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Business Book-Keeping Part 2

By Paul Michael
27th October, 2009

Double Entry Book-keeping

Perhaps one of the areas of most confusion is that of double entry book-keeping.
 
Luca Pacioli is considered to be the father of accounting having documented the double entry accounting method in 1494, although there may be evidence that such a system was used prior to this time. http://en.wikipedia.org/wiki/Double-entry_bookkeeping_system
 
The system comprises Debit and Credit transactions that are entered into accounts associated with specific ledgers. A Debit entry in one ledger should have a balancing Credit entry in another. The confusing bit is knowing if a transaction is a Debit or a Credit in any given ledger.
 
Consider this accounting equation: Property = Rights to Property
 
You have a house that is worth £100,000. That is equal to a mortgage of, say, £50,000, and the proportional rights you have as owner as the remaining £50,000.
 
Your Property (£100,000) = Your Property Rights (£50,000 + £50,000)
 
This is fairly simple for us to grasp as home owners. We could work the same analogy if we own a car – it has a current market value and if we deduct anything we owe, like a loan, what is left is ours. This is the basis of double-entry book-keeping; each side of the equation must be in balance at all times.
 
Let’s look at the Property Rights. We have a mortgage, which is classed as a Liability, and we have the owner’s proportion, which is classed as Owner’s Equity, also known as Capital. The property itself is classed as an Asset.
 
We now have: Assets = Liabilities + Owner’s Equity (sometimes called Capital).
 
These items make up the General or Nominal ledger and were introduced in the previous section. They are just words used in the world of finance to classify every-day items, related transactions and their values.
 
It should be noted that other financial terms are creeping in, like Capital instead of Owner’s Equity. Unfortunately, this is the way of the world where there are many words that mean the same. American influences have also crept into traditionally British naming conventions as globalisation has ensued. Major themes are also sub-categorised, like Fixed Assets and Current Assets, which are different types of the Assets we have been discussing. Don’t worry too much about these aspects. Simply put, it is a way of breaking down a meaningless total into meaningful categories.
 
In order to maintain the property (Assets), we have to incur costs (known as Expenses). The money to pay for the Expenses and the Liabilities must come from somewhere. So we typically go to work to raise income and put some of it into the property (Revenue), to pay for the Expenses and the Liabilities.
 
Therefore:
Assets = Liabilities
+ Owner’s Equity
+ Revenues
– Expenses
 
 
What this means is that if we increase the value of an asset, we must also increase the value of any of the other elements on the opposite side of the equation (Except Expenses, which may be decreased), and vice versa.
 
It should be noted at this point that Revenue, Expenses and two other elements that we have yet to discuss: Investments and Drawings, are sub-ledgers of Owner’s Equity. In other words, Owner’s Equity is balanced by its four sub-ledgers.
 
If we increase our mortgage, it does not mean that the value of our property increases, especially in the current climate. Instead we effectively create another type of asset in the form of cash (classed as a Current Asset). Therefore, the sum of the assets increases, as do the Liabilities (the mortgage), in proportion to each other. If we take out the cash for other purposes, our Assets and Owner’s Equity will decrease in line with each other. If we use the cash to enhance the property, the values will be distributed between Expenses, Assets and Investments.
 
If the property is devalued, then so is the Owner’s Equity – because the mortgage value will not change. If the property is significantly devalued, we could end up in a negative equity situation. This is a term often bantered around in a recession.
 
Looking at the accounting equation, it would make more sense to place the Expenses element on the Assets side of the equation. Who said that algebra has no use in the real world? Here is your chance to use it, and we do it to form a Debit and Credit equation:
 
Assets                             =                   Liabilities
+ Expenses                                           + Owner’s Equity
                                                                        + Revenues
 

Debits & Credits

Let’s take our ‘Property’ theme a bit further and turn it into a business. We are going to let the property, for which we will get real Revenue (or Income), and we hope to generate some earnings from a profitable business.
 
Other elements associated with a business are Investments and Drawings.
Investments capture anything that the Owner might put in or take out over any given period, although many people regard Investments and Owner’s Equity as one and the same. Drawings is the money that the owner draws down as earnings or wages. Drawings sit nicely on the Assets side of the Debits & Credits equation, although, like Expenses, would normally be subtracted from the right side, as a sub-ledger of Owner’s Equity in the accounting equation.
 
So here we have a fully expanded Debit & Credit equation:
 
Debits                                                 Credits
Assets                             =                   Liabilities
+ Expenses                                           + Owner’s Equity
+ Drawings                                                       +Investments
                                                                        + Revenues
 
Everything on the left is said to be a normally Debiting ledger (positive), while everything on the right is a normally Crediting ledger (negative).
 
To increase the value of a Debiting ledger, we create a Debit transaction. To decrease a Debiting ledger we would create a Credit transaction. For example, create a Debit transaction in the Expenses ledger to increase our expenses.
 
To increase the value of a Crediting ledger, we create a Credit transaction. To decrease a crediting ledger we would create a Debit transaction. For example, create a Credit transaction in the Revenue ledger to increase our revenues or sales.
 
You might have spotted that transactions can be debited or credited within a normally debiting or normally crediting ledger. For example, we might get a refund in an Expense account, and so we would create a Credit transaction in the normally debiting Expense ledger.
 
Note: when you are said to be in credit with your bank, it is normally a good thing. So why are Debits positive and Credits negative? Well, a bank statement is written from the bank’s point of view that you are a creditor to the bank - its supplier – it owes you money. The statement you receive is simply a T Account report of the bank’s Trade Creditor account it has on you.
 
Some people like a nifty way of remembering equations. You could try:
Debit ADE = Credit LOR
…or make up your own acronyms. It is worth noting that the Debit is normally written on theft and the Credit on the right.
 
In the next installment we will take a look at some sample transactions and building some simple business reports.

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