Understanding Double Entry Accounting
Sir Isaac Newton's third Law of Motion, the law of reciprocal actions, states that for every action there is an equal and opposite reaction. The same can be said for accounting. For every financial transaction, there are two sides. There is a debit side and a credit side. For every transaction, these sides must be equal for your books to balance.
To understand double entry accounting, you must first understand what a debit is and what a credit is. Put simply, a debit is something you own or money that is owed to you and a credit is money that you owe to someone else. Let's look at this in terms of the different types of account that a business has.
Assets - these are debit items as they are items that are owned by the company. An increase in assets is a debit and a decrease in assets is a credit.
Liabilities - these are credit items as they are items that the business owes to someone else. An increase in liabilities is a credit and a decrease in liabilities is a debit.
Owners Equity - this is a credit account because the balance of the owner's equity account is the money that is owed by the business to the owner of the business. An increase in owner's equity is a credit and a decrease in owner's equity is a debit.
Expenses - These are debit items because the purchase of an expense item decreases an asset item (eg. Cash at bank) which is the credit site of the transaction.
Revenue - These are credit items because the receipt of revenue increases an asset item (eg. Cash at bank) which is the debit side of the transaction.
Let's look at a simple example:
Let's say you want to go to the shop to buy a bottle of milk, which costs $3. Your purchase of the milk is a financial transaction. Before you go into the shop, you own $3 so this is a debit item, which is balanced by owner's equity.
When you go into the shop and pick up the bottle of milk, you now have a bottle of milk, which is worth $3, and you owe $3 to the shop owner. Therefore, the bottle of milk is a debit and the $3 you owe is a credit.
When you pay the shop owner for the bottle of milk you are reducing the amount of money that you own (debit item will be credited) as well as reducing the amount of money you owe (credit item will be debited).
Note that in each step of the transaction, the debit and credit side of the transaction are equal and the balance of all accounts has equal debit and credit sides.
So what happens when you drink the bottle of milk? You no longer have a $3 bottle of milk; you have an empty bottle that is worth nothing! This is why we have expense accounts. Assets, which are debit items, are things that the business owns for a long period. Expenses, which are also debit items, are things that the business owns for a short period before they are used up.
This is why we have two separate major reports for a business. The balance sheet is used for those items that are constant in a business. The profit & loss Statement (or Statement of Income & Expenditure) is used for those items that flow in and out of a business on a regular basis. The resulting balance of the profit & loss statement is put into the capital section of the balance sheet to balance things out.
Another report you may have heard of is the trial balance. This is used to make sure you haven't made a mistake before preparing the balance sheet and profit & loss statement. At the end of an accounting period, the closing balance of all your accounts (assets, liabilities, owner's equity, expenses, and revenue) are put into this report to make sure that your debits equal your credits. If they don't, you know you have made a mistake somewhere and you will need to find your mistake before you prepare the major reports. The total of the debit column should equal the total of the debit column.