Businesses all over the world need to keep records of their finances in order to satisfy investors and legislators. The accepted way of keeping these records is by using the Double Entry System.
Whenever a normal transaction takes place, two things happen: something is gained and something is lost, and they are equal and opposite in value. For example, if a grocer buys apples, he gains the apples and loses money. When he later makes a sale, he gains money and gives away the apples. (Hopefully he gains more money than he paid out originally. Otherwise what's the point?) The opposing entries are expressed as Debit and Credit entries in the written records, and usually shown as left- and right-hand columns in a document. Money coming in is always a Debit (ie, on the left). If every entry has equal and opposite entries then logic dictates that the total of debits and credits must be equal. Regularly ensuring this is the case is called balancing the books.
The Accountant's Method of Debit and Credit
Accountants calculate their Debits and Credits in a different way to the rest of us because, in the UK at least, most people get their definition of debit and credit from their bank statement. Your statement actually shows the bank's account with you. The key thing to understand is that the bank's account with you is a mirror image of your account with the bank. The statement shows how much money the bank owes you (assuming you haven't got an overdraft, of course). When you write a cheque to someone, you are reducing the bank's debt to you. This is as good as money coming in, so it's a 'debit' entry.
Fred borrows £2000 from a loan shark to start his business. He spends £1500 cash on goods on the same day, and then sells the goods for £4000.
Every entry is made into an account. An account is basically just a list of similar transactions. Fred will have accounts for the following:
- His Loan
At this stage, it might be easier if the reader grabs pen and paper. Create a heading for each account and leave a half dozen lines under each. Remember: debit on the left, credit on the right.
As stated, money coming in is a debit, so the first entry is to debit Fred's Cash account with £2,000. The double entry for this is to credit the Loan account with £2,000.
The second entry is for the purchase of goods. Debit the Costs account with £1,500 and credit the Cash account with the same amount.
The next entry is the sale. Money is coming in, so debit the Cash account with £4,000. Then credit a similar entry to the Sales account.
For each account, calculate the difference between the debit and credit entries. It should be as follows:
- Loan - £2,000 Credit
- Cash - £4,500 Debit
- Costs - £1,500 Debit
- Sales - £4,000 Credit
The total of the debits equals the total of the credits, and so the accounts balance.
Sales minus Costs = £4,000 - £1,500 = £2,500 Profit. Fred has cash in his pocket of £4,500, of which £2,000 is owed to the loan shark. Any repayment of the loan would debit the Loan account and Credit the Cash account, and so the profit would remain the same whether Fred repays the loan shark or not.
Thus it can be seen that a business can make lots of profit, but if it does not manage its cash effectively it can still get its legs broken with a baseball bat. The Double Entry System helps make the distinction between profit and cashflow clearer by clarifying and enumerating both.
The Double Entry System gets very complicated once things like credit sales, shares and assets get involved. But the principle remains the same, and many accountant have got themselves out of a fix by remembering the two mantras:
- Money coming in is a debit
- Debits are on the left