be expected to give up a higher value to the entity for that privilege of the company assembling & packaging that wealth for him/her. And so, there are parallel, balanced entries reflecting the NEW value (DR) coming into the entity, giving appropriate CR to the Equity interest of the entity (sales revenue account). Is this helpful?
Itz really informative for indepth study for me an my students….. Thk u so much…..
How about this Mic.
There are two economic values in play when a customer purchases goods (stock) from a business. One is the customer’s cash and the other is the business’ stock. Your example only looks at one aspect of the transaction (2), being the movement in the economic value of the stock when a customer places an order to purchase that stock. At some time in the future, a second aspect (1) will take place to complete the transaction. I think you need to see the entire transaction to fully understand the flow of economic values.
So, looking at the complete transaction involving both the cash and the stock, the business would apply the source and destination of economic value principle in the following way:
(1) – The business sees the cash coming from customer “X” being the source of the economic value (Sales customer “X” – Credit) and the bank account of the business being the destination of the economic value cash (Cash at Bank – Debit).
(2) – The business then sees the stock being sourced from the business’ (Stock on Hand – Credit) with the destination of that stock being transferred to customer “X” who is purchasing it (Sales customer “X” – Debit).
Now accounting, rather than include both source and destination aspects of this transaction in the one Sales account, it separates out the Debit transactions of Sales and puts them into a separate account called “Cost of Goods sold”. This separation allows for greater analysis and more meaningful information for stakeholders.
The complete transaction involving the purchase of stock from a business is then:
Sales – Credit (Source)
Cash at Bank – Debit (Destination)
Stock on hand – Credit (Source)
Cost of goods sold – Debit (Destination)
i understand it more because of the way you explain it. is soooo good..
the information are really useful and wish to know the further details about accounts to maintain in a firm.
accounting is very essential for our lives
Thank you for providing this useful tutorial, it’s very helpful and I think every accountant should go through this.
I think thi is one off the most important information for me.
And i’m glad reading your article. But should remark on few general things,
The web site style is perfect, the articles is really nice :
D. Good job, cheers
Can you explain why credits decrease cash?
Cash is an Asset (an item of economic value that provides future benefit for the firm). Under the rules of double-entry bookkeeping, if an asset increases you debit the account and if it decreases you credit the account.
In the original Latin (where double-entry bookkeeping was first practiced), Credit meant ‘to entrust’ and debit meant ‘to owe’. So the value of the assets is owed to the funders who entrusted money to the firm. This is represented in the Accounting equation, (Assets = Liabilities + Equity), where assets represent the use of the funds provided by the external funders (Liabilities) and the internal funders (Equity). This could be simplified to: The amount of money owed by the firm = the amount of the money entrusted by the funders or Debits = Credits.
So when an asset like cash decreases, then the amount of money owed to the funders also decreases, because the accounting equation must stay in balance at all times. The way we decrease an asset in the double-entry bookkeeping system is to credit the account.
Nice explanation through Infographics and Images.
thank you very much may God bless you with this explanation you have given to us.
I love this. Thank you for providing this article. It is more useful than my professor of my college course that I pay up the @$$ for. Kudos.
I’d also like to point out that the Debit or Credit poster below Table 1 seems to missing a link to download for free. I’m only able to see the thumbnail when I click the image. Is this option still available?
Thanks Amber. Links re-established.
you are great Peter, continue to make accounting alive
thanks for giving the most of accounting information
the lesson was worth following and is much educative . thank you very much Peter
I was really struggling with Debits & credits but the summary of CREDITS being the source & Debits being the destination is such a revelation. Thanks V. Much
The informational is educational inHISTORY & ACCOUNTING. THANK YOU.
thanx sir
thank you so much…
Thank you sir
Excellent. Found this to very very usefull. Thank you.
Thank you for this simple to understand explanation. I have learn accounting as a concept like learning math but to day, I have understood it in a more practical way. thank you once again
Really it is wonderful job….basicaly i’m not in accounts backgroud. Unfurthunatily joing in accounts deportment ….thank sir…your circular helps me lot….
Thank you
Hi all,
Thanks for such a nice share, it helped me a lot in my interview. The reason i’m happy that I had more info than the interviewer………..
Thanks again!
i love this and would like to learn more
After getting wonderful explanation, I feel it obligatory to appreciate and compliment the author. The concept of movement of economic resources best describes the debit and credit. I would love to get befitted by reading other worthy explanations. Thanks one again.
As already said by you plz. Notify me about accounting knowledge, thanks for the above it’s great
Hello to all, the contents existing at this website are actually remarkable for people
experience, well, keep up the nice work fellows.
Thank you for your article. It has helped me understand a little more but I still can’t get my head around why a debit entry on a T account is money coming in and a credit entry is money going out? Are you able to simplify this for me or set me on the correct track if I have got completely the wrong end of the stick!! Thank u. Ruth
I’m guessing that you are comparing this response with what happens with a bank statement where the reverse is true (credit = cash increasing) and (debit = cash decreasing). Well the reality is that each entity (the business and the bank) records financial transactions from their own point of view. So when a business banks money into an account at the bank, the business will record the transaction as a debit in their books and the bank will record the same transaction as a credit in theirs. This is because the transaction represents an increase in Assets for the business and therefore Debit but the money deposited represents an increase in liability for the bank (credit) because the bank views the deposit as ‘money owning back to the business’.
At a macro level, these are simply the rules you need to keep the accounting formula in balance. Assets = Liabilities + Owners Equity
Because cash is an Asset you need to debit increases and credit decreases. The accounts on the other side of the equation then need to be recorded in the opposite way if the formula is to remain in balance. i.e. For liability and equity accounts you will need to credit increases and debit decreases.
Thank you very much peter for such a great article. Really helped me lot. Many many thanks.. Keep writing on further accounting concepts. One question.. please mention that according to table 1, cost of goods sold belongs to which account group? so i could better understand that when it should be credited or debited.
Your help on this concept would be much appreciated.
Thanks alot in advance..
“Cost of goods sold” is a special type of expense and expense accounts are debited when they increase and credited when they decrease. The typical sale of merchandise transaction would be: Cost of Goods sold (Debit) Merchandise (Credit).
Many thanks for the explaination.. got it now.. 🙂
Thanks for the Knowledge shared, it has absolutely cleared my doubts on the credits and debits concept.
A wonderful article, enriched with a lot of valuable information about debit and Credit concepts,
Simple explanations are really helpful to understand the concept easily to the beginners.
Detailed information about debit and credit concept, Basics have been explained for better understanding to every one.
Relevant examples, entries, accounts examples have been provided with for easy understanding.
It is really helpful, thanks.
A wonderful article, enriched with a lot of valuable information about debit and Credit concepts,
Simple explanations are really helpful to understand the concept easily to the beginners.
Detailed information about debit and credit concept, Basics have been explained for better understanding to every one.
It really helps to understand various accounting entries, the logic behind the debit and credit entry, various types of accounts, double entry system, accounting principles of debit and credit, assets, liabilities, expenses, revenue, investment, owners equity etc..
This article is really helpful to understand the origin of debit and credit, why it is called Debit and credit and also underpinning concepts of debit and credit.
Relevant examples, entries, accounts examples have been provided with for easy understanding.
It is really helpful, thanks.
The definition of bookkeeping is keeping a detailed record of the business transactions for a person or business.
Can you explain this entry. Why retained earning is decrease?
Retained earning
Dividen payable
Thanks for sharing the handy post with us. Keep it up.
Thank you a lot for this explanation Mr Peter , but I still haven’t understood the whole concept. My question is how does all of it work. How do we determine how much we owe to a person and how much some one owes by directly seeing the Dr. and the Cr.
For example
Paid $10,000 to Max
Max Dr 10,000
To Cash a/c Cr 10000
Received 5000 from Max
Cash Dr 5000
To Max a/c Cr 5000
So in this case
Dr | Cr
15000 15000
——————————
From this final result or the above given equation , how do we derive how much we are supposed to pay or how much we we are supposed to receive and what is the significance/meaning of the final numbers(apart from showing that there is no mistake)
Thanks
And just to clarify I’m a beginner
What is the relationship between debit and credit in accounting as + or – or * or /?
LOVE this article!!! Thank you so much! Knowing the history of the terms debits and credits has finally allowed me to understand the concept. This is such great information!