Demystifying Debits and Credits

Accounting as a method of maintaining an official account of a business venture has been around for thousands of years with the first evidences of accounting stretching all the way back to ancient Babylon and Assyria more than 7,000 years ago. Back then most transactions were simple bartering and little was required to keep accurate accounts of the business transactions[1].

Accounting as we know it today actually began in the late thirteenth century. During this era, Europe moved away from bartering and began using a monetary system. This allowed for banking houses to begin lending to merchants providing them capital to expand into international economic empires. With these changes, the Italian merchants began to realize that the simple counting of property that their predecessors had used was no longer sufficient. In addition to tracking their property, the merchants now needed a method to track their debts as well (which is a difficult task when you consider that negative numbers had not been accepted in the business world yet). The complexity and quantity of transactions also expanded as the merchant empires moved further into foreign shores. There came a point where merchants needed accounting personnel meaning that the owner could not be constantly aware of what was happening in his books. This meant that the new accounting system also had to help in reducing human error and minimize the risk of fraud. What developed was a system of accounting called “Dual-Entry Accounting” which has remained mostly unchanged into modern times. Dual-entry accounting is a method of accounting where every transaction is recorded twice. Transactions are entered twice in order to ensure accuracy by confirming that each side of the transaction is equal to the other.

To better understand the underlying concepts of dual-entry accounting, let’s look at a textbook. Actually, we will be looking at the textbook: Summa de Arithmetica, Geometria, Proportioni et Proportionalità by Luca Pacioli which is recognized as the first official text on dual-entry accounting. Pacioli’s text was widely circulated as a reference for merchants, a textbook for their children, and as a source of entertainment (yes, accounting can be entertaining, even in the 1300s)[2].

In his book, Pacioli explained that the principle reason for dual-entry accounting was to “provide the trader with data readily available regarding his [property (called Assets)] and [business debts (called Liabilities)]”[3]. This created a difficult problem for Pacioli since, as I mentioned earlier, he couldn’t use negative numbers. The solution to this problem was to divide the page vertically down the middle to create sides so that your accounting resembles a “T”. Even today, these are called T-accounts.

On the left side of the account, Pacioli put the value of anything owed to the merchant (such as property and any debts owed to him- called accounts receivable) and on the right side, Pacioli put the value of anything that the others entrusted to the merchant (any debts – called accounts payable or liabilities). The transaction would now look like this:

In Latin, which was the language that Pacioli wrote his book in, the term “he owes” is Debit and the term “he trusts” is Credit[4]. This makes inherent sense when you think about it because a debt is when a bank or person extends you credit – or trust. So any time what someone owes you (like your accounts receivable or your assets) goes up, you would put the value on the left (“he owes” – or Debit) side. If what is owed you decreases, since there are no negative values, you would put the value on the right (or Credit) side. Likewise, if you wanted to increase the amount that someone has entrusted you with (an extension of credit), you would add this amount to the right (“he trusts” – or Credit) side. Any time you pay off your debts, you would reduce the liability by placing that amount on the opposite – or Debit – side of the transaction.

So let’s look at a simple transaction like a bank deposit. If I earned money and deposited it in the bank, the bank owes me that money so it’s a Debit. “Now wait a minute!” You are probably thinking, “On my bank statement deposits show up as a credit! Withdraws are debits, isn’t that why they call it a Debit card?” Well… the simple answer is yes. If you think about it, the bank prints those statements from their perspective, not yours. So if you think about it from the bank’s side, every time you make a deposit you have entrusted the bank with your funds. This is a credit. Anytime you withdraw the money, this trust is reduced and it’s a debit. This is why banking is opposite to the natural flow of accounting – you’re just looking at it from the wrong side of the fence.

This is also why many people get confused easily with the concept of debits and credits. At their core, though, I think you’d agree that debits and credits are really easy. They are simply an efficient way to track what is owed to you and what is entrusted to you without using zeros. Nothing more, nothing less.

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