Double Entry Accounting

In the last post I talked about the Five Basic Accounts. I will be talking about how these accounts are used to keep proper accounting books through the Double Entry.

The accounting equation has to stay balanced. Which translates that for any change in one account there must be a change to another (i.e., any activity in your financial life is translated into TWO changes in the equation) . This is called the Principle of Balance.

For example buying a new house worth Rs.300,000 is an activity in your financial life. The result is an increase in you assets equal to Rs300,000 AND an increase in your liabilities (mortgage) equal to 300,000.

Assets - Liabilities = Equity

(Assets + 300,000) - (Liabilities + 300,000) = Equity

The equation stayed balanced.

Any proper accounting system will follow the principle of balance through double entry, and there are two reasons to do so:

1. Keep an accounting trail. If your cash at the bank is less by Rs.1000 than it should be, you want to know where the money went. As stated, since any financial activity is translated into two changes, you can go to the first account change (Your Assets of cash decreased by Rs.1000) and you find the related second account change (increase in assets in the form of your wife's new pair of shoes).
2. Double check the accountant work. For example if the husband is keeping the books at home and he made a mistake while adding up the expenses (e.g., typing Rs.100 instead of Rs.10). If he is following the double entry rule most likely he will notice the mistake because the equation will not balance, and will have a difference of Rs.100-Rs.10=Rs.90. He then can go back to check for his mistake.

Double entry accounting has been around since the late 15th century after it was described by an Italian named Luca Pacioli. Traditional book keeping involves recording each transaction in a book called a Ledger, then copying each part of the transaction to a separated book called a Journal. Till today we are using the same method in the business world for the two reasons described above.

All of that said, most of this is done nowadays by accounting applications without us noticing, but still understanding how they work is very important specially for business owners.

Follow up with the next article Debit and Credit