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Accounting made simple? I don't think so.

Guest post by: Robert Taylor

Article Overview: A light hearted look at the mere mortal's main barrier to understanding accountancy, Credits and Debits.

Accounting made simple? I don't think so.

Q. What's the definition of an accountant?
A. Someone who solves a problem you didn't know you had in a way you don't understand.

OK, I’ve got a degree in pure mathematics, with subsidiary qualifications in quantum mechanics and relativity, and I’ve been in the computer industry for 25 years. No I’m not trying to boast, but merely indicate that when it comes to straightforward arithmetic I am reasonably competent, or at least should be. So how come that within about 5 minutes the first visit to my prospective accountant, many years ago, left me feeling innumerate, and doubting the very integrity of the logical laws that govern the universe?!

‘So, I pay for my office computer by cheque, and I can’t believe it! The bank debited my account by £3500 rather than £350’, I say to the accountant. A wry smile begins to creep across his face. ‘Actually the bank credited your account by £3500’, he said. ‘No’, I say ‘the bank took more money out of my account than they should have’. ‘Yes that’s right, they credited your account. Remember your bank account is an asset’.

Now at this point a number of thoughts immediately sprung to mind. First, this was some standard joke perpetrated by the accountancy profession. Secondly, this guy simply didn’t know what he was talking about, and I should get out of his office ASAP. Lastly, he did know what he was talking about, and any initial thoughts I had of doing all my own accounts after a quick chat with a professional, and thereby saving a considerable amount of money, where pure fantasy. Yes you’ve guessed it, the latter.

‘Look, it’s pretty simple’, he said. ‘If I credit an asset account I decrease it. If I debit an asset account I increase it’. I interrupt, ’Ah I get it. It’s simply reversed, what normal people call credits you call debits, and what we call debits you call credits. That’s pretty confusing, but I can work with it’. Feeling cocky now, as though I had has a mastered accountancy in a single stroke, I offered another example. ‘So if I sell a computer, it generates income, which in normal terms would credit my account, showing the sale. But because we are reversing everything, it’s a debit right?’. ‘No that’s incorrect’, he said. ‘If you increase your income it’s a credit’. ‘What! You’re joking?’ My new found confidence was suddenly shattered. ‘Next you’re going to tell me that expenses from my purchases, which actually means an increase in my expense account, is a debit’. ‘You’ve guessed it!’ he said, almost revelling in my confusion.

Given my mathematical background I then began to try and establish the moral high ground by arguing that the system was ridiculous and confusing, but I could sense this line of reasoning was futile. ‘Look Rob, I know it might seem confusing but this system has been in place since 1494; double entry bookkeeping was devised by a Franciscan Monk called Luca Pacioli. It’s just the way things are’. ‘Hang on forget the Monk, what’s this about double entry bookkeeping, I thought that just meant you just double checked all your figures’. ‘Not exactly, you need to get back to first principles. I thought you would have known this being a mathematician…’.

‘Right, just explain it to me in simple mathematical terms. I’m not interested in Monks, or any other history, just the facts.’
‘Ok, everything is based on a simple equation called the “Accountancy Equation”. In its simplest form this is,

Assets = Liabilities + Equity

‘Hang on, simple equation, but what does it actually mean?’, I say. ‘Well, a way of looking at it is “what you own minus what you owe is equal to the residual value of the business, or ‘
Asset – Liabilities = Equity

‘So for example, if you have stock worth £1000, but you owe £250 your equity is £750.’

‘Ok I get it, but what does this have to do with credits and debits?’. ‘Well before I explain that its worth noting that for a business, whatever transaction is performed, such as a sales invoice, a purchase such as your computer, or a simple bank transaction, the accountancy equation must hold.’. ‘So what if it didn’t hold’, I say. ‘Then there has been an arithmetic error, and that is exactly the point of double entry bookkeeping. For every transaction in your business you can write down the effect on the Asset, Liability and Equity accounts. If the equation does not balance, there is a problem’. ’Ah, I see, that’s what it means by balancing the books then’. ‘Yes, now remember the initial form of the accounting equation? By convention (and not by common sense) the left hand side is always called “Debit” and the right hand side is always called “Credit”. So for any transaction, the debits and credits must always balance. Hence the term “double entry”, one entry for the debit side, and one for the credit. Let’s have another look:-

DEBIT: CREDIT:
Assets = Liabilities + Equity

‘Now your bank account is an asset, so if I decrease the cash by £3500 as happened with you we get:-’

Asset – £3500 = Liabilities + Equity

Or re-arranging

Asset = Liabilities + Equity + £3500

You see we have credited the asset account because the positive value lies on the right side of the equation i.e. the credit column. I could say this was a negative debit of course, but why confuse you more!’

‘Ok, this is actually beginning to make some sort of sense. But hang on, what about expenses and income how do credits and debits affect them?’
‘Well, the difference between income and expense is actually considered part of the equity. So the full equation becomes

Asset = Liabilities + (Equity + Income – Expense)

Or rearranging,

DEBIT: CREDIT:
Asset + Expense = Liabilities + Equity + Income

Now then, this equation tells you the whole story in terms of debits and credits. For example, if I spend money, and increase my expense it’s a debit, because a positive increase in expense is on the debit side. Similarly, if I take a loan out it’s a positive liability which is a credit. Another example, if I get income from a sale this increases the income account, which is a credit. I could go on but you get the general idea?’

‘Yes, so in fact the key causes of confusion are the terms credit and debit, because they have a common well understood meaning in everyday use, but a specific different meaning with respect to double entry accounting’. ‘That’s right, you’ve got it! Of course in the good old days the credits and debits of all transactions in the business were written down in a ledger, if the books, i.e. the ledger, did not balance it could be a nightmare to try and find the problem. These days the beauty of a computer accounting system is that it automatically ensures all transactions balance, so you don’t have to worry. In fact, if you knew nothing about accounting you may never realise its doing anything at all in terms of bookkeeping. On most systems you can look at the credits and debits associated with each transaction, say an invoice, by clicking the ‘Show Account Entries’ button, it’s worth doing this to get a real idea of what is going on’.

Years later I was at a party, and happened to be speaking with a very senior accountant in the treasury department. We were discussing Salesorder, and in particular the accounting functionality. ‘So a whole accountancy system has been developed with multicurrency, UK and US Tax, together with full financial reporting, and do you know what the most confusing aspect of the whole development was?’ I said, hoping to make her gasp with incredulity. ‘Debits and Credits’, she said without hesitation.

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Article Tags: accountancy profession, accountant, amount of money, arithmetic, asset account, cheque, computer industry, fantasy, initial thoughts, integrity, joke, logical laws, office computer, pure mathematics, quantum mechanics, relativity, single stroke, subsidiary, universe, wry smile



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