A Simple Guide to Bookkeeping
This is a simple guide to double-entry bookkeeping, a pattern like all good patterns that has stood the test of time (modern double-entry was outlined in Benedetto Cotrugli’s treatise Delia Mercatura et del Mercante Perfetto in 1458 and expanded in Pacioli’s Summa de arithmetica 36 years later). The problem with most guides (certainly all those I have read on the subject) is that they start off with the balance sheet. This is enough to put most people off for life.
This guide takes an entirely different approach. By using a few transactions and some simple guidelines the logic behind double-entry becomes clear and the jargon falls into place.
Words like nominal ledger and trial balance will become second nature. You will have no problem with your debits and credits. In short, you will be able to post a journal just as easily as you can now post a letter.
By the end, you will be able to talk, and understand, the same language as your bank manager, accountant, and tax inspector.
When we buy something there are two things to consider:
- Where the money came from (i.e. the account that is paying for it, e.g. bank or cash)
- Where the money went to (i.e. what it was spent on, e.g. petrol, stationery, insurance)
In a single-entry accounting system entries are recorded one after another in a book which typically has columns for the account used and the analysis of what was bought. Whilst we have no problem looking at the bank and cash columns as accounts, we rarely think of the analysis headings as accounts in their own right.
In a double-entry system all of these are referred to as accounts (e.g. a cash account, a petrol account etc.), and more importantly, separate entries are made for each account involved in a transaction.
Suppose we pay for some petrol with cash. Two entries are required:
- one to show where the money came from (cash)
- and the other to show where it went to (petrol).
This from and to aspect of each transaction is known as crediting and debiting. It is what the term double-entry means.
In order to record these entries we need somewhere to write them down. These are called Day Books or Journals.
This is a book (similar to a diary) that contains various columns where day to day financial transactions are recorded. The minimum number of columns required is five:
- amount to debit
- amount to credit
All transactions are entered one after another in date order, therefore the book contains a complete history of transactions in chronological order. In practice, a business will use more than one book, each of which will be devoted to a certain aspect of the business and each will be given a name to reflect this (e.g. ‘sales’ or ‘purchases’).
Let’s start with the example given earlier: purchasing petrol with cash. Two accounts are involved in this transaction (petrol and cash) so we will need to make two entries.
The entries show how the money flows from one account to another. To achieve this the first entry will credit one of the accounts and the second will debit the other. However, deciding which account to debit and which to credit is not particularly obvious (getting it the wrong way round is by far the most common error in double-entry).
This is where our first helpful hint comes in:
Every transaction must come from somewhere and go to somewhere else. The from side is the credit side and the to side is the debit side.
So, from=credit and to=debit. You can remember this easily because the F in ‘from’ comes before the T in ‘to’ and C in ‘credit’ is before the D in ‘debit’. Remember this single rule of wisdom and you always know your credits from your debits.
Traditionally the debit column is shown to the left, and the credit column to the right. That is, double-entry goes to before it knows where it came from, hence the famous T-Shirt slogan ‘Accountants do it backwards’!
If you apply this from and to principle to our first transaction you will know which account to debit and which to credit: the money is coming from cash and going to petrol so we credit cash and debit petrol.
Lets take a look at the cash account to understand exactly why we credit it when we are taking money from it.
The cash account should be thought of as a real cash box. When you remove some money to buy some goods, you should replace it with a receipt or petty cash slip to say what the money was used for. A receipt or petty cash slip is a form of credit note, so the cash box now contains a credit note instead of the cash, hence we show the entry as a credit. (Logically, if you returned the goods because they were faulty, the receipt would be given back in exchange for the cash).
The exact same applies to any monetary account whether it is cash or a current bank account. When you take money from it, it is credited in your books.
Looking at the debit side (where the money went to), the petrol account now has the money (albeit in the form of half a tank of petrol!), it got the money from cash so it is in debt to cash - hence it is entered as a debit.
This is the fundamental principle of double-entry, we are keeping track of where the money came from (a credit) and where the money went to (a debit).
Furthermore the first rule of accounting states that all the debits must equal the credits. Therefore, provided all your entries are correct, no money can ever escape the system or be introduced into it without a complete record of it being shown in the journal.
The second example will be a sale. You will need one more account that we shall call Sales. In this example we will sell something for cash. Therefore the second set of entries will credit sales (where the money came from) and debit Cash (where it went to).
As we enter more and more transactions it will become increasingly difficult to calculate our current cash balance (or for that matter our total sales). Therefore we need a way of looking at each account separately. This is achieved by making exact copies of the entries in the journal to another book called the ledger. This is called posting.
When posting you are not moving an entry, but making a copy of it somewhere else. Your original entries will always exist in the order you entered them in the journal.
Posting is traditionally done at the end of each month but is entirely at your discretion - if you need to know what your sales figures are, then you will need to make sure all your transactions are entered in the journal and posted to all the relevant accounts in the ledger as we are about to see.
A ledger is just another book but with each page devoted to a single account. It is simply an alternative view of your journal entries - the journal entries are in date order, the ledger is a re-arrangement of the journal in account order.
The important thing to remember is that all your transactions are entered in the journal first. The ledger merely contains copies of them re-arranged by account.
Just like the journal, most businesses will use more than one ledger, each devoted to a certain aspect of the business and each given a different name to reflect this (e.g. ‘Sales Ledger’ and ‘Purchase Ledger’), but whatever the case, a single general ledger will always be opened. This is called the Nominal Ledger (called the General Ledger in the US).
Although it is termed ‘nominal’ for reasons which will become clear later, it is nevertheless important to realise that it is the main ledger of a business (i.e. where other ledgers are also in use, the final balance of those ledgers will also be held in the nominal ledger). Therefore, the nominal ledger will hold the full picture of a business however many other ledgers are used.
In order to post (i.e. make copies of) the entries from the journal we must draw up a list of the accounts used so far and give each one its own page in the ledger.
We need three accounts at this stage: a cash account, a petrol account and a sales account.
The layout of each account in the ledger is identical to the journal with the exception that the ‘account’ column is no longer required - we are looking at the entries of just one account so it can be included as the title of the page instead.
Once we have posted our entries into the ledger we can then begin to see how the business is doing.
Posted entries are exact copies of the original. If the entry was a debit entry in the journal then it is also a debit entry in the ledger. Although we can now see the relevant entries we don’t yet know what the balance is; furthermore we don’t know whether that balance means we have a surplus or a deficit of cash. To find out, follow this procedure:
- Start by adding up the debit and credit columns and show the totals on a new line.
- Subtract one from the other to get the balance using the following rules:
- If the debit total is greater: the balance=debits-credits and the result is put in the debit column.
- If the credit total is greater: the balance=credits-debits and the result is put in the credit column.
- In other words, we are always going to get a positive balance, and it will always be placed under the highest total (this is the reason the columns were totalled first).
Because the balance of every account is always expressed as a positive value it doesn’t tell us where we stand in relation to it (e.g. do we have a surplus of cash or is it overdrawn?).
We can overcome this by applying our from/to guide again (from=credit and to=debit). If the balance is in the debit column, then we have a positive cash balance (more money has gone to it than from it). If it shows a credit balance then it is overdrawn.
How does it apply to the sales account? If it has a credit balance, then we have positive sales. Where has the money come from? Sales. And finally, look at the petrol account. Where has the money gone to? Petrol.
The next step is to check that all the journal entries have been posted correctly to the ledger. This is called a trial balance.
The Trial Balance
The trial balance is a complete list of your account balances from the ledger. The layout is similar to the ledger except that only three columns are required: the account name and a debit and credit column.
Just the final balance line of each account is copied into the trial balance using the debit column if the account has a debit balance, or the credit column if the account has a credit balance.
The debit and credit columns are then totalled and checked that they match each other to satisfy the first rule of accounting (all the debits must equal the credits).
If they are not equal to each other it is proof that a mistake has been made. An audit is then carried out to find the error.
An audit simply means going through each entry in the journal to check that it matches the original paperwork (this is called an audit trail). If no error is found then it must be due to a mistake when posting the entries to the ledger. The audit then continues by checking each journal entry against the ledger entries.
OK, so lets discover if the business is making a profit or a loss.
The Profit and Loss Account
The Profit and Loss account (aka P&L), as its name implies, tells us whether we are making a profit or a loss: are we earning more money than we are spending? (a profit), or vice-versa (a loss).
The layout of the P&L account is just like any other account. To compile the P&L account copy the balances of the sales and expense accounts into it. We can then use our from/to guide on the resulting balance to determine if a profit or loss has been made. If more money has come from sales than has gone to expenses, we have made a profit. That is, if the credit side is greater than the debit side we have made a profit.
Having established the P&L account we must do one more thing: take a look at the business as a whole. For this we need to prepare the balance sheet.
The Balance Sheet
We can now look at the main equation of a double-entry system which will show that the first rule of accounting (the debits must equal the credits) not only applies to each transaction but continues right up to the main financial statement of the business; the balance sheet.
The P&L account reflects the balance of a specific area of your business over a particular period of time. The balance sheet reflects the current balance of everything since the business began.
The ledger holds this information, so like the trial balance we can compile the balance sheet by copying all the account balances into a report. The only difference is that the accounts are re-arranged to show what the business owns and what it owes. These are broken down into 3 groups:
These are the things the business owns. They are usually broken down into two groups: Current Assets and Fixed Assets.
Current assets include money in the bank, petty cash, and money owed to the business by its customers.
Fixed assets include capital items like business premises (assuming they are not rented), company cars and office equipment.
These are the things the business owes to third parties. They too are usually broken down into 2 groups: Current Liabilities (e.g. overdraft at the bank) and Fixed Liabilities (e.g. Long Term Loans).
Equity represents what the business owes to the owner of the business. This includes money paid for shares or capital introduced, any profits (or losses) brought forward from previous years as well as the current balance from this year’s P&L.
These three groups make up what is known as the accounting equation:
Assets = Liabilities + Equity
Easily remembered by those who like a pint with the acronym: ALE.
Just like any mathematical equation a balance sheet can be re-arranged in any order you like:
Equity = Assets - Liabilities
Liabilities = Assets - Equity
Probably the most useful view is Equity. Since equity is what the business owes its owners, it represents the value of the business from the owners point of view. If this were your personal accounts, it would be your net worth.
Compiling a balance sheet is just more of what we have been doing so far; rearranging account balances by copying them into a different order. Assets first (bank balances, cash balances, debtors, unsold stock, buildings and company vehicles), then Liabilities (overdrafts, creditors, loans, mortgages), then Equity (P&L, Paid-up share capital, profit or losses brought forward from previous years). The Assets will have a debit balance, the liabilities (including equity) will have a credit balance. Add the two resulting columns up and they should both have the same balance.
Although this is a very simplified view of accounting from an initial transaction right through to its effect on a balance sheet, it shows just how simple the process really is. Before computers came along, the whole process was carried out manually exactly as above. Early software emulated this process, making things only marginally quicker by automatically adding columns. Modern software takes things a stage further by eliminating the need to post anything. All you need to enter are the original transactions.