Confusion about the terms ‘Debits and Credits’
‘Debits and Credits’ is possibly one of the most difficult concepts to understand in accounting. This is due in large part to the additional meanings that have been added to these terms from the ones that were first coined some 500 years ago. Yes that’s right. The accounting system we use today was first used by the Venetian merchants in the late 1400s.
The Latin text that described the Venetian accounting system was translated into English in the 16th century. At that time the Latin terms ‘Debere and Credre’ were translated into ‘Debits and Credits’ in English. Now while ‘Debits and Credits’ has its own special and unique meaning in accounting, the English language has evolved allowing new meanings to be given to these terms.
It is these new meanings and the attempt by students of accounting to form a relationship between these meanings that causes the most confusion. For example the term ‘Credit’ today has more than 10 different meanings including:
- To ascribe an achievement to someone
- The ability of a customer to obtain goods or services before payment
- The money lent or made available under a credit arrangement
- The acknowledgment of a grade level in an examination
- A source of pride that reflects well on another person or organization
The accounting meaning of the term ‘Credit’ should not be confused with any of the above nor should the term ‘Debit’ be equated with the concept of debt. Furthermore, ‘Debit and Credit’ has no relationship with the concepts of ‘good and bad’ nor ‘positive and negative’. So the first step to making sense of ‘Debits and Credits’ in accounting is to understand these terms only within their accounting meaning.
Definition: ‘Debits and Credits’ is a classification method that is used in accounting to record the financial transactions of a business. The ‘Debits and Credits’ method records the flow of financial resources from a source (Credit) to a destination (Debit). Every financial transaction in a business involves this flow of financial resources. The uniqueness of the ‘Debit and Credit’ classification method is found in the fact that while various individual account values may change with each new financial transaction, the accounting equation that underpins the accounting system (Assets = Liabilities + Equity) always remain in balance.
The Accounting Equation
The relationship between the Accounting Equation and ‘Debits and Credits’
The Accounting Equation reflects the economic reality of a business. See, a business is created by owners to make a profit for the benefit of owners. When that business is formed by the owners, the accounting system sees the new business as a separate entity that is distinct from the owners. This means that the accounting system will record financial transaction from the point of view of the business entity not the owner’s.
From an accounting point of view, when a new business is initially formed by the owners, the new business has zero assets. The only way a new business can get to control assets is if the assets are provided by others. ‘Others’ in this case may be external funders like banks who lend money to the business (Liabilities) or internal funders like owners who invest money in the business (Owners equity). So because all the assets of a business have been supplied by ‘others’ (Liabilities and Owners), then these ‘others’ have an economic claim over the business that is the equivalent of the value of the total assets that the business controls. Hence, the founding principle underpinning the Accounting Equation:
Assets = Liabilities + Owners Equity
It was obvious to the Venetian merchants that a system was needed to record the impact of the numerous financial transactions on the business without upsetting this underlying economic principle explained by the accounting equation. So you guessed it – they came up with the concept of classifying individual financial transactions by ‘Debits and Credits’, although they referred to them in Latin as ‘Credre’ and ‘Debere’.
This ‘Debit and Credit’ classification method that the Venetians invented for the recording of individual financial transactions, ensured that the fundamental accounting equation explained above, always remained in balance. The ‘Debit and Credit’ classification method achieves this by applying the rule that:
- changes in value to accounts on the left side of the accounting equation (Assets) will be a debit if the account values increase and a credit if the account values decrease.
- changes in value to accounts on the right side of the accounting equation (Liabilities & Owners Equity) will be a credit if the account values increase and a debit if the account values decrease.
- that for each financial transaction, the total of the Debits must equal the total of the credits.
The finance system
The finance system’s source and destination of funds and ‘Debits and Credits’
The final concept to help you make sense of ‘Debits and Credits’ in accounting is to understand how this classification method relates to the finance system.
See, finance is a closed system. This means, that money does not just appear in your bank account nor does it just disappear into thin air from time to time. In finance there is always a source and a destination of funds – you can not have one without the other. In other words financial resources ‘flow’ from one place to another and the ‘Debits and Credits’ system completes this record of financial funds movement. The credit side of the financial transaction represents the withdrawal from the source and the debit entry represents a deposit in the financial transaction’s ultimate destination.
So, this classification system of ‘Debits and Credits’ in accounting is very closely related to the economic concept of duality in financial transactions. i.e. for every financial transaction, the debit entries must equal the credit entries because in a closed system there must be a source and destination of an equal amount for each financial transaction.
While it is best to determine the ‘Debits and Credits’ classification via the decision tree above, as a general rule, the source of a financial transaction is credited and the destination is debited. For example:
A Franciscan friar, mathematician and friend of Leonardo Di vinci called Luca Pacioli (1446–1517) is widely regarded as the “Father of Accounting”. This is because he was the first to codify and publish this accounting system in his book titled “The Collected Knowledge of Arithmetic, Geometry, Proportion and Proportionality” (translated). The book was first published in 1494 and was one of the earliest books published on the Gutenberg press.