Double Entry Accounting — Putting Value In The Numbers

This has long been a bug-bear for many. Why? Because the basics of accounting are rarely taught to anyone, except those who want to become accountants.

Yet, we are all affected by double entry accounting, one way or another; no matter what we do! Am I suggesting some sinister plot by accountants, or government to keep us off balance? Far from it!

You want me to explain myself. Sure, but first let me paint a picture.

Seeing we’re talking about bookkeeping, let’s use the other kind of bookkeeping as an example — a library.

You will know, I am sure, that a library has a system whereby it records all of the books that it owns. So far, so good. But, at any one time, a significant quantity of those books will be in the hands of the library’s customers (a.k.a. borrowers), and some will be on loan to other libraries.

How is this recorded? Well, every time a book moves location — from the library to your place, or vice versa, or from the library to another library, or vice versa — this movement is recorded. So, the book remains on the library list, but in the system, its location moves to or from the library’s column (as an example) to the other appropriate column (your place, my place, or another library).

I’ve used the word ‘column’ above to make the following example chart more understandable. Let’s say this is how things were last Friday:

This minuscule example is what would show on the Library system.

So, let’s say, this week, the following happened:

1. You returned Book Two (you’d finished it), and took out Book One;
2. I returned Boor Four (it was boring); and
3. The Other Library returned Book Five, but borrowed Book Three.

As you can appreciate, each of these events will give rise to changes in the Library records. Let’s think about what those changes would be:

1. Book Two would be removed from Your place to Library, and Book One would move from Library to Your place;
2. Book Four would move from My place to Library; and
3. Book Five would move from Other library to Library, while Book Three would move from Library to Other library.

Here’s what the Library record would show after all of this:

The point here is not what the position was last Friday, nor the position after this week’s movements. It is that these movements are recorded — by moving the book from one position to another, in order to correctly record what has happened.

Okay, so you understand that, but what in the world has it got to do with double-entry accounting? Well, funnily enough, quite a bit.

Let’s go deeper, and look at the record for Your place, as an example:

As you can see, the library record shows that:

• When you return a book, it leaves Your place, and arrives in the Library — both of these is shown;
• When you take out a book, it leaves the Library, and goes to Your place — again both are shown.

In short, at a very basic level, this is double-entry library-style.

Has the entry been entered twice? No! It’s just that there are two legs to each entry — to record where the book came from, and where it went to.

And, that, in a nutshell, is what double-entry is all about — recording movement from one account to another. We’ll look at some basic examples shortly. But, first, let’s look at why double-entry came into being.

You’ll have heard of Newton’s third law of physics:

For every action, there is an equal and opposite reaction.

Well, double-entry is just like that — for every entry removing value from an account, there is an equal and opposite entry adding the same total value into another account (or accounts).

You see, back in the late 13thcentury — at least that’s when the earliest surviving examples come from — some smart people figured out that, for example, if you borrow $X from someone, that means two things (remember the two legs we referred to before):

• That you have $X more money, and
• That you owe them the $X back.

(We’re ignoring interest for the purposes of this example.)

So, just like our library example, an item (in this case $X) has moved from one location in the accounts to another. Using the library format above — ignoring any previous balances — the accounts would look like this:

“But”, you say, “they can’t both have the same balance!” And, you’re right — because one is an asset (the cash you have), and one a liability (the money you owe). While the amount is the same (at least until you spend some of the funds) they are not both going to show on the same side of your ledger (*). It’s all about debits and credits.

(*) the old-fashioned name for a set of accounts — because the book the records were kept in was called a ledger.

But before we shed some light on the debits and credits, there’s something else we need to cover off.

Three Letters That Must (Always) Be Equal

So, what does it mean? It means that, in order for the books to balance, your Assets must always equal your Liabilities plus your Equity. Double-entry — using those debits and credits we’ll get to shortly — is what ensures your books balance.

But first, what do those letters refer to?

Assets include any item that is either cash you own, or something you own that you can sell for cash, or money that is owed to you. So, they can include the following types:

• Current Assets — assets convertible to cash in the next accounting year, such as:
• Savings accounts,
• Debtors (also called Accounts Receivable) — money owed to you by customers,
• Stock (also called Inventory) — items you sell, or use in products you sell.
• Fixed Assets — assets you use in the business, usually depreciable, including:
• Land & Buildings,
• Plant & Machinery,
• Furniture & Equipment, and
• Computer Equipment.
• Intangible Assets — assets you can’t actually touch, but are used in the business, like:
• Other Long-term Assets — assets you can or will receive cash for after the next financial year, typically:
• Loans to other parties
• Investements

Liabilities include any item on which we owe money. These include the following types:

• Current Liabilities — liabilities which must be paid during the next accounting year, such as:
• Bank overdraft,
• The current portion of a Loan,
• Creditors (also called Accounts Payable — money you owe suppliers,
• Long-term Liabilities — liabilities which must be paid after the next financial year, including:
• Loans due after the next financial year.

Equity includes the Share Capital of a company, plus Accumulated Profits (also called Retained Earnings). While the above are all Balance Sheet (or Statement of Financial Position) items, this includes all the Profit & Loss (or Statement of Financial Performance) items — for both this year and prior years.

“Did I really need to know that?”, you might ask. Well, let’s simplify it a bit. Yes, this is where we start talking debits and credits.

The Left Must (Always) Equal The Right

No, we are not talking politics. It’s just that those wise people from the past decided that debits would be on the left, and credits on the right.

Think of an old-fashioned set of scales — with $ amounts on the left, and $ amounts on the right. For the scales to balance there must be equal amounts on each side. And it is exactly the same for a set of books (or accounts as they are also called) — the total $ credits must always equal the total $ debits.

So, now we have two “must always equal” statements. Do they conflict? No! Why? Because the Letters we have mentioned have also been assigned to the left and right:

We’ve included Income and Expense to ensure you get the whole picture. Incidentally, the ‘P’ next to Equity refers to Proprietor (=owner).

Now you will understand why someone who owes you money (their amount is an asset) is called a Debtor, and someone who you owe money to (their amount is a liability) is called a Creditor.

Let’s use an example to clarify.

Imagine you had been asked to visit your library and total up all the books (by type), all the chairs, all the shelves, all the scanners, and all the computers. So, you went there, and totaled them up like this:

And so on …

How useful is this list? We have different types of books, but one entry mixes them up. And, the list is in no particular order. Needless to say, some sucker is going to have to go through the list and add up the various types of components to arrive at totals by type. And they are probably going to have to recount the mixed books into their type. Don’t forget the list for a whole library would be pages long…

Meanwhile, no one in their right mind would just total up the numbers column (as it stands, for the whole list), and say the library has e.g. 231,465 items, would they? Why? Because there are different types of item in the list. And they have different values, for good measure. So, the number would be meaningless.

As you can see, what is needed is a system to categorize the items appropriately. Those of you who go to your local library will know it uses a system for categorizing its books (only). This system is called the Dewey Decimal system.

Okay, so you understand that, but what in the world has it got to do with double-entry accounting? Well, funnily enough, quite a bit.

You see, in any set of accounts, you will find a number of different types of accounts. Some of them will relate to assets you have and money people owe you, and some of them will relate to the money you owe to others. Others will refer to money you’ve received, and still, more will relate to the money you’ve spent.

So, let’s follow the library example, and make a list:

And so on …

Would adding all these amounts up give a meaningful number? You’re right, it would be of no use whatsoever! You kind of get that, but you’re really not sure why?

Well, just like with library books, it all comes back to the system. In accounting, the system is double-entry. So, using our knowledge of which accounts have debit balances, and which are credit balance accounts, we can restate the list like this:

Better still, we can re-order the list by type, like this:

You will notice that the total debit balances equal the total credit balances. In case you wondered, the list, as stated above, is called a Trial Balance. This is what is prepared before completing a set of accounts. (Of course, software generates them automatically, these days.) You will also notice that the Bank Overdraft is a liability. If the Bank account goes back into funds it will become an asset (because the bank will now owe you money).

To complete the loop — remember we mentioned double-entry is about recording movement of funds, let’s just go through a couple more examples, at a deeper level.

Firstly, let’s just say that one of the Debtors paid $10,000. What would that do?

Well, your Debtors account is a debit balance account, so what must happen to reduce the balance? Yes, the $10,000 must be credited to that account.

What does double-entry tell us? There must be a debit of an equal amount. Where to? The bank account (which will now be in funds, and go back to being an asset). This is how it would show in the accounts:

Finally, let’s say you paid an urgent Creditor $2,000. How is that reflected in the accounts?

Following the same reasoning as we did before, Creditors is a credit balance account, so we must debit it to reduce the amount owing (reflecting the payment made). Similarly, the payment will be a credit to the Bank account. These entries would be as follows:

To summarise, double-entry is a system of recording movements within a set of accounts, using debits and credits, to ensure the accounts are always in balance — i.e. that the accounting equation is adhered to. This also means that the accounts are not just a meaningless list of unrelated things.

Oh, and I’m sure there are books in your library that will help explain things further.

Originally published at beanstalkknowhow.com on February 28, 2018.