Archives for Debits and Credits

Debits and Credits – Founding principles

Posted by  on Sunday, October 26th 2014     

category: Debits and Credits
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In accounting, why do we debit expenses and credit revenues?

Posted by  on Wednesday, October 1st 2014     

I wish there was a simple answer to this question … but there isn’t. The rules of debit & credit in accounting are simple enough to learn and apply, but understanding the ‘why’ is far more complex, particularly when you are trying to understand the ‘first principles’ of a system that was created over 500 years ago.

Others may answer this question quite differently to me but here is the ‘first principles’ thinking that I use to understand the concept of ‘debits and credits’ in accounting and to explain the reason why expenses are debited and revenues are credited in the double-entry bookkeeping system. But to get to the answer, we must first understand some basic principles and concepts regarding business, finance and accounting. These are:

The relationship between the business and the owners of the business

See at its inception, a business is a new entity that is created by owners for the purpose of making them money (profits). So a business begins with nothing and only gets its assets when owners, who are desirous of profits, transfer (invest) economic value (funds) to the business . Any profit subsequently made by the business is then owed to the owners. In this state, regardless of how the business came to have assets under its control, the owners still have a claim over all of them. So the items of economic value controlled by the business would be equal to the owners investment plus the profit that are owed to the owners. This relationship can be represented by the formula:

Assets of the business (items of economic value) =  Owners Equity (Owners investment + business profits)

The relationship between the business and external funders

Ever since the rise of the banking system in Venice in the 1400s,  businesses have been able to leverage their assets to secure borrowed funds from financial institutions. These funds, that are transferred into the business, are different to the owner’s investments because the financial institutions were not chasing the profits of the business and only wanted to get their funds repaid + an extra charge for the use of these funds (interest). These types of funds are called Liabilities. Now while these liabilities increase the assets of the business, in this case, it is the external funders that have a claim over them rather than the owners. Businesses that accept external funding in the form of liabilities create an adjusted formula to the one previous stated. The new formula is:

Assets of the business (items of economic value) – Liabilities (money owed to external funders) =  Owners Equity (Owners investment + business profits)

The assets of the business minus the value of the liabilities is often referred to in finance and accounting as Net Assets. So the formula above can be simplified down to:

Net assets of the business = Owners equity

The formation of the debit and credit concept

In this simplified form we can begin to see what the mathematician and Father of Accounting (Luca Pacioli) saw in 1494 when he codified the double-entry bookkeeping system. It is his codified system that outlined the rules for applying debits and credits when recording the financial transactions of a business in the double-entry bookkeeping system.

Now remember that Luca’s book in 1494 was written and published in Latin and at a time when the concept of negative numbers was not yet accepted in Europe. So he spoke of the terms  ‘Debere’ and ‘Credere’ which means in Latin ‘to owe’ and ‘to entrust’ respectively because to him they reflected the interlocking relationship created by a business and its owners and represented in the above formula:

To maintain this fundamental truth that the value of the net assets of the business must be equal to the value of the owners equity, Luca introduced the concept that the net assets side of the equation would be represented as Debere (Debits = funds owed to the owners) and the owners equity side would be represented as Credere (Credits = funds entrusted).

Consequently, he could also see that financial activities that caused net assets to increase should be debited (more funds owed to the owners) and credited if decreased (less funds owed to the owners). The same principle applies to the owners equity side. An increase in owners equity would be credited (more funds entrusted in the business) and a decrease debited (less funds entrusted in the business).

Treatment of expenses and revenues

Finally, the treatment of expenses and revenues in the double-entry bookkeeping system.

As mentioned earlier, the profits of the business are claimed by the owners. Now profits are the net result of the revenue earned less the expenses incurred in earning that revenue. This means that revenue has the potential to increase profits and thereby increases the owners equity side of the equation. This in turn will lead to more money entrusted in the business, so revenue is credited. Conversely expenses, by being offset against the revenue will reduce the profits and so reduce the available funds to be entrust in the business, so expenses are debited.

Conclusion

I fully understand that the explanations about ‘why’ we do certain things can be long-winded. But if the ‘why’ is as important to you as it has been to me, then I hope this explanation has added to your understanding or has at least prompted you to ask more questions and research answers as it did for me.

category: Debits and Credits
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Why is it so difficult to grasp the idea of debit vs credit without confusing the two?

Posted by  on Sunday, August 17th 2014     

Answer by Peter Baskerville:

Why is the idea of debits and credits so difficult to grasp? It is clearly the most confusing concept to understand in accounting, which is why most students simply learn the ‘debit’ and ‘credit’ rules by heart and then apply them according to the rules. But I still think it is important to fully understand the concept if you are going to get the best out of your accounting knowledge and skills. Here’s why I think ‘debits’ and ‘credits’ is such a difficult concept to grasp and some explanations that should help you to better understand it:

  • Confusion about the terms: The terms ‘debit’ and ‘credit’ have unique meanings in accounting and they have no relationship with any other meanings of the terms. The accounting terms ‘debit’ and ‘credit’ are always going to be difficult to grasp if you keep trying to relate them to other uses of these terms in everyday life.
  • Confusion created from a long history: The concept of ‘debit’ and ‘credit’ originated over 500 years ago with the Venetian merchants. The first double-entry bookkeeping textbook was written in Latin by Franciscan friar Luca Pacioli (1445 – 1517) in his Summa and published in 1494. If you don’t understand that the terms ‘debit’ and credit’ originated in Latin as ‘debere’ and ‘credere’, then you wouldn’t realise that these terms mean (to owe) and (to entrust). See Luca Pacioli saw that external funders and owners entrust  (credit) money to a business so it can acquire assets. But  the business then in turn owes (debit) the value of these assets back to the funders. If you don’t understand the history of accounting then the concepts of ‘debit’ and ‘credit’ will be difficult to grasp. This animation and narrated story may help in this regard.
    https://www.youtube.com/watch?v=caNGir_fhUQ&list=TLHhV9NMwYE4BTwe2MbU9g5UQPwXfrVMce
  • Confusion about ‘+’ and ‘-‘: A review of history will also tell you that negative numbers were not a generally accepted mathematical concept in Europe when Luca Pacioli codified the double-entry bookkeeping system in 1494. So it was an incredibly innovative concept at the time of getting the books of a business to balance by using ‘debit’ and ‘credit’ rather than ‘+’ or ‘-‘, which must be very confusing to 21 century students today where the concept of negative in mathematics is so mainstream.
  • Confusion about the role of business: The concept of ‘debit’ and ‘credit’ is built on a fundamental truth that a business is created by the owners for the owner’s benefit. So the value of all the assets (less the liabilities or debts that the business has incurred) are owed to the owners. This truth can be formulated into an equation of: Assets – Liabilities = Owners Equity or rearranged into what has become known as the accounting equation: Assets = Liabilities + Owners Equity. The role of ‘debits’ and ‘credits’ is to accurately maintain this fundamental truth, as represented by the accounting equation. If you didn’t understand this vital role of ‘debit’ and ‘credit’ then you wouldn’t understand why certain accounts are debited and others credited, nor would you understand why the treatment of a recorded transaction would change depending on what was needed to ensure that the balance in this equation is always maintained.
  • Confusion about different treatments of the same transaction: Luca Pacioli’s double-entry bookkeeping system was designed so that the owners of the business could get a constantly updated report on the financial position and performance of their specific business. So financial transactions in the double-entry bookkeeping system are recorded from the perspective of the individual business. If you did not understand this principle then it would be difficult to understand why say a deposit to the bank account of a business is recorded as a debit in the Cash at Bank account of the business but recorded as a credit on the bank statement produced by the bank. See while Cash at Bank is an asset account in the double-entry bookkeeping system of the business, the bank must treat the deposit as money owed to another business and therefore records it as a liability in their double-entry bookkeeping system for their owners.
  • Confusion about the application of ‘debits’ and ‘credits’: I remember asking questions of my teachers about the reason why ‘debits’ and ‘credits’ were applied in the way they were and always got the same response … because that’s the system. In accepting that answer I learned to apply ‘debits’ and credits’ long before I understood the why. I have explained previously much of the reasoning behind the ‘debit’ and ‘credit’ concept, with the final explanation being that ‘debits’ and ‘credits’ really represent the flow of economic resources that takes when a financial transaction occurs in the closed system that is the world of finance. See financial transactions cause economic values to flow from something to something else. We see this concept represented in the Latin meanings of the words ‘debere’ and ‘credere’, where economic value is entrusted ‘credere’ to a business which then creates an obligation on the business to owe ‘debere’ the equal amount of economic value back to the entrusters. Rather than simply apply the ‘debit’ and ‘credit’ rules, you can explain all financial transactions in terms of the first-principles of economic value flow: from (credit) to (debit). Here is the full story on how you could do that – Basic Accounting Concepts 2 – Debits and Credits

The truth is, you will be better off in your student years to just learn the rules of ‘debit’ and ‘credit’ and then apply them correctly. Still, if understanding ‘the why’ drives you to insanity as it has me, then make sure you follow my accounting answers on Quora or my blog (above) because I am determined to figure it all out before I shuffle off this mortal coil.

Why is it so difficult to grasp the idea of debit vs credit without confusing the two?

category: Debits and Credits
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Debits & Credits – History and definitions

Posted by  on Monday, December 9th 2013     

category: Debits and Credits, History of Accounting
tags: , ,

How can I better understand debit and credit?

Posted by  on Tuesday, May 14th 2013     

I personally think that trying to understand the debit and credit concept in accounting is near impossible when you are first confronted with it. Learning how to apply the debit and credit concept is far easier. You can be an outstanding bookkeeper or accounting student by just learning the application rules that are taught in courses.

Still, while I have been involved with teaching accounting students for many years and have ‘kept the books’ for my own businesses, it always bothered me that I never really understood the rationale behind the debit and credit concept in accounting.

Also, in my opinion, the dictionary definitions do very little to aid in understanding.

  • Debit – an entry in the left hand column of an account (“T” account) or the left hand side of the Balance Sheet.
  • Credit – an entry in the right hand side of an account (“T” account) or the right hand side of a Balance Sheet

Adding to the confusion is the fact that the debit and credit concept and terminology was developed over 500 years ago, with the first accounting textbook being actually written in Latin. English as a language has morphed incredibly in the past 500 years since the Venetian method of accounting was first translated, producing many different meanings for the terms ‘debit’ and ‘credit’. I have identified eight different meanings and applications in English for the term ‘credit’ alone. Is it any wonder then that the debit and credit concept is a difficult one for students to understand with 21st century English.

So, I wrote an article in an attempt to provide a better understanding for myself of the debit and credit concept in accounting and here it is … http://basicaccountingconcepts.w…

Summarizing that rather long article I would offer the following explanations when trying to better understand the debit and credit concept:

  • to help understand the terms ‘debit’ and ‘credit’ in accounting, you should not try to link these terms with any other meanings or uses in every day English.
  • ‘debit’ and ‘credit’ does not automatically mean: “plus” and “minus”, “good” and “bad” or “increasing” and “decreasing”.
  • ‘debit’ and ‘credit’ are accounting terms used to acknowledge and record the duality that naturally occurs with financial transactions. i.e. finance is a closed system and money just doesn’t appear or disappear in a business. For example, if money is received by a business then it must have been given by others and vice versa (so two/dual entries of equal amounts are required to record the complete transaction and the transaction’s affect on financial resources = ‘credit’ the source of funds and ‘debit’ the destination of the funds)
  • ‘debit’ and ‘credit’ are accounting concepts that capture in the books of a business the flow of economic resources from a source (credit) to a destination (debit). i.e. a bank provides funds to a business as a loan … Bank loan is the source of funds so it is recorded as a ‘credit’ and the Bank account of the business is the destination of the funds so it is recorded as a ‘debit’. Applying this principle will help you identify the ‘credit = source’ and ‘debit = destination’ of every transaction.
  • ‘debit’ and ‘credit’ is a recording system that ensures that the accounting equation always remains in balance after each and every transaction. i.e. Assets = Liabilities + Equity. The Venetian merchants that developed this system 500 years ago decided that increases on the ‘assets’ side would be called a ‘debit’ and increases on the ‘liabilities’ and ‘equity’ side would be called a ‘credit’ with corresponding ‘debit’ and ‘credit’ entries for decreases. If every transaction is recorded with an equal amount for the ‘debit’ and the ‘credit’, then the accounting equation will always remain in balance. A balanced accounting equation allows business managers to accurately calculate and split the claims that all parties have over the assets of the business. (Liabilities = external parties like banks and suppliers, Equity = owners)
  • ‘debit’ and ‘credit’ is always recorded from the perspective of the business. This is why if the ‘Cash-at-bank’ account in the books of the business is a ‘debit’ balance then the bank balance on the bank statement will be a ‘credit’ balance. Because while cash is an assets to the business (an item of value that the business owns) it is a liability for the bank (money owed to a customer, you)

This article may also help you understand the ‘debit and credit concept’ better:
http://basicaccountingconcepts.w…

category: Debits and Credits
tags: , , , , , , , , ,

Making sense of Debits and Credits in Accounting.

Posted by  on Saturday, March 31st 2012     

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:

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 ‘Debit and Credit’ rules
This table help determine the ‘Debits or Credits’ for each account involved in the financial transaction

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:

Source and Destination = ‘Credits and Debits’

Interesting fact:
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.

eBook by this author

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