Basic Accounting Concepts 2 – Debits and Credits basicaccountingconcepts.education /basic-accounting /basic-accounting-concepts-2-debitsconcepts-2-debits-and-credits/ and-credits/
Most people don’t find the math of Accounting as difficult as understanding the concepts of accounting, and for many there is no more difficult concept to grasp than that of Debits and Credits. Now the concept of Debits and Credits is actually more than 500 years old, being used extensively by the Venetian merchants of Italy in the 15th century Renaissance period. The concepts were first documented in Latin in the 1400’s and were later translated into English in the 16th century. Is it any wonder then, with the passage 500 years, that we may have become a little confused about the original meaning and concepts, particularly with the English language adopting new legal and everyday meanings for these age old words. So it may be beneficial then, as we try to understand the concept of Debits and Credits, to go back to where it all begun … but first some background.
Basic accounting concepts – for bookkeeping students This training session is targeted at students who have a desire to learn more about bookkeeping. While specifically developed for students other people interested in understanding more fully the accounting concepts, concepts, may also find this training session beneficial. Prior to commencing this training session, it is recommended that you first complete the Basic Accounting Concepts 1 – Definitions. This training session assumes that you know a little about bookkeeping but that you realise to progress in your work application or your learning, you need to understand more fully the concept of Debits and Credits. So, this session seeks to deliver training on the concept of Debits and Credits, from the student bookkeeper’s point of view.
Keywords Key words Credits, debits, firm, accounts, accounting concepts, bookkeeping, bookkeeping, financial transaction, accounting system, Luca Pacioli, account group, double entry bookkeeping, duality of financial transactions.
Learning outcomes At the completion of this training session, you will be able to answer the following focus questions: 1. What is the origin of Debits and Credits? Credits? 2. Why was it called Debit and and Credit? 3. What are the underpinning concepts for Debits and Credits? 4. How would they they have applied applied Credits and and Debits in the the 1400’s? 5. Is there another another way to look at applying applying Debits and and Credits?
Introduction – Debits and Credits The dictionary defines Debits and Credits, for the bookkeeping system, as Debits ‘ being those entries recorded on the left side’ and and Credits ‘being those entries recorded on the right’ side. side. Now some people are comfortable with this definition and after learning all the other rules and axioms of bookkeeping, go on to become very good bookkeepers.
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However, there are others that want to know more about this basic accounting concept of Debits and Credits so that they can apply them in a more meaningful way. If you are in the latter group, then this Knol is for you. It will also make it clear that “while rules must be learnt, at some stage the reason for them must be made clear; if this is not done it has little educative value” (Russel, B. (1924) Economic Individualism. Cambridge. On Education) Before proceeding, it would be very useful for both the rule-learning and concept-understanding bookkeeping students to learn ‘off by heart’ the table given below and to also have a solid understanding of the definition of each account group used in the bookkeeping/accounting process. Note: One thing that is very clear is that the terms ‘debit and credit’, as used in bookkeeping, has its own special meaning and it should not be confused with any other meaning of the term. (i.e. Debt as in owing money to someone or Credit as in having time to pay for the purchase of goods are not definitions of the Accounting Debit and Credit) Also, the accounting meaning of a term may have a different application to the legal meaning within the same country.
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Download poster here:https://app.box.com/s/e5ls2e8h1g7h8ykxfp3p Under the Table 1 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. Table 2 – Definitions of Basic Accounting Concepts
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. 3/13
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 Table 1) they credit your account.
Session – Debits and Credits PART 1 – What is the origin of Debits and Credits?
In more primitive trading times, bookkeeping was not such a big issue because the person who manufactured or produced the goods was usually the person selling or trading the goods in the market place. However, the Renaissance period saw a huge increase in both trade and banking systems brought about by the Roman-built transport systems and the growth of more sophisticated societies like those in Italy (particularly Venice). So, the merchants of Venice in the 1400’s, developed an accounting system to accurately record these more complex financial dealings that were prevalent of the time. Now a Franciscan friar and mathematician from that era, Luca Pacioli (1446–1517), is widely regarded to be 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 (about the time that Columbus discovered America) and it was one of the earliest books published on the Gutenberg press. Luca makes no claims about inventing the system but he does present it in a way that others can easily understand it. His motive for recording the bookkeeping system, that was used by the Venetian merchants during the Italian Renaissance period, was to help Guidobaldo, the Duke of Urbino , in the management of his financial affairs. This documented system, described in only one section of the five-section book, has become known as the ‘double-entry accounting’ system. The 36 short chapters on the accounting system contained in the book, became the only accounting text-book for the next hundred years and its principles have been continuously followed by accountants right up to today. Interestingly, Luca Pacioli was actually a colleague of Leonardo da Vinci and it was Leonardo who helped him illustrate his second most important manuscript De Divina Proportione (“Of Divine Proportions”). This fact was mentioned by the author and Leonardo Da Vinci mentions Pacioli many times in his notes. Opposite is a drawing of the Polyhedra which was one of the illustrations by Leonardo in Luca’s book. Other 4/13
interesting facts are uncovered by Marcino Guerrero in his Knol Pcaioli and Da Vinci# Most of Luca’s work still underpins the accounting system we use today. Those basic accounting concepts from his book in 1494 that are still practiced today include; The accounting cycle The use of journals and ledgers Debits equalled credits – ‘double entry bookkeeping’ The account groups of assets (including receivables and inventories), liabilities, capital, income, and expenses Year-end closing entries The trial balance, which he believed should be used to prove a balanced ledger. Summary In Part 1, we learned about the 500 years history of Debit and Credits and the significant contribution made to the world of accounting by the Franciscan friar and mathematician Luca Pacioli with his ‘double entry bookkeeping system.
PART 2 – Why was it called Debit and Credit?
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Now remember, Luca was more a mathematician than an accountant, so his mind would have been trained to look for the key principles, concepts and symmetry that underpinned the Venetian merchant’s financial recording system. Key concepts he would have identified were (1) that in the accounting world, the business (or firm) was an entity in its own right and that that entity was separate and distinct from the owners. Another principle he would have seen is that (2) the financial world is a closed system. That is, money just doesn’t just materialise form nowhere. If money is received by someone it must have been given by someone else and vice versa. This closed system of giving and receiving would have led him to see the concept of ‘duality’ in financial transactions relating to a firm. For example, when an amount of money is entrusted by someone to a separate and distinct firm, then that firm would now have an obligation and owe that person the same amount of money in return. Using his native Latin, Luca named the act of entrusting – ‘Credre’ (which means ‘to entrust’) and the corresponding obligation on the firm – ‘Debere’ (which means ‘to owe’). So, from the point of view of the firm, he could see that this principle of duality held true for every financial transaction entered into by the firm. For him, it was not just a formula but an aspect of existence where one side could not exist without the other. In a closed system, every ‘ Debere’ must have a corresponding ‘Credre’ and vice versa. In other words, ‘Debere’ and ‘Credre’ were two sides of the same coin. (In finance – when someone ‘entrusts’ money then someone else ends up ‘owing’ it’). Luca would also have noted that this duality of financial transaction extended to the fact that financial resources transfer from one place to another. In other words, for every financial transaction there must have been a transfer of economic resources from a source to a destination. Again he applied the concept where the source would be credited and the destination debited as financial resources flowed from one place to another. He was so convinced of this concept of duality, that he is said to declare that no one should go to sleep at night without ensuring that the ‘credre’ equalled the ‘debere’. (credits = debits)
Note: The English translators used the Latin roots for these concepts and so named them Debits and Credits. It is highly probable that we also got the abbreviated forms of these terms (Dr and Cr) from the Latin roots as well, because there is no ‘r’ in the English word Debit but there is one in its Latin form ‘Debere’.
Summary In Part 2, we see the emergence of the concept of duality where debits and credits are just two sides of the same coin in the way that the Chinese concept of ‘yin and yang’ are complementary opposites within a greater whole. We begin to see the concepts that underpin the application of Debits and Credits and the link to the original Latin root with its original meaning. 6/13
PART 3 – What are the underpinning concepts for Debits and Credits? To properly understand Debits and Credits you will need to first understand the concepts that underpin the whole accounting process. Some of these are called Accounting Conventions and others are simply re-enforcing the way that the accounting systems looks at and records financial transactions. Basic Accounting Concept 1 – The business or firm is an entity.
In simple terms, the legal system defines an entity as a person or non-person that is capable of suing or being sued under the laws of the land. In most countries of the world, companies are given this ‘non-person’ entity status and are given the same rights and obligations of individual persons. Accounting takes this concept a step further by stating that every firm (including sole traders and partnerships), creates its own ‘accounting entity’ and that the income and net worth of each entity must be calculated based on its own financial transactions.
Basic Accounting Concept 2 – The business (firm) is a separate entity distinct from the owners
A firm, while it has ‘legal’ control over items of value, it is not the ultimate owner of those things. In other words, if the firm sold everything it had, it would be obliged to distribute all those monies to meet the claims made by other people or entities. The firms first obligation is to pay the claims made by external people (i.e. loans and creditors) with the balance being given to meet the claims made by the owner(s). The business would then return to how it all began, as a blank sheet without obligations or the control of any items of value.
Basic Accounting Concept 3 – People can wear multiple hats.
While this a not a strict accounting concept, it is an important one to understand when getting the right perspective on financial transactions. Just like one person can be a parent, sibling, cousin or an offspring, so too a person can be an investor in a firm, a creditor/debtor of a firm, the manager of a firm or a director of a company that controls the operations of a firm. The important thing to remember is, that in accounting the financial transactions are always analysed and recorded from the firm’s point of view with you as the manager (not owner).
Basic Accounting Concept 4 – Every financial transaction has two sides to it and involves a source and a destination of economic resources.
The financial world is a closed system. That is, money does not just arrive from nowhere and it is not just paid into thin air. If money is received by one person or entity, it must have been given by another person or entity and that in every traction involving financial resources there must be a source and a destination. This gives us our first insight into the Debits and Credits system that we use in accounting today.
Basic Accounting Concept 5 – The profit from the firm’s activities belongs to the owners.
As understood from Concept 2, the firm does not really own anything, from an accounting perspective. It may have legal rights of ‘ownership’ or control, but fundamentally in accounting 7/13
terms it is an accounting entity set up by the owners to manage their affairs. So, when a firm makes a profit it does so for the owner’s benefit, not for the firm’s. Remember, if everything was sold off the firm would be left with nothing because everything of value would be used to first pay off liabilities with the remainder going to the owners.
Summary
In Part 3, we get to understand the accounting concepts that not only underpin the concept of Debits and Credits, but the whole accounting system as well. We learnt that; 1. The business or firm is an entity. 2. The business (firm) is a separate entity distinct from the owners 3. People can wear multiple hats and operate in multiple capacities. 4. Every financial transaction has two sides to it. (a source and a destination) 5. The profit from the firm’s activities belongs to the owners.
PART 4 – How would they have applied Credits and Debits in the 1400’s?
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As Lucia pointed out, the accounting system he documented was being widely used by the Venetian merchants. These people seem to be the 15th century entrepreneurs. Let’s say that a Venetian entrepreneur named Antonio asked Lucia to record the financial transactions of his new business (firm) prior to Luca completing his famous ‘Summa’ book in 1494. (Note: For the purposes of this story we will use the $ rather than the Venetian ducat or Florence’s famous fiorino d’oro ‘golden florin’ and use the English accounting terms rather than the Latin) The story goes … Antonio had spotted an opportunity to sell Italian olives to Egypt. Antonio thought he could make a killing. So, Antonio (as manager of the new firm) approached an Italian olive provider and convinced him to supply $100,000 worth of olives but with the promise to pay him on his return from Egypt. Antonio did not mention the profit he was going to make because the olive provider’s only interest was in being paid for the olives. So, Lucia had his first financial transaction, and noted the following using the Latin meanings for Debits and Credits:
The source of the economic resources was the Italian olive producer whom the firm now owed $100,000 – Credit (Cr) Accounts payable and The destination of the transfer of economic resources was the olives that the firm now had as inventory – Debit (Dr) Inventory
Using the Table 1 approach we would make the following entry:
Asset – Inventory (increase) Liability – Accounts Payable – Olive Provider (increase)
$100,000 Dr $100,000 Cr
Soon after, Antonio took Luca to see the $50,000 ship he had bought, using $30,000 of his own money and $20,000 from a bank (loan funds). Antonio was excited because he now knew that he had the means to make 9/13
his idea a reality and make that fortune he dreamed of from selling these olives. Luca realised that while Antonio was always speaking about what he had done, Luca knew that he was really speaking about what the firm had done with Antonio as its manager. Luca realized that the firm had been involved in its second financial transaction and again noted the following from the firm’s point of view:
One source of economic resources was the bank who the firm now owed $20,000 in the form of a loan – Credit (Cr) Bank loan and Another source of economic resources was the $30,000 from the owner Antonio who the firm treated as a separated entity to itself – Credit (Cr) Capital and The destination of the economic resources sourced from the bank and the owner was a ship that was purchased for $50,000 – Debit (Dr) Ship
Using Table 1 approach we would make the following entry
Asset – Ship (increase) Liability – Bank Loan (increase) Owners Equity – Capital – Antonio (increase)
$50,000 Dr $20,000 Cr $30,000 Cr
Luca was happy because in both financial transactions (1) the total of the debits equalled the credits and (2) the underlying concepts of the ‘double entry bookkeeping’ system had been adhered to. Summary Armed with the underpinning ‘double entry bookkeeping’ concepts and the concept of the source and destination of economic resources, we attempt to see what Luca saw as he contemplated the entries that would be made in the fictitious books of this 15th century business.
PART 5 – Is there another way to look at applying Debits and Credits? Today we look at Luca’s notes and we discover an emerging pattern. It appears that Luca could use concepts of source and destination of financial resources to describe every transaction. It seems that …
… on with the story. Antonio was soon back in town after successfully completing his ‘sales trip’. Antonio explained that he (as 10/13
manager) had sold all the olives for $200,000 and the trip had only cost $30,000 including the $1,000 interest he paid to the bank. He explained that he had paid these amounts out of the sale proceeds and that he had visited the Olive provider to repay his account. He also said that he had used $10,000 of the sales proceeds to buy furniture for his house in celebration of a successful trip. We soon realise that a third series of financial transaction for the firm has happened involving five main parts.
Part 1 – The sale of the olives for $200,000 cash Part 2 – The Olive provider was paid for his outstanding account. Part 3 – The use of $30,000 of cash proceeds to pay for the trip costs and interest expense Part 4 – The withdrawal and use of $10,000 by Antonio (as owner)
Taking over from Luca, we will look at these transactions and apply the source and destination approach to determining the Debits or Credits of the transaction and comparing the results with the table rule approach identified above. Here is what we would have come up with;
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All the account groups have been affected in this transaction, yet you can see that we still achieve the same outcome using the ‘source and destination’ approach as the learned-Table 1 approach, but there is an underlying meaning to the questions and they are in keeping with Luca’s original Latin meaning. Summary In Part 5, we explore the idea that all financial transactions could be interpreted from the point of view of the source and destination of economic resources. Having just two main questions, we are able to apply a different and more meaningful approach to determining a Debit entry into the firm’s books, or a Credit one. We have attempted to link this approach to the likely meaning that Luca Pacioli had for the terms Debits and Credits. So, apart from learning and applying the logic of the Table 1 approach to your debits and credits, you could also apply this alternative view developed from the first principles of Luca Pacioli’s work using concept that the source of economic resources in any transfer is credited and the destination of those economic resources is debited .
Additional resources 1. Chapter 21 of the ‘Tao of Financial Information” http://taofinancial.blogspot.com/ 2. Articles on bookkeeping and accounting
Conclusion – Debits and Credits The key learnings from this training session were: 1. To understand the origins of the terms Debits and Credits 2. To understand the reason it called Debits and Credits 3. To identify and comprehend the underpinning accounting concepts for Debits and Credits 4. To see how would they have applied Credits and Debits back in the 1400’s. 5. To find a meaningful way to apply Debits and Credits to financial transactions.
We set out at the start of this article to understand more fully the basic accounting concepts of Debits and 12/13
Credits. We know that we can be a successful bookkeeper by simply applying the learned Table 1 approach, but some people want to understanding the ‘why’? By going back to the time of its conception, and looking at the original meanings we have been able to give meaning and a new approach to determining the Debits and Credits of financial transactions.
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