To fully understand the accounting equation and financial data in general, we need to have an accurate definition of the terms “debit” and “credit.” These two terms are historical and their origins are of semantic significance. What a bookkeeper does when he records a transaction with debit and credit entries goes to the very essence of financial information.
For starters, debit and credit are not Latin words for “left” and “right,” despite claims of various textbooks. The whole financial world would work unchanged if debits were recorded on the right rather than the left. Within the computers that process accounting software, left and right have no real meaning. If debit and credit have any significance in producing critical and accurate financial information, they are not substitute terms for left and right.
And, despite authoritative claims to the contrary, debit and credit do not change their meaning as we go from the left side of the accounting equation to its right.
Assets = Liability + Equity
A debit to the Assets side of this equation behaves exactly like a debit to the Liability term on the far side of the equal sign. It increases a debit balance equally on both sides; it decreases a credit balance exactly the same in both places; and in all cases, a debit represents an increase in the amount of financial resources available at the location to which it is applied. Most importantly, the terms debit and credit were used exact as they are today for several hundred years before the Accounting Equation did. The two terms are in no way defined by the Accounting Equation itself.
Returning to the Latin sources of the terms, they have simple meanings that describe exactly their role in double-entry bookkeeping and reveal exactly the underlying meaning of all financial data. A debit is a Latin term that serves as a root for our modern term “debt.” It represents a deposit of something from some other place. Its original use in accounting and its use in modern financial data remain consistent with its original Latin meaning; a debit is a deposit of financial resources, regardless of which side of the accounting equation and which side of the t-account that it is recorded upon.
In turn, credit is derived from a Latin term meaning the source of a deposit. This also is consistent with modern bookkeeping entries that credit revenue, equity, and liability accounts when they serve as sources to deposits to cash and other asset accounts. This is also consistent with the application to credit entries to the cash account when that account serves as the source of deposits to expense accounts
Accounting debits and credits are just records of deposits and withdrawals as financial resources flow from one place to another in a defined financial space. As a withdrawal, a credit is the opposite of a debit and numerically is accurately used as a negative debit in parts of the accounting process.
The problem is that the polar opposition between debit and credit is often obscured by the inaccurate application of the Accounting Equation, rendering modern accounting fragmented and subject to unnecessary rules that need to be learned by rote memory. Correcting the arithmetic in the Accounting Equation would make all financial data simpler and more accessible to the average person.
Assets + Liabilities + Equity = 0
And this, in turn, would make critical financial information more available to those who allocate the financial resources of our economy.
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11 comments:
I strongly disagree with the claim that the acctg equation should be Assets + Liabilities + Owners' Equity = 0. Over my 38-years as an accounting professor who did much executive education teaching, I was readily able to get hundreds of nonfinancial folks to understand that "the reason a balance sheet balances is because every dollar invested in an asset had to have a source, either from a creditor or owners."
It was interesting how very few with some accounting training could explain the balance sheet with this sources-uses approach and without saying that "debits must equal credits." In non-degree programs, I taught the basics of accounting as understanding what financial statements do and do not report, and I never used the words "debit" or "credit."
I also used the definitions of "revenues" and "expenses" from the textbook I co-authored with Robert Anthony for five editions: increases and decreases in Retained Earnings arising from operations of the entity. Participants saw how that, if one had an eraser (in my earlier years; PC in my later ones), all transactions could be recorded directly as balance sheet changes. It was then easy to explain income and cash-flow statements as explanations of why Retained Earnings and Cash changed between the beginning and end of the accounting period.
By the way, practitioners were able to get this non-technical understanding strongly embedded in their minds with class sessions as short as 4 hours, and the feedback was always very favorable, including from accounting/finance folks.
James S. Reece
Professor Emeritus
Ross School of Business
University of Michigan
Thanks for your comment. I agree with your teaching of the balance sheet and its foundation in the accounting equation. However, I believe that I can get you see that balance is algebraically shown as all terms summing to zero.
We can still put the non-asset terms on the right side of the equal sign for purposes of reflecting the balance sheet. In this way, I agree with your teaching experience. However, by moving these terms across the equal sign, we change their signs, indicating that they have credit balances while the assets term has a debit balance.
in the first class of accounts i had in high school i pointed out that this system did not make any sense, it had no common thread running through it. All i could do was pass the exams after drawing arrows pointing up down with the accounts to save myself the agony of a useless system.
Accordingly i became an attorney instead of a chartered accountant!
Now i know what was wrong! thanks so much! i hope accounting boards across the globe adopt this vector based approach as soon as possible.
Thanks Robert!
Prof James Reece
You can easily work in t-based accounting with memorising the golden rules but when it comes to journal entries there is where the directions are so important.
Harmonising the system without the need for memorising is a very big step for accounting in my humble opinion.
I’m very little directly into studying, however by some means I obtained to learn numerous content inside your webpage. It’s amazing just how interesting it is that i can go to anyone usually especially that i want to work in one of those atlanta consulting firms someday.
Thank you for the comment. The advantage of using correct math is power. With the accounting equation expressed in mathematics that correctly expresses opposites, the balance sheet becomes far more expressive and can be used to show far more information. I you would like a copy of my book "The Tao of Financial Information," please let me know. More information can be found on the blog http://taofinancial.blogspot.com/
Any skill that is done from rote memory is limited in its application and its creative use. It is better to be told "why" something must be done a certain way. The "why" of accounting is so practical and so open to common sense that memorization is counter-productive.
Tks very much for your post.
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Best rgs
I would be glad to assist anyone who is interested in the details of this perspective on accounting. Note that I consider it simply a matter of perspective. The vectors have been there for five hundred years, they just haven't been used.
Please send me an email to receive a free copy of one of my books on this subject. There is so much power in understanding double-entry conceptually, rather than the usual rote memory that accounting classes subject the student to.
This is really what the renaissance merchants were doing when they invented double-entry.
Accounting equation suggests that for every debit there must be a credit. Assets, liabilities and owners’ equity are the three components of accounting equation that make up a company’s balance sheet.
https://iedunote.com/accounting-equation
Accounting equation suggests that for every debit there must be a credit. Assets, liabilities and owners’ equity are the three components of accounting equation that make up a company’s balance sheet.
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