Learn Book-keeping Get to Know your Debits and Credits Lesson 1
Book-keeping is the first step in accountancy, and is the process of recording financial transactions. Accountancy is the process of taking those records and ‘adding value’ e.g. producing more complex reports and tax calculations.
The key to understanding book-keeping is identifying the basic transaction types, and knowing one very basic rule. This rule is very similar to Newton’s rule that states ‘for every action, there is an equal and opposite re-action’. In the case of book-keeping the two sides of the action (transaction) are debit (left) and credit (right). These are normally abbreviated as Dr. and Cr. respectively.
Basic Transactions and Examples
There are 4 really basic transaction types, examples of which are below. Understanding the difference between them lays down the foundations for book-keeping.
1: If a friend lends you some cash, you then have an asset, the cash in your hand. However, the friend is expecting to get the cash back at some later point, and therefore you also have a liability.
2: If a friend gives you some cash for some work that you’ve done for him, you have the asset of the ‘cash in hand’ and you have had some income (profit).
3: You buy a car using a loan from a bank. You now have an asset; the car, but you also have a liability of the loan that needs to paid off. If you already had the cash (an asset) to pay for the car then you would have the asset of the car, but would have reduced the amount of your cash asset by the amount you paid for it.
4: You pay to have your car serviced. Your cash asset has reduced and you have had an expense (loss).
As you can see from the examples, types 1 and 3 are movements between assets and/or liabilities i.e. swapping between different ‘asset’ types. These are known as Balance Sheet items.
Types 2 and 4 are to do with income and expenses (profits and losses) that also affect assets and liabilities. It is very rare for transactions to affect only income and expenses.
How do I identify whether a payment is an asset or expense type
To check if something is an asset/liability, ask yourself ‘does it persist after the transaction has been completed? Could I re-sell the thing that I have just paid for?’
In some cases you may have to go in slightly more depth, and it is the ultimate, normal use by the company, that determines the type.
Purchases of items that are combined with other items before selling on would be classed as assets and are generally known as ‘Stock’ or ‘Raw Materials’ e.g. a dressmaker buying buttons, so although they will get used, and not sold by themselves, they are a component of the company’s product, and therefore form part of the company’s Stock.
Another example would be envelopes. Unless you are a stationer where you would sell on the envelopes (and therefore be classed as Stock), these would normally get used and not resold; so although in theory you could re-sell them, they are not normally, so purchases of envelopes would be classed as an expense.
Cash Account (Cash Book) v’s Bank Statements – Debits & Credits
The above transactions would all be entered into a ledger, which is a collection of accounts. Each account lists one side of transaction. For example there may be an account for ‘Car Servicing’, so every time that Car Servicing is paid, an entry would go into the ‘Car Servicing’ account with the other side in the ‘Cash Account’. In this case the Cash Account would have a Credit entry (reflecting a reduction of an asset), and a Debit entry in the ‘Car Servicing’ Account (reflecting and Expense)
Most people get confused with Credits and Debits when thinking of assets and money in their bank account. This is easily done as a ‘Bank Account in Credit’ is ‘a-good-thing’ and they, therefore, think of Credit balances as being Assets. It is good to have a credit balance on your Statement as it means that the bank owes you money, but it is showing an account from the bank’s perspective – a Credit balance reflects the liability the bank has to you and NOT your perspective - your asset.
The account in your ledger that is your recording of transactions that affect your bank account, would have a debit balance (assuming that you are not overdrawn), which, if every item has gone through the bank account, matches the credit balance shown on your Bank Statement.
Types of Books for Entering Transactions
Most modern companies now use computer systems with specialist programs to record their transactions, and the old technical names are irrelevant, but these are often too expensive or too complex for small companies and the ‘one-man band’ situations. These people have to rely on Accountants to ‘build’ the books from scratch by entering invoices and receipts, looking at bank accounts etc. Obviously they will be paying for experience that covers areas that relate to the far more technical aspects of accountancy than is needed just to do the book-keeping.
When most companies used the old fashioned pen and paper method the Cash Account was often maintained in a book separate to the rest of the ledger as it was used more often and was referred to as the ‘Cash Book’.
In many cases a more experienced clerk used to write non-cash transactions that had to go into the ledger in a Day Book (Journal) for a less experienced clerk or apprentice to enter into the individual Accounts. The senior clerk would write the cash transactions into the Cash Book for the junior clerk to update the other side of the entries in the Ledger.
As a company got bigger the functions of receiving and paying invoices/bills was split from the function of raising invoices and receiving monies. This meant that the ledger was split as well and the two halves were known as ‘Bought Ledger’ and ‘Sales Ledger’ and often had their own Journals (Purchase Day Book and Sales Day Book respectively).
The Cash Book and the Ledger pages usually followed the single column layout (where it could be on a single side of a page or the centre in the crease between the left and right hand pages) whereas the Journals tended to follow the Double column layout, but there is no reason why the double column layout could not be used in the ledger or cash book.
You may have heard the term ‘Control Account’. These are just summary Accounts of other multiple accounts. For example, your company owns lots of properties and would have an account for each tenant, however, the financial director would need to know the total amount of rents that are owing, but does not need to know which tenants are in arrears. This means that any entry in a tenant’s account is replicated in a Control Account, (which in this case would probably be known as Rent Debtors Control Account).
Every now and then the senior clerk would have to check that the junior clerk had entered the transactions properly, so the balances of each account were listed down to test that all the debits added up to the same amount as all the credits. This became known as the ‘Trial Balance’. Control Accounts would normally be used instead of each of the underlying accounts, but a check would also be made to ensure that the sum of the underlying accounts does add up to the balance on the Control Account.
It is usually at this point at which a book-keeper’s duty ends and an accountant’s work begins. For most people it would be very simple to get to this point and then pass the books to an accountant to audit (check that all entries have been entered and are handled correctly) and calculate tax obligations, fill in tax returns etc.
I do the books for a small company and I use Excel. I have a tab for cash transactions and a Journal tab for non-cash transactions. These entries are then used to calculate the Trial Balance and when required, Excel macros build the individual accounts from the entries in these tabs to create the Ledger.