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Debits and Credits - Accounting

Module by: Peter Baskerville. E-mail the author

Summary: The difficulty with accounting has less to do with the math, as it does with its concepts. Now, there is no more difficult yet vital concept to understand than that of Debits and Credits. Debits and Credits are at the very heart of the 'double entry bookkeeping' that has been the foundation stone on which the financial world's accounting system has been built for well over 500 years. Now, given the length of time, is it any wonder that confusion has surrounded the concept of Debits and Credits as the English language and its laws have morphed to bring new definitions for two words that in the accounting world have their own very special significance and meaning. In this session we will look into the meaning and application of this vital area of bookkeeping and accounting.

INTRODUCTION to Debits and Credits

The accounting system we use today is actually very similar to the one used by the Venetian merchants during the Renaissance Period in the 15th century. It was actually known back then as the ‘Venetian Method’ and was first documented by a Franciscan friar and mathematician called Luca Pacioli (1446–1517).

Luca Pacioli is widely regarded as the "Father of Accounting" 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 published in 1494 and it was one of the earliest books published on the Gutenberg press.

One section of his five section book, contains 36 short chapters on the details of the ‘double-entry accounting’ system that was widely used by the Venetian merchants of Italy. One of those chapters dealt with the concept of Debits equalling credits -'double entry bookkeeping’

Now the dictionary defines Debits and Credits, for the bookkeeping system, as Debits ‘being those entries recorded on the left side’ and Credits ‘being those entries recorded on the right’ side. Now while this is correct, many students of accounting would like to know more about this rather illusive concept.

To do this we should look at the meaning of the original Latin word that Luca used. The English translators took their word Credit and Debit from the Latin word ‘Credre’ and ‘Debere’ respectively: ‘Credre’ (means ‘to entrust’) and ‘Debere’ (means ‘to owe’). So how does this help us understand the ‘double-entry bookkeeping’ concept?

When one looks closely into these two concepts one realizes that they are actually two sides of the same coin. In a closed financial system, money can not just materialize. It can not come from nowhere. If money is received by someone it must have come from someone. That is, if someone ‘entrusts’ an amount of money to someone then that person receiving the ‘entrusted’ money would ‘owe’ the same amount of money in return: i.e. the ‘Credre’ must equal the ‘Debere’. Luca could see the duality that existed in a closed financial system and so was able to describe the entire ‘double-entry bookkeeping’ based on this concept.

It is quite possible that we have adopted the abbreviations of ‘Dr and Cr’ from the Latin roots as well, because while there is no “r” in Debit there is one the the Latin form ‘Debere’.

It is prudent for all accounting students to learn off by heart the rules relating to debits and Credits as applied to the different account groups. They are:

Do I DEBIT it or CREDIT it?

ASSET - Debit if you increase Credit if you decrease the $ amount LIABILITY - Credit if you increase Debit if you decrease the $ amount OWNERS EQUITY - Credit if you increase Debit if you decrease the $ amount INCOME - Credit if you increase Debit if you decrease the $ amount EXPENSES - Debit if you increase Credit if you decrease the $ amount

Steps to Determine Debit or Credit

Under this approach you would ask the following questions when ever required to record a financial transaction in the firm's accounts. 1. What accounts are involved? (There must be a minimum of 2) 2. What account group do they each belong? (They must belong to one of the five) 3. Has the financial transaction increased or decreased the $ amounts in this account? 4. Apply the table logic. 5. Make sure that the total amount $ of the debits = the total $ amount of the credits.

WHOSE PERSPECTIVE?

One 'credit' that worries most newcomers to accounting, is the one that appears on their bank statement. See they have just learnt that 'cash at bank' is an asset and according to Table 1 when you increase an asset you 'debit' it ... so how come the credit balance in my bank account goes up when I deposit money ... they ask. Well the answer is one that is fundamental to the accounting system. Each firm records financial transactions from their own perspective. So, think about the bank's perspective for a moment ... how do they view the money you have just deposited? Whose money is it? That's right ... it is yours! So your deposit is treated, from the bank's perspective, as a liability (money owed by the bank to others). When you deposit money into your account, THEIR liability increases which is why (using the logic above) they credit your account.

Now, if you would like more in-depth reading on this concept, go to the link provided above.

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