In Part 1 of this series, we discussed basic accounting concepts like the Accounting Equation. From there we identified the different Account categories and how transactions are placed under Debits or Credits.
You may be thinking, “Ok good, I get why this is being used by companies and banks, but this does not apply to me!“. Perhaps you may be right, but have you asked yourself these questions before?
- How much did I receive as salary this year?
- How does it compare to my earnings from my side business?
- I have been paying my car loan for quite some time now. How much did I pay for it so far and what is left to pay?
- Considering everything including non-cash assets, what is my net worth?
These questions are easily answered if you are recording everything using a double-entry system.
Accounting Concepts Review
We can start by defining some example Accounts that we need for recording our transactions:
- Salary (Revenue Account) – this is where your salary goes when you receive your paycheck
- Savings (Asset Account) – your savings account in the bank
- Car Loan (Liability Account) – your car loan
- Bills (Expense Account) – monthly bills
- Salary Loan (Liability Account) – loans from the bank
Based on the Account category, transactions go into the Debit or Credit column depending on how the transaction affects the balance. To recap:
|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|
Personal Accounting Examples
Now that we have our Accounts set up, we can now start recording transactions. Let’s begin with a few examples:
Receiving your Monthly Salary
When you receive your salary, it normally goes to your bank account (your Savings account). This increases the money in your Savings account, and since an Asset account increases on Debit (Debit balance), we put it under the Debit column.
Now a Debit transaction must have a corresponding Credit transaction. Here, we will put it under the Salary account. The Salary account (Revenue Account) increases on Credit (Credit balance), so we put it under the Credit column. Note that the Salary account records all of our “revenues”, so this means that we have a “revenue” of 30,000 that came as our salary.
Paying your Car Loan
The following day, our automated debit arrangement kicks in for our car loan. In this case the money comes out of our Savings account and goes to the bank.
Since the Savings account, being an Asset, decreases on Credit, the loan payment is recorded under Credit. The corresponding transaction for the Car Loan account (a Liability) is on the Debit side. Since Liability accounts increases on Credit, this means that our total loan obligation has decreased.
Paying your Electric Bill
When we pay our bills, the transaction looks similar to paying our car loan, except that the other account is our Bills account (Expense) instead of Car Loan (Liability). However, the difference here is an Expense account increases on Debit, while a Liability account increases on Credit.
Therefore when we pay our bills, it means that our expense account increases as well. This records the total amount that we have paid for Bills. Compare it to the Car Loan account that records the total remaining amount that we have to pay for the loan.
Getting a Loan from your Bank
As the middle of the month comes, you feel that your money will not be enough to pay for an unexpected expense, so you decided to get a loan from your bank. Here, the money goes directly to your Savings account, which means an increase and therefore goes into the Debit column. The corresponding Credit column goes to your Salary Loan account (Liability), which also increased the amount that you owe by the same amount.
Paying back your Loan
Before the month ended, the unexpected expense turned out to be smaller than expected, so you have extra money left. You decided to pay back some of the amount that you owe to the bank.
Since we will transfer the money from our Savings account to pay for the loan, the amount goes into the Credit column, as it decreases our asset. The corresponding Debit amount goes into the Salary Loan, which means that the amount that we owe has decreased.
Note that the transaction is not limited to having only two accounts, one for Debit and one for Credit. The beauty of a double-entry accounting system is that it allows you more flexibility on how you record your transactions.
Let’s say that when you receive your salary, you keep half into your checking account and half into your savings account. We can record this transaction as follows:
You can use as many accounts as needed, as long as the sum of the amount under the Debit column always equals the sum of the amount under the Credit column.
One of the advantages of using a double-entry accounting system is the ease of generating reports. In our simple example above, we can easily determine the balances that we have under each account.
For our Savings account, we just need to tally all of the transactions that involve the account and get all the amounts under Debit and Credit.
Since Savings is an Asset account, it carries a Debit balance. This means that we need to get the total Debits and subtract the total Credits to get the account balance. In our example:
Total Debits = 30,000 + 7,000 = 37,000
Total Credits = 10,000 + 2,000 + 4,000 = 16,000
Account Balance = 37,000 – 16,000 = 21,000
Therefore at the end of the month, we know that we have 21,000 stored in our Savings account.
What if we want to know how much is on our Savings account during the middle of the month? To get this, we only need to consider the transactions up to 2020-03-15.
Total Debits = 30,000
Total Credits = 10,000 + 2,000 = 12,000
Account Balance as of March 15 = 30,000 – 12,000 = 18,000
Another advantage of using a double-entry system is the ability to check for errors and be able to zoom in on the offending transactions. Since the total amount of Debits must always match the total amount of Credits, in the case of a mismatch we can see where it was not balanced.
Let’s explore this using the examples that we had earlier:
Total Debits = 53,000
Total Credits = 46,000
As we can see, the total amount of Debits and the total amount of Debits do not match. Now we try to find which transaction had an error. One way to do this is to re-compute the balance on a given date range. In the example, let’s check the balance at the middle of the month:
Total Debits (2020-03-15) = 30,000 + 10,000 + 2,000 = 42,000
Total Credits (2020-03-15) = 30,000 + 10,000 + 2,000 = 42,000
We can see that the total Debits and Credits by 2020-03-15 are matching, thus the transaction error did not occur on March 15 and earlier. Let’s now check the dates from March 16 to the end of the month:
Total Debits (2020-03-16 to 2020-03-31) = 7,000 + 4,000 = 11,000
Total Credits (2020-03-16 to 2020-03-31) = 4,000
Now we see that the Debits and Credits are not matching. As we continue to look closer, we will determine that the error lies on the transaction on 2020-03-17. On this transaction, there was no amount recorded under the Credit column.
You may have noticed that the examples we discussed are all very basic. This does not mean that using a double-entry accounting system is limited to these kinds of examples though. In practical use, it allows for some very complex transactions involving multiple accounts and sub-accounts.
The examples we discussed, although simple, highlight some of the features of using a double-entry system. It enables us to generate useful reports and also to identify and fix errors in our records. This article shows us that a double-entry accounting system is not only useful to large companies, but we can apply it to our daily finances as well.