Debits and credits
Debits 'and credits' in double-entry bookkeeping are entries made in account ledgers to record changes in value resulting from business transactions. A debit entry in an account represents a transfer of value to that account, and a credit entry represents a transfer from the account. Each transaction transfers value from credited accounts to debited accounts. For example, a tenant who writes a rent cheque to a landlord would enter a credit for the bank account on which the cheque is drawn, and a debit in a rent expense account. Similarly, the landlord would enter a credit in the rent income account associated with the tenant and a debit for the bank account where the cheque is deposited.
Debits typically increase the value of assets and expense accounts and reduce the value of liabilities, equity, and revenue accounts. Conversely, credits typically increase the value of liability, equity, and revenue accounts and reduce the value of asset and expense accounts.
Debits and credits are traditionally distinguished by writing the transfer amounts in separate columns of an account book. This practice simplified the manual calculation of net balances before the introduction of computers; each column was added separately, and then the smaller total was subtracted from the larger. Alternatively, debits and credits can be listed in one column, indicating debits with the suffix "Dr" or writing them plain, and indicating credits with the suffix "Cr" or a minus sign. Debits and credits do not, however, correspond in a fixed way to positive and negative numbers. Instead the correspondence depends on the normal balance convention of the particular account.
History
The modern double entry system was likely a direct precursor of the first European adaptation many centuries later. The first known use of the terms "debit" and "credit" occurred in the Venetian Luca Pacioli's 1494 work, Summa de Arithmetica, Geometria, Proportioni et Proportionalita. Pacioli devoted one section of his book to documenting and describing the double-entry bookkeeping system in use during the Renaissance by Venetian merchants, traders and bankers. This system is still the fundamental system in use by modern bookkeepers.It is sometimes said that, in its original Latin, Pacioli's Summa used the Latin words wiktionary:debere and wiktionary:credere to describe the two sides of a closed accounting transaction. Assets were owed to the owner and the owners' equity was entrusted to the company. At the time negative numbers were not in use. When his work was translated, the Latin words debere and credere became the English debit and credit. Under this theory, the abbreviations Dr and Cr derive directly from the original Latin. However, Sherman casts doubt on this idea because Pacioli uses Per for the debtor and A for the creditor in the Journal entries. Sherman goes on to say that the earliest text he found that actually uses "Dr." as an abbreviation in this context was an English text, the third edition of Ralph Handson's book Analysis or Resolution of Merchant Accompts and that Handson uses Dr. as an abbreviation for the English word "debtor". The words actually used by Pacioli for the left and right sides of the Ledger are "in dare" and "in havere". Geijsbeek the translator suggests in the preface:
f we today would abolish the use of the words debit and credit in the ledger and substitute the ancient terms of "shall give" and "shall have" or "shall receive", the personification of accounts in the proper way would not be difficult and, with it, bookkeeping would become more intelligent to the proprietor, the layman and the student.
As Jackson has noted, "debtor" need not be a person, but can be an abstract party:
...it became the practice to extend the meanings of the terms... beyond their original personal connotation and apply them to inanimate objects and abstract conceptions...This sort of abstraction is already apparent in Richard Dafforne's 17th-century text The Merchant's Mirror, where he states "Cash representeth a man to whom I … have put my money into his keeping; the which by reason is obliged to render it back."
Aspects of transactions
To determine whether to debit or credit a specific account, we use either the modern accounting equation approach, or the classical approach. Whether a debit increases or decreases an account's net balance depends on what kind of account it is. The basic principle is that the account receiving benefit is debited, while the account giving benefit is credited. For instance, an increase in an asset account is a debit. An increase in a liability or an equity account is a credit.The classical approach has three golden rules, one for each type of account:
- Real accounts: Debit whatever comes in and credit whatever goes out.
- Personal accounts: Receiver's account is debited and giver's account is credited.
- Nominal accounts: Expenses and losses are debited and incomes and gains are credited.
For example, if a company provides a service to a customer who does not pay immediately, the company records an increase in assets, Accounts Receivable with a debit entry, and an increase in Revenue, with a credit entry. When the company receives the cash from the customer, two accounts again change on the company side, the cash account is debited and the Accounts Receivable account is now decreased. When the cash is deposited to the bank account, two things also change from the bank's perspective: the bank records an increase in its cash account and records an increase in its liability to the customer by recording a credit in the customer's account. Note that, technically, the deposit is not a decrease in the cash of the company and should not be recorded as such. It is just a transfer to a proper bank account of record in the company's books, not affecting the ledger.
To make it more clear, the bank views the transaction from a different perspective but follows the same rules: the bank's vault cash increases, which is a debit; the increase in the customer's account balance is a credit. A customer's periodic bank statement generally shows transactions from the bank's perspective, with cash deposits characterized as credits and withdrawals as debits in depositor's accounts. In the company's books the exact opposite entries should be recorded to account for the same cash. This concept is important since this is why so many people misunderstand what debit/credit really means.
Commercial understanding
When setting up the accounting for a new business, a number of accounts are established to record all business transactions that are expected to occur. Typical accounts that relate to almost every business are: Cash, Accounts Receivable, Inventory, Accounts Payable and Retained Earnings. Each account can be broken down further, to provide additional detail as necessary. For example: Accounts Receivable can be broken down to show each customer that owes the company money. In simplistic terms, if Bob, Dave, and Roger owe the company money, the Accounts Receivable account will contain a separate account for Bob, and Dave and Roger. All 3 of these accounts would be added together and shown as a single number on the balance sheet. All accounts for a company are grouped together and summarized on the balance sheet in 3 sections which are: Assets, Liabilities and Equity.All accounts must first be classified as one of the five types of accounts . To determine how to classify an account into one of the five elements, the definitions of the five account types must be fully understood. The definition of an asset according to IFRS is as follows, "An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity". In simplistic terms, this means that Assets are accounts viewed as having a future value to the company. Liabilities, conversely, would include items that are obligations of the company.
The Equity section of the balance sheet typically shows the value of any outstanding shares that have been issued by the company as well as its earnings. All Income and expense accounts are summarized in the Equity Section in one line on the balance sheet called Retained Earnings. This account, in general, reflects the cumulative profit or loss of the company.
The Profit and Loss Statement is an expansion of the Retained Earnings Account. It breaks-out all the Income and expense accounts that were summarized in Retained Earnings. The Profit and Loss report is important in that it shows the detail of sales, cost of sales, expenses and ultimately the profit of the company. Most companies rely heavily on the profit and loss report and review it regularly to enable strategic decision making.
Terminology
The words debit and credit can sometimes be confusing because they depend on the point of view from which a transaction is observed. In accounting terms, assets are recorded on the left side of asset accounts, because they are typically shown on the left side of the accounting equation. Likewise, an increase in liabilities and shareholder's equity are recorded on the right side of those accounts, thus they also maintain the balance of the accounting equation. In other words, if "assets are increased with left side entries, the accounting equation is balanced only if increases in liabilities and shareholder’s equity are recorded on the opposite or right side. Conversely, decreases in assets are recorded on the right side of asset accounts, and decreases in liabilities and equities are recorded on the left side". Similar is the case with revenues and expenses, what increases shareholder's equity is recorded as credit because they are in the right side of equation and vice versa. Typically, when reviewing the financial statements of a business, Assets are Debits and Liabilities and Equity are Credits. For example, when two companies transact with one another say Company A buys something from Company B then Company A will record a decrease in cash, and Company B will record an increase in cash. The same transaction is recorded from two different perspectives.This use of the terms can be counter-intuitive to people unfamiliar with bookkeeping concepts, who may always think of a credit as an increase and a debit as a decrease. This is because most people typically only see their personal bank accounts and billing statements. A depositor's bank account is actually a Liability to the bank, because the bank legally owes the money to the depositor. Thus, when the customer makes a deposit, the bank credits the account. At the same time, the bank adds the money to its own cash holdings account. Since this account is an Asset, the increase is a debit. But the customer typically does not see this side of the transaction.
On the other hand, when a utility customer pays a bill or the utility corrects an overcharge, the customer's account is credited. This is because the customer's account is one of the utility's accounts receivable, which are Assets to the utility because they represent money the utility can expect to receive from the customer in the future. Credits actually decrease Assets. If the credit is due to a bill payment, then the utility will add the money to its own cash account, which is a debit because the account is another Asset. Again, the customer views the credit as an increase in the customer's own money and does not see the other side of the transaction.