10. Accounting for debits and credits

By: Andrea Terzi

Double-entry bookkeeping

A double-entry bookkeeping account is a technique of documenting records of economic transactions made by an economic entity (such as a household, a business enterprise, a nonprofit institution, a government). Its raw form is a ledger that records, in time sequence and for a specified time period, the value of all transactions expressed in a common unit of account. It is called “double-entry” because every transaction is recorded twice: once as a debit and once as a credit.

The foundation of this principle is rooted in the contractual means of transferring value. Each single transaction is viewed as an exchange of “equivalents,” between the value delivered and the value acquired. Notice that such equivalence is determined by nobody else than the parties who mutually accept a given trade.

Any acquisition of value (e.g., when merchandise is received) implies an obligation to deliver a corresponding nominal value, and it thus makes the recipient of value a debtor towards the party that has released the value. Thus, that side of a transaction which brings value to the economic unit is entered as a debit.

Equivalently, any delivery of value (e.g., a monetary payment) implies a right to receive a corresponding value, and it makes the giver of value a creditor towards the party that has received the value. Thus, that side of a transaction which subtracts value from the economic unit is entered as a credit.

Every ledger entry includes an item definition and two columns, one for the debits and one for the credits. Figure 1 shows how double-entry bookkeeping applies to a single transaction and a single economic unit. A single transaction is broken down into two items: an acquisition of value, recorded in the debit column, and a relinquishment of value, recorded in the credit column.

Figure 1. Double-entry bookkeeping: How one party keeps records of a single contractual transaction

Credits, debits, and their significance

Because each transaction has both a credit side and a debit side (of equal value), then, for any number of transactions, the sum total of the two columns must be identical. For any economic unit, debits and credits balance by construction. And because each transaction involves another party, all debit entries of a given economic unit have their counterparts as credit entries in the accounts of some other units. If all economic units kept an accurate ledger, all their debits would exactly match all their credits.

Because a ledger in its raw form is no more than a list of transactions, where debits equal credits by construction, it cannot provide any meaningful information on the economic entity’s ability to manage its trades to its own objectives. Indeed, a ledger becomes a meaningful account only when it is deliberately and thoughtfully rearranged by categories of records. This is possible when a conceptual interpretation of the accounts is used to consider the different nature of each entry. For example, the meaning and consequence of receiving a sum of money differs depending on whether it results from the sale of a product, the sale of a stored asset or the receipt of a loan.

Three basic conceptual schemes serving the purpose of constructing a meaningful account structure stem from the ledger and are used to determine key financial information in any monetary economy. A balance sheet measures a unit’s net worth. An income statement measures a unit’s net income. A flow-of-fund account measures a unit’s net financial position.

Next module: Balance sheet and net worth
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