Guest post by Peter Baskerville. Read the original post on Quora: In accounting, why do we debit expenses and credit revenues?
I wish there was a simple answer to this question … but there isn’t. The rules of debit & credit in accounting are simple enough to learn and apply, but understanding the ‘why’ is far more complex, particularly when you are trying to understand the ‘first principles’ of a system that was created over 500 years ago.
Here is the ‘first principles’ thinking that I use to understand the concept of ‘debits and credits’ in accounting and to explain the reason why expenses are debited and revenues are credited in the double-entry bookkeeping system. But to get to the answer, we must first understand some basic principles and concepts regarding business, finance and accounting. These are:
1. The relationship between the business and the owners of the business
See at its inception, a business is a new entity that is created by owners for the purpose of making them money (profits). So a business begins with nothing and only gets its assets when owners, who are desirous of profits, transfer (invest) economic value (funds) to the business . Any profit subsequently made by the business is then owed to the owners. In this state, regardless of how the business came to have assets under its control, the owners still have a claim over all of them. So the items of economic value controlled by the business would be equal to the owners’ investments plus the profit that are owed to the owners. This relationship can be represented by the formula:
Assets of the business (items of economic value) = Owners Equity (Owners investment + business profits)
2.The relationship between the business and external funders
Ever since the rise of the banking system in Venice in the 1400s, businesses have been able to leverage their assets to secure borrowed funds from financial institutions. These funds, that are transferred into the business, are different to the owner’s investments because the financial institutions were not chasing the profits of the business and only wanted to get their funds repaid + an extra charge for the use of these funds (interest). These types of funds are called liabilities. Now while these liabilities increase the assets of the business, in this case, it is the external funders that have a claim over them rather than the owners. Businesses that accept external funding in the form of liabilities create an adjusted formula to the one previous stated. The new formula is:
Assets of the business (items of economic value) – Liabilities (money owed to external funders) = Owners Equity (Owners investment + business profits)
The assets of the business minus the value of the liabilities is often referred to in finance and accounting as net assets. So the formula above can be simplified down to:
Net assets of the business = Owners equity
3.The formation of the debit and credit concept
In this simplified form we can begin to see what the mathematician and Father of Accounting (Luca Pacioli) saw in 1494 when he codified the double-entry bookkeeping system. It is his codified system that outlined the rules for applying debits and credits when recording the financial transactions of a business in the double-entry bookkeeping system.
Now remember that Luca’s book in 1494 was written and published in Latin and at a time when the concept of negative numbers was not yet accepted in Europe. So he spoke of the terms ‘Debere’ and ‘Credere’ which means in Latin ‘to owe’ and ‘to entrust’ respectively because to him they reflected the interlocking relationship created by a business and its owners and represented in the above formula.
To maintain this fundamental truth that the value of the net assets of the business must be equal to the value of the owners’ equity, Luca introduced the concept that the net assets side of the equation would be represented as Debere (Debits = funds owed to the owners) and the owners equity side would be represented as Credere (Credits = funds entrusted).
Consequently, he could also see that financial activities that caused net assets to increase should be debited (more funds owed to the owners) and credited if decreased (less funds owed to the owners). The same principle applies to the owners’ equity side. An increase in owners’ equity would be credited (more funds entrusted in the business) and a decrease debited (less funds entrusted in the business).
4. Treatment of expenses and revenues
Finally, the treatment of expenses and revenues in the double-entry bookkeeping system.
As mentioned earlier, the profits of the business are claimed by the owners. Now profits are the net result of the revenue earned less the expenses incurred in earning that revenue. This means that revenue has the potential to increase profits and thereby increases the owners’ equity side of the equation. This in turn will lead to more money entrusted in the business, so revenue is credited. Conversely expenses, by being offset against the revenue will reduce the profits and so reduce the available funds to be entrust in the business, so expenses are debited.
I fully understand that the explanations about ‘why’ we do certain things can be long-winded. But if the ‘why’ is as important to you as it has been to me, then I hope this explanation has added to your understanding or has at least prompted you to ask more questions and research answers as it did for me.
Have you seen Business Manager?
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