Debits and Credits – Founding principles

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In accounting, why do we debit expenses and credit revenues?

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.

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

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?

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Debits & Credits – History and definitions

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FAQ – Basic Accounting Concepts

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