The Basics of Double Entry Book-keeping
Created | Updated Feb 12, 2002
Business all over the world need to keep records of their finances in order to satisfy investors and legislators. The accepted form of keeping these records is by using the Double Entry System1.
Whenever a normal transaction takes place, two things happen; something is gained and something is given away. They are equal and opposite. For example, if a grocer buys apples, he gains the apples and gives away money. When he later makes a sale, he gains money and gives away the apples2.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 Debit3.If every entry has equal and opposite entries then logic dictates that the total of debits and credits must be equal. Ensuring this is the case is called "Balancing the Books".
Why do accountants do Debits and Credits differently from the rest of us?
Well, in the UK it's because most people get their definition of debit and credit from their bank statement.
Your statement 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 4. When you write a cheque5, you are reducing their debt to you. This is as good as money coming in, so it's a debit entry.
Example for Illustration
Fred borrows £2000 from a loan shark to start his business.
He spends £1500 on goods for cash on the same day.
He then sells the goods for £4000.
Keeping records
Every entry is made into an Account. An account is basically just a list of similar transactions. Fred will have accounts for
- His Loan
- Cash
- Costs
- Sales
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 £2000. The double entry for this is to credit the Loan account with £2000.
The second entry is for the purchase of goods. So debit the Costs account with £1500 and credit the Cash account.
The next entry is the sale. Money is coming in, so debit the Cash account with £4000. The credit entry is to the Sales account.
For each account, calculate the difference between the debit and credit entries. It should be as follows:-
- Loan - £2000 Credit
- Cash - £4500 Debit
- Costs - £1500 Debit
- Sales - £4000 Credit
The total of the debits equals the number of the debits, and so the accounts balance.
Sales minus Costs = £4000 - £1500 = £2500 Profit
Fred has cash in His pocket of £4500, of which £2000 is owed to the loan shark.
Any repayment of the loan would debit the Loan account and Credit Cash, 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 hellishly complicated once things like credit sales, shares and assets get involved. But the principle remains the same, and many an accountant has gotten himself out of a fix by remembering the two mantras:-
- Money coming in is a debit
- Debits are on the left
