Don't the debits go toward the window? An introduction to double-entry bookkeeping. Douglas A. Kerr.
No, "double entry bookkeeping" doesn't mean having one set of financial records for the IRS and another for yourself. It refers to the ingenious concept that is the basis of the bookkeeping systems used by almost all major business today.
When we look at the manuals for double entry accounting software packages, we often find unfamiliar terminology and concepts. Let's penetrate this veil of mystery and see what double entry really is all about.
The principle of double entry bookkeeping is simple. Every financial transaction--that is, any movement of money or another item of value--is recorded by making a change in one account and an equal but opposite change in another account. The symmetry of this method allows us to perform various checks throughout the process to prevent arithmetic and procedural errors. This is one of the most important features of the double entry system.
The accounts maintained are of five types. The first type is the asset account. These accounts indicate the items of value the business currently holds. An item of value may be cash (meaning, generally, bank accounts), or the value of buildings, furniture, material, or other property. Another item of value is the right to collect amounts owed by others, such as customers. These amounts are called accounts receivable.
The second type of account is the "liability" account. These show how much the business owes to others--in effect, how much of the total assets does not really belong to the business. A common kind of liability account is called accounts payable. It shows how much the business owes to others, such as suppliers.
The net amount currently invested in the business by the owners (their equity) is reflected by the third type of account, called capital. From a procedural standpoint, capital accounts are treated much like liability accounts. It is as though the business owed these amounts to the owners.
These first three types of account represent the current status of the items of value held by the business. In contrast, the last two types show the flow of money into and out of the business. They are called revenue (or income) accounts and expense accounts. Those names are self-explanatory.
Debits vs. Credits
At the outset, we described making equal and opposite changes to a pair of accounts. What exactly does that mean?
In traditional mathematics, there is the concept of two directions of a number, which are called positive and negative. In accounting there is also the concept of two directions of a number; they are called debit and credit.
The current value of an account is its balance. By convention, the direction of the balance of a normal asset account is debit. Since a liability account carries the opposite meaning, its normal balance is in the direction of credit, as is the balance of a capital account.
Revenue and expense accounts are directly related to capital accounts. The net income of a business--that is, the revenue less the expenses--increases the amount of the owners' equity. Accordingly, the direction of the balance in a revenue account is credit, just like that of a capital account, and the direction of the normal balance of an expense account is the opposite--debit.
In many common formats for keeping double entry records, the balances in the different accounts do not carry debit and credit markings to show their direction. Bookkeepers and accountants know the normal directions, and standard bookkeeping procedures keep everything pointed the right way.
Using this terminology, we can restate the fundamental concept of double entry bookkeeping thus: when a transaction is recorded, one account receives a debit (a change in the debit direction) while the other receives a credit of identical size.
As in the case of conventional mathematics with positive and negative numbers, the effect of a change upon the numerical value of the balance depends on the directions of the balance and of the change. For example, a credit applied to an account with a balance in the credit direction (a credit balance) increases the balance; a credit applied to an account with a debit balance decreases the balance.
For example, suppose that we pay the power company $150 for the month's service. We would record that transaction as in Figure 1.
The first part increases the balance of the Utilities Expense account, which shows that an additional amount has been spent on utilities. The second part decreases the balance of the Cash on Hand account, which shows that the business now has less cash.
If we then received $100 for performing a service for a customer, we would record thee transaction as shown in Figure 2.
The debit to Cash on Hand increases the balance, showing the increase in our cash. The credit to Fees Earned also increases that balance, showing that additional fees have been earned.
When a business is founded, the initial balance of every account is zero. We can say that the sum of all the debits (none at this time) equals the sum of all the credits (also none at this time).
Each time we post a transaction, we apply a debit to some account and a credit to another. If we post several transactions at one session, the sum of all the transaction debits will equal the sum of all the transaction credits. After the transactions have been posted, the sum of all the debit balances will still equal the sum of all the credit balances.
The process of checking for this equality of debits and credits on all transactions and on all account balances following the effect of the transactions is called balancing. It is like a giant pairity check on the entire accounting process.
We said that there was a normal direction for the balance of each type of account. Sometimes, the value of an account can have the opposite direction. Take for example the accounts receivable account for one customer. It shows what the customer owes us. This account is an asset account, because the right to collect what the customer owes us is an item of value. Accordingly, such an account normally has a debit balance. Purchases by the customer result in debits to the account, and payments result in credits.
Assume, however, that the customer for some reason makes a payment larger than the amount he owes us. This results in a credit balance in his account (signifying that we owe him). Since debit is the normal direction of the balance of such an account, the credit balance is abnormal and is shown on the records with a CR (credit) symbol, by putting parentheses around the number, by printing the number in red, or by preceding it with a minus sign.
We said before that in recording a transaction a debit is made to one account and a credit to another. In fact, sometimes there can be more than two accounts involved. Suppose we have paid $75 to the stationer, $50 for printing business cards and $25 for office supplies. We might record that transaction as shown in Figure 3. This is called a compound entry. It still follows all the rules--the sum of the debits equals the sum of the credits.
Incidentally, the example in Figure 3 shows an accounting convention: the debits are shown in the lefthand column, and the credits to the right. This allows the debits and credits to be summed in a batch of transactions to see if they balance. It is customary to list the debit elements first.
A list of transactions in this format is called a journal. Transactions are recorded in a journal as they take place. The bookkeeper then can post their components to the various accounts at some convenient time, marking on the journal when each transaction has been disposed of.
We often see the term general ledger in connection with accounting systems. The general ledger of a business is its basic set of accounts, reflecting overall financial operations. Although these accounts reflect all financial activity, they do not always reveal the details. For example, there is not normally a separate receivable account for each customer in the general ledger. Rather, there is a single accounts receivable account summarizing the total owed by all customers.
This is then supplemented by a set of subsidiary accounts--one for each customer. Customer transactions (purchases, payments on account, etc.) are posted to each customer's individual subsidiary account. The total of these transactions is then posted to the overall accounts receivable account and the other affected accounts in the general ledger.
Each account in the general ledger is usually identified with an account number. It is customary to arrange the accounts and their numbers in groups, such as all asset accounts in the 100 series, all liability accounts in the 200 series, and so forth. A list of all the accounts in a company's general ledger is called the chart of accounts.
At the end of an accounting period (usually a month), the bookkeeper engages in a process known as closing the books, which includes verifying that all transactions have been posted and that the accounts are in balance. Various accounting reports are then prepared to show the financial state of the business.
One important report is the Income Statement. This lists the balances in all the revenue accounts followed by the balances in the expense accounts. Finally, it states the difference, which represents the net income (or loss) for the business during the period.
After the Income Statement is prepared, the balances of all revenue and expense accounts are transferred to a special capital account. This reflects the effect of the net income (or loss) of the business on the owners' equity. The transfer process also brings the individual revenue and expense account balances to zero. In this way, those accounts start fresh for each period.
However, a separate set of running totals of all revenue and expense accounts is kept throughout the year. This allows the accumulated year to date figures for the different accounts to be seen at any time. These are usually printed on the income statement along with the balances for the current period.
Next, a report known as a Balance Sheet is prepared. This lists all asset, liability, and capital account balances. Since all other accounts (revenue and expense) have zero balances at this time, the accounts shown on the balance sheet will be in balance by themselves.
These, then, are the fundamentals of the double entry bookkeeping system. I hope this introduction has helped to clarify the language used in accounting software manuals or by your accountant.
Of course, we have just touched the surface of the subject, and I have taken a few liberties with rigorous accounting terminology in the interest of clarity. The reader who would like to learn more, or who plans to become involved in the use of double entry bookkeeping, may wish to consult one of the many books which are available on the subject.