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What Is Accounting? What Are Debits
and Credits?
Do debits and credits confuse you? Does the subject of accounting scrabble your synapses or lapse you into a coma? You’re not alone. Most students enrolled in an introductory class in accounting often find themselves asking, “what am I doing here!?” And then immediately avoid all future accounting courses and major in marketing. Accounting is a language as much as it is a quantitative discipline. It is often referred to as the language of business, having a grammar and syntax all of its own. Once you understand the syntax—the rules of the language—it will make sense to you. A short history of its evolutionary history may assist you in understanding this unique language. In the early Renaissance in Venice, Italy, subsequent to trade opening with the Far East, bankers and merchants needed a system to keep track of monetary transactions: how much money and goods had been entrusted by someone and from whom. The tracking required two components: how much of what; and how much from whom. In 1494, a monk (Luca Pacioli) codified this system of accounting for monetary transactions in the first book on accounting, outlining its syntax, or grammatical rules, the basis of the double entry method of accounting still in use today. Of course, these two components—the total amount of what has been entrusted to or owed by one, and the total amount of who loaned or entrusted the what—should always be equal. This duality—the “what” and the “from whom (or where)”—are two sides of the same coin. These monetary transactions were recorded in statements, or accounts. Accounts were established for the major kinds of whats and whos. It facilitated the repetitive entry of similar transactions, involving the same whats and/or whos. But what are debits and credits, and how did they evolve to such significance in accounting? In accounting the words debit and credit refer to the opposite sides of an account: debit means the left side of an account; credit means the right side of an account. The term debit comes from the Latin debitum which means "that which is owing" (the past participle of debere "to owe"). ). The term credit comes from the Latin credere/credit meaning "to trust or believe"/"he trusts or believes" via the French credit and the Italian credito. It is easy to see how the term debit became the conventional business term to refer to the total of that which is owed (i.e., the what) in a monetary transaction; and credit became the conventional business term to refer to the total of who entrusted (i.e., the who) the what in that monetary transaction. And probably because merchants recorded the “what” before the “who”, the term debit evolved to refer to the entry recorded on the left side of the account, and the term credit to the entry on the right side of the account. Let’s review quickly what has been discussed above, reducing the associations into equations: Total of what we have = Total of who provided the what (where we got the what) Debits = Credits We can rewrite the top equation as the follows: Assets = Equities From these two equalities we see the following: to reflect an increase in what we have, we debit an asset account; to reflect an increase in the who or source (i.e., the where) of the asset, we credit an equity account. Conversely, to reflect a decrease in what we have, we credit an asset account; to reflect a decrease in the source of or the where we received what we have, we debit an equity account. (Note that neither of these two terms—debit or credit—mean an increase or a decrease per se. Debit simply refers to the left side of an account; credit to its right side. When we recognize an asset, we post an entry to the left side of the appropriate account; when we recognize an equity transaction, we post an entry to the right side of the account. Both entries represent increases in their respective accounts.) Assets = Equities is our very basic accounting equation. Of course, there are different kinds of assets and equities. Equities are categorized into two basic types: liabilities and stockholders’ equity, with the latter representing the amount of equity provided by the owners of the business entity, and the former representing the equity provided by those not having an ownership interest in the entity. Now let’s rewrite the accounting equation to reflect this distinction: Assets = Liabilities + Stockholders’ Equity As you plainly can see, this basic accounting equation is the essence of today’s Balance Sheet. Of course, it means that what we have (assets) should always equal the total of the amounts provided by our creditors (liabilities) and by us, the owners (stockholders’ equity). We provide resources as owners in two principal ways: either we directly contribute money, other resources, or capital to the company; or the company itself generates money, other resources, or earnings, and is left or retained in the company by us. In other words, Stockholders’ Equity consists of two major components: Contributed Capital; and Retained Earnings. Consequently, we can rewrite our basic accounting equation as follows: Assets = Liabilities + Contributed Capital + Retained Earnings The company earns money and resources from its principal business activity. Remembering that all increases in sources of assets are reflected as credits in bookkeeping, all incoming revenues are posted to accounts as credits. Conversely, recalling that all decreases in sources of assets are reflected as debits in bookkeeping, all expenditures of money are posted to accounts as debits. Since the activity of our business is the main reason why we have a bookkeeping system in the first place, Retained Earnings, as a separate account in our bookkeeping system, is further decomposed into sets of accounts: one set representing all revenues earned from our business activity; another set representing all expenditures or expenses incurred from our business activity; and an account representing distributions from earnings (i.e., dividends) to the stockholders. Retained Earnings = Revenues – Expenses – Dividends Expenses and Dividends have a minus sign because they are debit entries, representing decreases in equity. Since our basic accounting equation is at a specific point in time—for example, as of December 31, 2009—the above equation may be written to reflect the change in Retained Earnings for the most recent year (assume 2009): Retained EarningsDecember 31, 2009 = Retained EarningsJanuary 1, 2009 + Revenues2009 – Expenses2009 – Dividends2009 Doing a little algebra, we derive the following equation: Change in Retained Earnings = Revenues – Expenses – Dividends Excluding dividends and focusing only on the results from our business activity, we may rewrite the above equation: Change in Retained EarningsBusiness Activity = Revenues – Expenses The periodic change in Retained Earnings from our business activity, of course, is referred to as our Net Income or Net Loss, depending upon the relative values of revenues and expenses: Net Income (Loss) = Revenues – Expenses This equation, of course, is the essence of today’s Income Statement. Because it is equally important not only to know what we have and who provided such, as in the basic accounting equation, but also to know the change over what we have from our principal business activity over a normal business cycle or period of time, this separate accounting equation assumed at least equal significance to the providers of equity as the basic accounting equation underlying the Balance Sheet. Let’s summarize what we reviewed here. Accounting records what we have (i.e., assets) as debits or as postings to the left side of an account, and the where or from whom we obtained the assets or the financial means to acquire them (i.e., equities) as credits or as postings to the right side of an account. Conversely, decreases in assets and equities are represented by credits and debits, respectively. The basic accounting equation is the essence of a Balance Sheet, showing what we have and where/from whom we got it all, at a specific point in time. An analysis of the change in Retained Earnings, a subcomponent of Equity in our basic accounting equation, shows the change in what we have over a period of time (customarily a month, quarter, or year) from the activity of our business, including any dividends to the stockholders. This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice. For further information, please consult appropriate professional advice from your attorney and certified public accountant. Have a tax or an accounting question? Please feel free to submit it to William Brighenti, Certified Public Accountant, Hartford CPA Accountants. For information and assistance on any tax and accounting issue, please visit our website, Accountants CPA Hartford, and our blog, Accounting and Taxes Simplified. If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein. The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor. |
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