Basic Principles of Accounting: The Double Entry, and What an Account Is

The pattern is worth seeing rather than memorising. Assets and expenses increase on the left. Liabilities, capital and income increase on the right. And that follows from the equation: assets are on the left of "Assets = Liabilities + Capital", and the other three are on the right.

The traditional Indian formulation, which many textbooks and MU's own reading list use, states the same thing as three golden rules:

• Personal accounts, those of persons and firms: debit the receiver, credit the giver.
• Real accounts, those of assets: debit what comes in, credit what goes out.
• Nominal accounts, those of expenses, losses, incomes and gains: debit all expenses and losses, credit all incomes and gains.

Either formulation gives the same answer. Use whichever you find easier and say which you are using.

The double entry

Every transaction affects at least two accounts, and the total debits equal the total credits.

The reason is not a convention but a fact about the world: every transaction has two sides. If cash comes in, it came from somewhere. If an expense is paid, something paid it.

The consequence is the great practical virtue of the system: because debits always equal credits, the books can be checked. Add up all the debit balances and all the credit balances; if they differ, there is an error. That check is the trial balance, in chapter [The Books a Lawyer Keeps: Cash Book, Ledger, Journal and Trial Balance].

A worked example

Take Advocate Nandini, who begins practice on 1 April. Each transaction, and its two sides.

1 April. She puts Rs 2,00,000 of her own money into the office bank account.

Cash at bank, an asset, increases: debit Bank Rs 2,00,000. Her stake, capital, increases: credit Capital Rs 2,00,000.

On the golden rules: bank is a real account, and cash comes in, so debit it; capital is a personal account and she is the giver, so credit it.

5 April. She buys a laptop for Rs 60,000, paid from the bank.

One asset increases and another decreases. Debit Computer Rs 60,000; credit Bank Rs 60,000. Note that this is not an expense: she still has the value, in a different form.

8 April. She pays office rent of Rs 15,000.

An expense increases: debit Rent Rs 15,000. The asset bank decreases: credit Bank Rs 15,000. Here the value is gone, which is what makes it an expense rather than an asset.

12 April. A client pays her Rs 30,000 as fees for an opinion she has given.

The asset bank increases: debit Bank Rs 30,000. Income increases: credit Professional Fees Rs 30,000.

15 April. The same client sends Rs 20,000 for court fees and expenses.

The asset bank increases: debit Bank Rs 20,000. And a liability increases, because she owes it to him or must spend it for him: credit Client A account Rs 20,000.

Notice what did not happen. Income was not credited. This is the single most important entry in the module, and it is the accounting form of rule 26, which requires entries to show whether money was received for fees or for expenses.

20 April. She pays court fee of Rs 12,000 out of that money.

The liability to the client decreases, because she has spent his money as instructed: debit Client A account Rs 12,000. The asset bank decreases: credit Bank Rs 12,000.

Again, no expense was recorded, because it was not her expense. It was his.

30 April. The matter ends and she returns the unspent Rs 8,000.

Debit Client A account Rs 8,000; credit Bank Rs 8,000. The liability is now nil, which is exactly what the account should show when a client has been fully accounted to.

The journal

A journal is the book in which transactions are first recorded, in date order, showing both sides.

Each record is a journal entry and is written in a fixed form: the account debited, then the account credited, then a short explanation called the narration.

Nandini's 15 April transaction, journalised:

Three conventions to know. The debited account is written first; the credited account is written below and indented, preceded by "To"; and the narration in brackets says what the entry is for. Rule 25 requires "all other necessary particulars", and a narration naming the suit is how that requirement is met.

Cash and accrual

Two ways of deciding when a transaction is recorded, and MU's topic on financial statements turns on the difference.

Cash basis: record income when the money is received and expenses when they are paid.

Accrual basis, also called the mercantile basis: record income when it is earned and expenses when they are incurred, whether or not money has moved.

For a professional practice the cash basis is common and is simpler. But it can mislead: an advocate who has billed Rs 5,00,000 and been paid nothing has, on the cash basis, no income at all, while his rent and salaries are being paid.

Chapter [Financial Statements: The Income Statement and the Balance Sheet] takes this up, because it is what separates a receipts and payments account from an income and expenditure account.

Capital and revenue

The other distinction that decides where an item goes.

Capital expenditure buys something of lasting value: the laptop, furniture, a library. It becomes an asset on the balance sheet.

Revenue expenditure is consumed in the period: rent, salaries, electricity, stationery. It is an expense in the income statement.

Get it wrong and both statements are wrong. Treating the laptop as an expense understates profit this year and understates assets; treating rent as an asset does the opposite.

Depreciation is the bridge between them: the laptop's value is consumed over several years, so a part of its cost is charged as an expense each year.

What beginners get wrong

Debit does not mean money going out. It means the left side, and for an asset it means an increase.

Client money is not income. It is a liability. This is the whole of rule 26 in accounting form.

Paying a court fee out of client money is not your expense. It reduces what you owe the client.

Buying an asset is not an expense.

The two sides are not "one in, one out". Both sides can be assets, as when a laptop is bought with bank money.

A journal entry without a narration is incomplete, and rule 25 requires the particulars.

Quick revision

• An account is a record of all changes in one thing. Debit is the left side, credit is the right. They do not mean good and bad or in and out.
• Accounting equation: Assets = Liabilities + Capital.
• Five classes: assets and expenses increase on the debit; liabilities, capital and income increase on the credit.
• Golden rules: personal, debit the receiver, credit the giver; real, debit what comes in, credit what goes out; nominal, debit expenses and losses, credit incomes and gains.
• Double entry: every transaction affects at least two accounts and total debits equal total credits, which is what makes the trial balance possible.
• Client money received is debit Bank, credit Client account: an asset and a liability, never income.
• Journal: first record, in date order, debit first, credit indented after "To", with a narration.
• Cash basis records on receipt and payment; accrual basis on earning and incurring.
• Capital expenditure creates an asset; revenue expenditure is an expense; depreciation moves cost from one to the other over time.

Test yourself

1. What do "debit" and "credit" mean? The left and right sides of an account. They do not mean good and bad, or money in and money out. Whether a debit increases or decreases the account depends on the class of account: assets and expenses increase on the debit, while liabilities, capital and income increase on the credit.

2. State the accounting equation and explain why it must hold. Assets equal Liabilities plus Capital. It holds because everything the business has came either from an outsider, which is a liability, or from the proprietor, which is capital.

3. A client sends Rs 20,000 for court fees. What is the entry, and why is it not income? Debit Bank Rs 20,000 and credit the client's account Rs 20,000. It is not income because the money is not the advocate's; it is held for the client, so it is a liability. That is the accounting form of rule 26, which requires entries to show whether money was received for fees or for expenses.

4. The advocate then pays Rs 12,000 of court fee from that money. What is the entry? Debit the client's account Rs 12,000 and credit Bank Rs 12,000. No expense is recorded, because the expense is the client's and not the advocate's; the entry reduces the liability owed to him.

5. Distinguish capital from revenue expenditure, with an example of each from a practice. Capital expenditure buys something of lasting value and becomes an asset, such as a laptop or office furniture. Revenue expenditure is consumed within the period and is an expense, such as rent, salaries or stationery. Depreciation charges part of an asset's cost as an expense in each year of its life.

6. State the three golden rules of debit and credit. For personal accounts, debit the receiver and credit the giver. For real accounts, debit what comes in and credit what goes out. For nominal accounts, debit all expenses and losses and credit all incomes and gains.