The most basic concept in accounting is “double entry bookkeeping”. This is a methodology where by using Debits (DR) and Credits (CR), you can record all transactions that happen in your business. After recording all activities for your business’ accounting period, the final balances can then be used to populate financial statements, which is a summary of your business’ financial results that you can use to present to key stakeholders, such as investors.
Double entry bookkeeping is not a modern concept. Florentine bankers used this method to keep track of their financial records more than 800 years ago! The first-ever recorded description of “double entry bookkeeping” came from a Croatian named Benedikt Kotruljević, who wrote about this concept in 1458 in his book called Book on the Art of Trade. Then years later, Renaissance man and Italian mathematician Luca Bartolomeo de Pacioli popularised the concept of double entry bookkeeping.
So what makes double entry bookkeeping so powerful? The simple answer is that it connects all of the different transactions of a business into a single consistent record. To begin learning double entry bookkeeping, you should first know which accounts are “debit accounts”, and which accounts are “credit accounts”:
As a general rule, if you want to increase the balance of a debit account, you should debit (DR) the account with the transaction amount. If you want to decrease the balance of a debit account, you should then credit (CR) the account with the transaction amount. This principle applies vice versa for credit accounts. See below for some example journal entries:
An asset is purchased using cash for $100.
DR Asset $100
CR Cash ($100)
Revenue is earned in cash for $50.
DR Cash $50
CR Revenue ($50)
Notice how both the DR and CR sides of each journal entry net off to zero exactly? This is the “magic” of double entry bookkeeping. The idea is that after you have recorded all journal entries relating to your business’ transactions, your books should “balance”. This is because double entry bookkeeping presents the financials of your business in an inter-related way. There are two key concepts created by double entry bookkeeping:
- The assets acquired by your business are funded by a combination of debt and equity.
- Profit/loss from your business is added into equity, which also contributes to the funding of assets.
For example, to demonstrate key concept 1, when you increase your Assets account such as by purchasing an asset (DR Asset), you may increase your debt to fund the purchase (CR Liability). Both sides of this journal entry balances to zero.
As another example, to demonstrate key concept 2, at the end of your business’ accounting period, the total net profit/loss in your business should be rolled into your equity account in the form of Retained Earnings*. Therefore, the profit/loss earned increases/decreases the equity balance of your business.
In accounting, the books and records that you need to maintain to keep track of the debit and credit balances of all accounts is called a trial balance. In a trial balance, debit balances are positive amounts, whereas credit balances are negative amounts. This way, when you add up all balances in the trial balance, total should sum up to zero, meaning that your books balanced. If you do see any difference remaining when you sum up your trial balance, you need to investigate this error and resolve it before you can “close the books”.
Once you have completed the trial balance for the current accounting period and closed the books, you can then use this trial balance to prepare your financial statements for the same accounting period. I will explain in another blog post about how to prepare financial statements for your business!
* This is another important accounting concept: balances at the end of an accounting period in the Balance Sheet accounts (Assets, Liabilities, Equity) carry forward to the next accounting period, but end of accounting period balances in Profit & Loss accounts (Revenues, Expenses) will be transferred fully into the Equity account. As a result, final Profit & Loss accounts balances should become zero at the end of the current accounting period.