Double entry bookkeeping requires that every transaction is entered into the accounts twice. For example, if cash is used to pay a debt, then the amount in the cash account decreases, and so does account tracking the amount owed. In double entry terminology, the cash account is credited and the creditors account is debited.
The terms credit and debit confuse may people. If you owe someone money, they are in credit with you and a called a creditor. If they owe you money, they are in debit and called a debtor.
The confusion arises largely because of how the terms are used in bank statements. This is because a bank statement shows the customer's account with the bank. Therefore a deposit in your bank account is a credit (it makes the bank owe you more money), and a withdrawal is a debit.
In your accounts, the debits and credits would be reversed. A deposit means that the bank owes you more money, therefore it is a debit. The bank's account with you is a mirror image of your account with the bank, apart from certain minor discrepancies.
When a bank statement arrives, it is important to reconcile it with your own accounts. This means checking that any difference in the balances can be explained. This is typically the results of timing differences such as cheques that have been written but not yet cleared.
Now consider what happens as a result of a slightly more complex series of transactions. Stocks (inventory to Americans) are bought for cash, and then sold for cash at a higher price. The transactions are recorded this way:
- credit cash and debit stocks,
- credit stocks, credit the profit and loss account and debit cash.
This illustrates several things:
- splits: a transaction may involve more than two accounts because one side (the credit in this case) may be split between two accounts,
- the balance sheet consists of a summary of all accounts that are kept, and,
- the two sides of the balance sheet remain balanced through all transactions.
In this case, one side of the balance sheet increases because the cash received exceeds the value of the asset sold. The other side increases because of the increase in the accumulated profit and loss account, part of the owners equity.
This relationship is sometimes expressed as the accounting equation: assets - liabilities = owners equity. This is more commonly written assets = liabilities + owners equity, but our form more closely resembles the presentation of most balance sheets.
The profit and loss account summarises the changes in the accumulated profit and loss line of the balance sheet, and therefore the owners equity, as an accounting statement.
The P & L does not show all changes to the balance sheet (for example the effects of new issues). It should therefore be reconciled to the accumulated profit and loss on the balance sheet. The STRGL also provides further explanation, of the changes, as does the cash flow statement and various notes.
The accounts are arranged hierarchically. The highest level ones are those shown in the accounting equation, or (in practice) those shown on the balance sheet. These are divided into sub-accounts: e.g. assets contains sub-accounts for current assets and fixed assets. Current assets would contain further sub-accounts for cash etc,. The hierarchy can continue down to a great deal of detail, such as individual accounts for some assets.
Historically, an advantage of double entry accounting was that it made it easier to find errors: if it did not balance there was an error, the size of the error could hold clues to its nature. For example, an error divisible by nine it is probably due to a missing zero or an incorrectly placed decimal point, on one side of a transaction.
While this advantage has somewhat been diminished by computerised systems, it is still more robust than simple single entry systems with regard to fraud and errors. Other advantages include the continual maintenance of asset and liability accounts, and the ability to easily extract accounting statements from the books.
For a more practical guide to how to use double entry bookkeeping system look at the documentation for GNU Cash. It includes explanations of accounting concepts and how to make entries on that particular system. As GNU Cash is free software and an easy to use system, trying it is a good way for those who want to learn how to keep books to practice.