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8FINANCE


The mystery of double-entry accounting


attendees admitted they could never remember whether it was debtors or creditors that owed them the money. Americans helpfully term them


A


receivables and payables, which gets over some of the confusion, but actually debtors and creditors are part of a much wider accounting mystery – double entry. Given that virtually every business from banks to boarding kennels uses this system, it is surprising that more emphasis isn’t placed on explaining it. Maybe this is the original conspiracy theory – double entry was first documented in Summa de Arithmetica, written by a monk in the Middle Ages to keep track of Venetian wealth! I’m sure if more people understood


the principle of double entry, it would greatly help to ease financial communica- tion. So let’s debunk debits, credits and double entry by following these steps:


1 Double entry is based on the following principle, which, like all great principles,


is confusingly simple:


When a business owner starts a business there are two distinct entities: the business owner and the business.


This is called the two entity principle and this principle applies irrespective of the legal structure of the business being created (eg sole trader or limited company).


2 When the business’ bank account is set up and the owner pays in £1,000


of opening capital, the business needs to record the money in the bank (now “owned” by the business) but also needs to record that the business owes the business owner £1,000 (as opposed to anyone else).


Two entries are needed to record this one transaction:


Bank . . . . . . . . . . . . . . . . . . .£1,000 Owed to owner . . . . . . . . .£1,000


Hence the term ‘double entry’, which derives from the two entity principle.


12


t one of my recent workshops on ‘Demystifying Business Numbers’, one of the


Double-entry accounting is a great way of keeping track of your finances, and it’s not as complicated as you might think. JOHNNY MARTIN explains the basics.


3 Years ago, the old hand-written ‘ledgers’ (books) that were used to record trans-


actions had two columns and these were headed debit and credit.


Don’t get hung up on the origin of these words – in any event it’s unknown. Debits and credits are just names like left and right.


As it happens you can remember – Credits go in the right-hand column because they have an ‘r’ in them!


4 The question people always worry about is ‘what’s a debit and what’s


a credit?’ Essentially debits record increases in assets (things the business owns) and credits record increases in liabilities.


To remember this, think about when you get a bank statement.


Money coming in to your account is recorded as a credit in the credit column in the bank statement. This is because your bank statement is showing the position from the bank’s point of view.


Table 1 Assets


Liabilities Income


Expenses


Debits record Increases Decreases Decreases Increases


Credits record Decreases Increases Increases Decreases


When you deposit money into a bank account, you become a creditor of the bank ie the bank must record your money as a liability because at some point you will want your money back!


Following the rules of double entry, the bank must also record your money as an asset.


So:


increases in assets are recorded as debits


increases in liabilities are recorded as credits


5 But what about recording sales and expenses? Where do they fit in?


Because profit is owed to the owner of the business (to be paid as a dividend) it is a liability of the business so anything that will result in an increase in profit for the business is recorded as a credit.


So sales are recorded as credits, while the opposite is true for expenses that reduce profit – they are recorded as debits. This is summarised in Table 1 below:


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Better Business No 189


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