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. Alt URL 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 increase the value of assets and expense accounts and reduce the value of liabilities, equity, and revenue accounts. Conversely, credits 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.Nigam, B. M. Lall (1986). Bahi-Khata: The Pre-Pacioli Indian Double-entry System of Bookkeeping. Abacus, September 1986. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1467-6281.1986.tb00132.x/abstract. 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 (A Summary of Arithmetic, Geometry, Proportions and Proportionality). 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 (to owe) and (to entrust) 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 (for debit) and Cr (for credit) derive directly from the original Latin. However, Sherman"Wheres's the "R" in Debit?" by W. Richard Sherman published in The Accounting Historians Journal, Vol. 13, No. 2 (Fall 1986), pp. 137–143. casts doubt on this idea because Pacioli uses Per (Italian for "by") for the debtor and A (Italian for "to") 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 (1633) of Ralph Handson's book Analysis or Resolution of Merchant AccomptsAnalysis or Resolution of Merchant Accompts 3e at WorldCat and that Handson uses Dr. as an abbreviation for the English word "debtor" (Sherman could not locate a first edition, but speculates that it too used Dr. for debtor). The words actually used by Pacioli for the left and right sides of the Ledger are "in dare" and "in havere" (give and receive)."For each one of all the entries that you have made in the Journal you will have to make two in the Ledger. That is, one in the debit (in dare) and one in the credit (in havere). In the Journal the debtor is indicated by per, the creditor by a, as we have said...The debitor entry must be at the left, the creditor one at the right." A facsimile of the original Italian is given on the facing page to the translation. Geijsbeek the translator suggests in the preface: [I]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...Jackson, J.G.C., "The History of Methods of Exposition of Double-Entry Bookkeeping in England." Studies in the History of Accounting, A. C. Littleton and Basil S. Yamey (eds.). Homewood, III.: Richard D. Irwin, 1956. p. 295 This sort of abstraction is already apparent in Richard Dafforne's 17th-century text The Merchant's Mirror, where he states "Cash representeth (to me) 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 (based on five accounting rules), or the classical approach (based on three 'golden rules'). 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.
Kind of account Debit Credit Asset Increase Decrease Liability Decrease Increase Income/Revenue Decrease Increase Expense/Cost/Dividend Increase Decrease Equity/Capital Decrease IncreaseAccounts with normal debit balances are in bold
Debits and credits occur simultaneously in every financial transaction in double-entry bookkeeping. In the accounting equation, Assets = Liabilities + Equity, so, if an asset account increases (a debit (left)), then either another asset account must decrease (a credit (right)), or a liability or equity account must increase (a credit (right)). In the extended equation, revenues increase equity, while expenses, costs, and dividends decrease equity, so their difference is the impact on the equation.
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 (increased) and the Accounts Receivable account is now decreased (credited). 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 (debit) and records an increase in its liability to the customer by recording a credit in the customer's account (which is not cash). Note that, technically, the deposit is not a decrease in the cash (asset) 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 clearer, the bank views the transaction from a different perspective but follows the same rules: the bank's vault cash (asset) increases, which is a debit; the increase in the customer's account balance (liability from the bank's perspective) is a credit. A customer's periodic bank statement generally shows transactions from the bank's perspective, with cash deposits characterized as credits (liabilities) and withdrawals as debits (reductions in liabilities) 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 (i.e. total 'Accounts Receivable' – balance owed) 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 (accounting elements) (asset, liability, equity, income and expense). 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 (i.e. cash, accounts receivable, equipment, computers). Liabilities, conversely, would include items that are obligations of the company (i.e. loans, accounts payable, mortgages, debts).
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 (retained earnings) or loss (retained deficit) 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.
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