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:
History of Debits and Credits
‘Debits and credits’ is a financial transaction classification system that was first used by the Venetian merchants in Italy in the 15th century. While it was widely used by the Venetian merchants, its took a mathematician by the name of Luca Pacioli to document and publish this system in a book.
The book Luca wrote to codify the Venetian method of bookkeeping in 1494 was one of the first published by Gutenberg on his innovative printing press. Today Luca is revered widely as ‘The father of accounting’ . Luca’s book explained the whole bookkeeping system of which Debits and Credits were a key part. The overall system that he documented has come to be known as the “Double- entry bookkeeping” system. Now while this system was developed over 500 years ago, its principles and processes are still followed by today’s accountants and bookkeepers the world over.
Latin terms – “Credre” and “Debere”
It is interesting to note that the concept of negative numbers was not generally accepted in mathematics in the 1500s when Luca first codified the double-entry bookkeeping system. This may further explain why he used “Debits and Credits” rather than + and – which is the system that the accounting software of today uses to process financial transactions. Still, let’s not get any more confused other than point out that a lot has changed in the world in past 500 years, but the double-entry bookkeeping system is not one of them.
Luca’s book was written in the vernacular of the age – Latin. So the terms he used for Debit and Credit in his book were “Credre” and “Debere” . In Latin the word “Credre” means “to entrust” and “Debere” means “to owe”. These Latin meanings give us our first glimpse into the underlying principles that the “Debit and Credit” classification system seeks to maintain. These principles will be explained in greater detail later in the series of articles on this topic. It is also clear that we got the Debit abbreviation of “Dr.” from the Latin, because unlike the Latin term, there is no ‘r’ in the English term Debit.
The evolving English language
Other confusions that cloud the understanding of “Debits and Credits” for most accounting students, is the fact that English as an evolving language has developed many different meanings for the terms “Debits and Credits” other than the ones originally coined by Luca in 1494. In fact, look at most dictionaries and you will discover over 10 different meanings for the term credit apart from the one we use in accounting. Some students even try and assimilate the terms Debit with debt, yet the two terms have no similarity in meaning even though they may have similar sounding tones.
Definition of ‘Debits and Credits’ in accounting
The very important point for accounting students to understand is that the Debits and Credits in accounting has its own special meaning and that meaning is not to be assimilated with any other English meanings of the terms.
The definition of “Debits and Credits” that this series of presentations will adhere to is:
Debits and Credits is a classification method that is used for coding the financial transactions of a business and recording them in the bookkeeping system.
In essence, this series will show that the Debits and Credits method captures and records the flow of economic resources that take place in a financial transaction as economic resources transfer from a source (credit) to a destination (debit). The Debit and Credits classification method also ensures that the accounting equation, which is the foundation stone on which the entire double-entry bookkeeping system is build, remains in balance after each transaction is recorded.
Summary – Debits and Credits
In summary then we can say that:
- “Debits and Credits” are a key component of a 500 year old double-entry bookkeeping system.
- “Debits and Credits” are English terms that were translated from the Latin “Credre‟ and “Debere‟
- English has evolved to create many different meanings for the terms “Debit and Credit” in the 500 years since they were first coined.
- The meaning of “Debits and Credits’ in accounting is unique to accounting and is not to be assimilated with other meanings of these terms.
- Debits and credits is a classification method that is used for coding the financial transactions of a business and recording them in the bookkeeping system.
- Debits and Credits reflects the flow of economic resources that takes place in a financial transaction as the economic resources transfer from a source (Credit) to a destination (Debit).
- The Debits and credits system ensures that the accounting equation remains in balance after each new transaction entry.
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 accounting 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 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 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 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 transaction represents the withdrawal from the source and the debit entry represents a deposit in the 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 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 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.