A credit in one account has to be offset by a debit in another account. A double-entry bookkeeping system is a set of rules for keeping track of debits and credits in a set of accounts. The system makes it possible to know at any moment how much money you have, and also how much money you owe.
For example, suppose people pay you to do work for them, and you pay your suppliers for the raw materials you use. If the total of your debits is greater than the total of your credits, then you have a cash flow problem: you are spending more money than you are making. And if the total of your credits is greater than the total of your debits, then you have a surplus: you are making more money than you are spending.
In other words, if your cash balance goes up over time, then at that moment your assets exceed your liabilities, and if it goes down over time, then at that moment your liabilities exceed your assets.
You have no doubt heard of “double-entry bookkeeping.” What this term actually means is that every transaction in the books of a business must be recorded as a debit in one account and a credit in another. The two accounts are set up to correspond to each other.
A purchase of supplies is recorded as a debit to an account named “supplies” and a credit to an account named, say, “cash.” A sale of goods is recorded as a debit to “goods” and a credit to “receivable.” If you pay out money for repairs, it appears as a debit to “repairs” and a credit to cash.
For every debit there must be an equal and opposite credit (hence the name). This rule holds true even if you’ve never heard of debits or credits.
A debit increases an account’s balance, and a credit decreases it. A journal entry is simply a record of the changes in one or more accounts. Suppose that you have two accounts, A and B. Each account has a separate ledger. Each ledger has pages for credits and debits. Suppose you are writing your entries in pencil in both ledgers, so that you can erase them later.
A simple transaction may affect only one of the two accounts. For example, if you buy a book for $10, the journal entry might look like this:
Debit Credit
Account A $10 Book Account B $10 Cash
The book cost $10, so there is a debit of $10 in the “Book Account”. The book was cash, so there is a credit of $10 in the “Cash Account”. One interesting thing to notice is that there are changes in both accounts. We say that both are affected by this transaction. If only one account changed, we would say that only that account was affected by this transaction.
You can use journal entries to keep track of stock prices or to record your checking account transactions or to record your household’s income and expenses or to record changes in any asset or liability or equity.
The reason the balance in a ledger has to be zero is a consequence of what a ledger is. A ledger is a record of debits and credits. If everything you owned was listed on one side of your ledger, and everything you owed on the other, then your net worth would be zero. In accounting, that’s called having “balanced books.”
This doesn’t mean that every entry in the ledger has to be zero. Two entries might show up as $100 each. But both of them have to refer to things you own, not things you owe.
If you keep a personal budget, you probably track your spending on a spreadsheet, or maybe in a program like Quicken. This is a simplification of the way businesses track their accounts.
Businesses don’t use spreadsheets or Quicken. They use double-entry bookkeeping, a system that has been around for more than five hundred years. The principle of double-entry bookkeeping is simple, though its implementation can get pretty baroque. Every transaction in a business must be recorded in two different accounts. If the business spends $100 on office supplies, it has to show that both as an expense and as a liability. If it takes in $100 from customers, it has to show that both as income and as a credit in another account.
The simplest account with a single debit and credit is a ledger account, in which you record increases and decreases in wealth. A simple example would be tracking the money in your wallet. Each morning you look in your wallet and write down its new balance.
If you spend any money, you write that down too. If you get any money back, such as if someone returns some of the change when you buy something, that goes on the credit side. If you lend some money to a friend, that goes on the credit side too.
Every transaction in your life takes money from one account and puts it in another. If you pay for something with a credit card, the money moves from your bank account to the store’s bank account. But when you make a purchase, say, by check or debit card, or even cash, the money has to come from somewhere. The same is true when you get paid—your employer deposits money into your account.
When you write a check to someone else, you are moving money out of one account—a checking account or some other asset account—and into another—a liability account like a loan or credit card balance. Checks are balanced by deposits. When you spend money in some way, it goes out of your checking account and into someone else’s. And so on.
Emil is a contributor at Accountant Log. We are committed to providing well-researched, accurate, and valuable content to our readers.
