The give and take of double entry bookkeeping

Accounts in the traditional approach

A business will need to keep track of three broad categories of account: real, personal and nominal.

• Real accounts represent what a business owns.
• Tangible assets like shelves, stationery, machines, inventory to be sold, or cash in a safe.
• Intangible assets like copyright, patents, trademarks or goodwill. The law and practice of precisely what these are and how they are valued is beyond the scope of this article. The gist is that they affect the value of a business in the same way that tangible assets would, but they are not physical objects that you can touch.
• Personal accounts represent what is owed by, or to, a business.
• Natural personal accounts represent individuals such as the owner, a staff member, the window cleaner, or an artisan that supplies a shop with goods for sale.
• Artificial personal accounts represent organisations such as a bank, wholesaler, or recycling company.
• Representative personal accounts group accruals or deferrals together for convenience or discretion, such as unpaid invoices, advances on staff wages or credit card sales.
• Nominal accounts represent the shop's income and expenses. At the end of the financial year the nominal accounts will all be transferred to a profit and loss account, with nothing carried over to the next financial year.

Of course, calling organisations, accruals and deferrals persons is a metaphor, but it's somewhat helpful because the different personal accounts work in a similar way. I'll come back to accruals and deferrals later.

The accounting journal

Each exchange of value between accounts is recorded as a transaction in an accounting journal. That might be an interaction with a supplier, customer or service provider, or it might be a shift of value within the business.

Now here's the double entry part: every transaction must give to one or more accounts and take from one or more accounts, and the total amount given must equal the total amount taken. It follows from this that if you add up everything given across all accounts and everything taken across all accounts, the two totals should be equal. Any difference represents a mistake. It's possible to make mistakes that balance, but checking if the totals match will catch a lot of errors.

What does it mean to give to, or take from, an account?

• Giving to real accounts increases what the shop has.
• Giving to personal accounts increases what the person has, or decreases what the shop has of theirs.
• Giving to nominal accounts increases the shop's expenses or decreases income (nominally).
• Taking from an account does the opposite.

What do you mean, nominally?

While some small businesses will account on a cash basis – simply noting when money is given or taken – this can give a misleading view of the state of that business's finances. So many businesses choose to use something called the accruals method. Under UK law, and in many (most?) jurisdictions, larger businesses are required by law to use the accruals method.

• When an invoice has been received, but not yet paid, an expense has been accrued.
• When an invoice has been issued, but payment has not been taken, income has been accrued.
• When a payment has been made in advance, the income or expense may be deferred until the goods are delivered or the services rendered.
• When a payment is made for something that will have benefits beyond a single accounting period – to the business or those it deals with – part of the expense may be deferred.

Accruals and deferrals are given to, or taken from, representative personal accounts. Accruals will later be transferred to real accounts as the payments are made, or to a nominal bad debt account if it becomes clear that they will not be paid. Deferrals will be transferred to the nominal accounts when deliveries are made or services rendered, or in installments over the period the products or services are used.

All of these accruals and deferrals are handled with transactions that try to make the nominal account represent the true value of business activities over time. Try to – to say that these accounts are nominal is to acknowledge that some adjustments may still need to be made for accruals and deferrals, before completely accurate financial reports may be generated. When the accounting year ends, the nominal accounts can be finalised. Then their give and take totals are transferred to the profit and loss account. The new financial year begins with no give or take in any nominal account – though accruals and deferrals may be waiting to be transferred at the appropriate time.

The day book and end of day accounting

Rather than fill the accounting ledger(s) with tiny transactions, a shop will normally keep a day book. This is a simple, single entry, list of transactions dealt with through the day. Typically it would be handled by an electronic till (cash register), but paper and pen may be necessary if the till fails. The shop's day book will record sales (cash and card), and returns. It might also record other expenses (stationery, refreshments, window cleaner) and whether they have been paid or accrued. In either case an invoice or receipt will normally be kept as evidence.

Other businesses may have fewer transactions to deal with, and record them directly in a double entry accounting journal. Or they may keep a book for a longer period such as a week or month, before accounting for the transactions in the journal.

Below are some example transactions for the end of a shop's trading day. The account names will vary from one business to another, and so might the typical series of transactions. These example transactions describe just one way of doing things.

• Total cash sales are given to personal→uncounted-cash and total card sales are given to personal→accrued→cards. Total sales, both cash and credit, are taken from nominal→sales.
• Not all of the sale price is profit, so another transaction is needed to account for the purchase price of the goods sold. The purchase price is given to nominal→sales and taken from real→inventory. This may be done automatically at the end of day if every item sold is known. That may be possible because few high cost items are sold or because every item has a barcode. Otherwise this will be done after stock-checks, with the purchase prices for a week or more's sales accounted for at once.
• The cost of tea and biscuits bought with petty cash from the till is given to nominal→refreshments and taken from personal→uncounted-cash.
• The window cleaner left an invoice which has not yet been paid. The amount owed is given to nominal→maintenance and taken from personal→windows, a deferral account.
• The price of any items returned to the store is given to nominal→returns and taken from personal→uncounted-cash or personal→accrued→cards.
• Like most shops, this one uses a cash float – an amount of cash in mixed denominations to put in the till at the start of each day. Now, at the end of the day, this is counted out into a cash box. Then the remaining cash is counted. A transaction is prepared that takes the net amount given to personal→uncounted-cash from that account and gives the amount counted to real→cash→safe. As always the amount given in the transaction should equal the amount taken. If not then the duty manager can try to correct the discrepancy – it could have been a miscount. If the transaction must be completed with an unresolved discrepancy then it can be given to, or taken from, personal→cash-discrepancies.

Debit and credit

That's the basics of maintaining double entry accounts the traditional way, except for one more tradition. What I've referred to as giving to an account is normally called debiting, and what I've referred to as taking from an account is normally called crediting. So why not call them give and take, as I have so far? Debit and credit are recognised internationally, while give and take are English words. Also accountants and bookkeepers are normally trained using the words debit and credit. So for good communication you may wish to use the conventional terms. But if you're accounting for your own business or your personal finances, then it's up to you.

The accounting equation approach

The accounting equation referred to in accounting equation approach is Assets = Liabilities + Capital, or for an accounting period, Assets = Liabilities + Capital + (Income - Expenses). I put the last two in brackets because, taken together, they are the change in capital over the course of the accounting period – profit or loss.

The nominal accounts have been split – those expected to be in debit have become expense accounts and those expected to be in credit have become income accounts. In the jargon of this approach, the expense accounts are debit accounts and the income accounts are credit accounts. Each of these accounts has a single total instead of two. When you credit a debit account, or debit a credit account, you subtract from the total. So it is now possible for one of these accounts to have a negative total, which normally represents an unusual or problematic state. For example if more goods are returned to a shop than it sells over some accounting period, it's income→sales account might be negative.

It won't be obvious from the equation alone, but personal accounts expected to be in debit are separated from other personal accounts in this approach. These join the real accounts as asset accounts. The owner(s)'s investment is also separated as one or more capital accounts. The remaining personal accounts are liability accounts. Natural, artificial and representative personal accounts are all split up like this. The asset accounts are debit accounts, like expenses, and the capital and liability accounts are credit accounts, like income.

Comparing the approaches

The tendency for accounts with a problem to have negative totals is considered an advantage of the accounting equation approach. It relies on creditors and debtors being separated into different account types though. So if one individual or organisation is both a supplier and a customer, the accountant must either try to predict whether the net balance will be in debit or credit, or set up two accounts for that one natural or artificial person. The former may result in accounts being negative where there is really no problem, and the latter makes it just a little harder to assess the business's relationship with the person in question. Nevertheless, negative balances can be useful warning signs for many businesses.

One disadvantage of the accounting equation approach – in the author's opinion – is that mixing personal and real accounts under assets makes the meaning of debit and credit a little more confusing. Debiting an asset account means something a little different depending on whether the account represents the business's own assets or those of a natural, artificial or representative person. It also results in a potentially misleading view of the business's financial security. Money owed to a business is not the same as money in it's possession, especially if the debtor is confused – or dishonest – about the security of their own finances.

It has been claimed that the accounting equation approach is easier than the traditional approach. This isn't really true if you understand both approaches. Assets = Liabilities + Capital + (Income - Expenses) doesn't really tell you anything more than the sum of all debits should equal the sum of all credits. You could just as easily separate the traditional accounts in debit (debit > credit) from those in credit, and say Real + Personal-Debits = Personal-Credits + (Nominal-Credits - Nominal-Debits), if you wanted to express the traditional approach in a similar equation. The real accounts should always be in debit.

The author's preferred approach

You may have guessed which approach I would recommend, but you may be wrong. If I had to do all my accounting with pen and paper I would prefer to use the traditional approach, but – bit of a boast – I own a computer. With much of the work of accounting being automated, I prefer to set accounts up for both approaches. Each account gets three identifiers: a short, descriptive label that I can refer to in my accounting journals; a label that categorises the account by the traditional approach; and a label that categorises it by the accounting equation approach. I keep spaces out of the short label so that my text editor can offer better auto­completion, while the other labels are better suited for labelling reports. Some accounts get combined for the traditional approach, so a shop might have accrued_card_sales and accrued_card_returns both point to Personal → Card accruals.

The transactions in my journals list debits and credits, which can be added directly to the debits and credits of my traditional accounts. For the accounting equation accounts, one of debit or credit must be converted to a negative number. For the debit accounts – assets and expenses – credit becomes negative, and for the credit accounts – liabilities, capital and income – debit becomes negative.

Once the reports are nicely set up, generating basic reports based on both approaches should be as simple as typing make reports, clicking a button, or they can be automatically generated. Getting accurate reports – especially if they must be suitable for publishing at the end of the financial year – may also require adjustment transactions to finalise the nominal accounts or correct errors.

Final words

There is more to accounting than this – I've barely touched on legal regulations and reporting, and haven't even mentioned tax, depreciation, amortisation or dividends. Most organisations will make use of professional accountants to do anything more complex than I've described here, and some will let accountants do most of what I have described. But hopefully I've at least made the meaning of debit and credit a little clearer for some people.