If you are not involved in finances in your work, accounting seems to be a very daunting concept. This is understandable as there is an Accountancy course in college which means that you need to spend years studying the whole thing. It should not dissuade us in learning about basic concepts however, as it will help us greatly in managing our own finances. This article will serve as an introduction to accounting for noobs or those new to the concept.
The main purpose of accounting is to enable recording of economic data (which is mostly money or asset values). From these data recordings we can then summarize them and provide useful reports for analysis. These reports are used to see how a business or organization is doing. The results of the data can then be analyzed to determine the next course of action.
Accounting is useful not only to businesses, but also for our own personal finances. In essence, we are all technically a “business”. We have income (our salary), expenses (bills, needs, and wants), and assets (our house, car, or home equipment). Even if you are employed, you can think of it as your own business but with only a single client (your employer).
Simple Accounting – Single Entry System
When I first started tracking my money more than a decade ago, I created a spreadsheet of my salary and expenses and recorded them the way I thought it should work.
I have columns for the type of income and expense and recorded them by date. In essence, I created a single-entry accounting system.
|Jan 10, 2020||Paycheck||10,000|
Jan 10, 2020
Jan 11, 2020
Jan 12, 2020
Jan 13, 2020
After years of using this method of recording my money, I eventually hit a problem. I was not able to create reports other than simple totals of each expense type. This is one of the limitations of a single entry system.
I also had problems trying to categorize other types of expenses.
- What if I bought an equipment to use in a business, is it considered an expense?
- When I took out a car loan, how do I record the value of the car?
- Are my loan payments considered expenses?
- How will I track how much I have already paid in the loan?
These questions are not answered well if you are using a single entry accounting system. In practice, a single entry system only works for simple use cases and it is not used by businesses to track their finances.
Debits and Credits
Another thing I was doing when tracking my finances was the way I marked each transaction as a debit or a credit. My previous exposure to this term came from my bank statement, where withdrawals were under the debit column, and deposits are under the credit column.
This led to my mistaken belief that cash coming out = debit and cash coming in = credit. While this is true in some cases, it is not true for everything, as we will see in the next sections.
Advanced Accounting – Double Entry System
The double entry system was created and used by the Romans and the Jewish a very long time ago. Today, this is the de facto method used by businesses to track their financial records. It follows the standard accounting equation:
Assets = Liabilities + Equity
This equation is true both for large businesses and (surprisingly) your household finances. As the double entry system follows this equation, it allows for better tracking and balancing of accounts. This in turn enables error checking and determining which transactions in your records are incorrect.
There are basic categories of transactions that we can enter into an accounting system. These are called Accounts. From the equation above we have what is called the Balance Sheet account categories:
- Asset Accounts – Cash on hand, receivables such as loan payments due to you, etc
- Liability Accounts – Payables such as loan payments that you owe, etc
- Equity Accounts – Owner’s claim to business assets such as capital
There are also additional categories that are related to the Income Statement:
- Revenue Accounts – Earnings from selling goods and services, your salary, etc
- Expense Accounts – Expenses that you incur such as bills, groceries, and luxury expenditures
Revisiting Debits and Credits
Let’s revisit my previous assumption that cash coming out = debit and cash coming in = credit. This is true for some of the account categories we described above, but also the reverse for the other categories. To illustrate:
|Account Category||Increases On||Type|
|Asset Accounts||Debit||Debit Balance|
|Liability Accounts||Credit||Credit Balance|
|Equity Accounts||Credit||Credit Balance|
|Revenue Accounts||Credit||Credit Balance|
|Expense Accounts||Debit||Debit Balance|
As an example, let’s say we have an Asset Account. When we add money into it, we put the transaction under Debit and when we take money out from that account, we put it under Credit. The inverse happens for a Revenue Account. When money comes in, we put it under Credit, and when money comes out, we put it under Debit.
Since an Asset Account increases its balance under Debit, it is what you call an account that carries a Debit Balance. A Revenue Account increases its balance under Credit, so it carries a Credit Balance.
Assets = Liabilities + Equity
An easy way to remember this is by looking again at the accounting equation. On the left hand side, you have Assets, and on the right hand side, you have Liabilities and Equity. The left hand side is the Debit side, and the right hand side is the Credit side, as indicated by how these accounts increase in amount. Accounting ledgers also typically list the Debit column first before the Credit column.
Now why is it important? Classifying transactions under Debit and Credit correctly ensures that all of the money is accounted for. In essence, the sum of Debits and the sum of Credits for all accounts must be equal. This is how a double entry system is able to identify errors in accounting. Money coming in from an account must always come from money coming out of another account.
Your Bank Statement
Going back to my bank statement, I can see that money I deposit to the bank is listed under Credits, and money I withdraw is under Debits. Why is that? In reality, your bank statement is actually not about you, but it is about the bank. Your savings account is actually a Liability Account from the bank’s perspective.
Now it makes sense! When you make a deposit, the bank actually owes you the same amount of money that you can then take out any time you need to withdraw. Thus people’s savings are under their liabilities. Looking back at our Account Categories chart, we can see that Liability Accounts are Credit Balance, meaning when money is put in, it is listed under Credits.
What’s In It For Me?
While we understand the basic concepts now, this may still feel too abstract. You may ask, “How does this relate to my daily life?“.
In Part 2, we will discuss some basic examples on how to use a double-entry accounting system for personal finances, and show you how it is going to be useful in your day-to-day activities.
Photo by Kelly Sikkema on Unsplash