The double entry accounting practice started a long time ago, is one of the most powerful accounting practice. According to this system there is always 2 accounts, which must be settled for transaction to happen. One account forms the To part which gets Debited, and other account forms the From part which gets Credited.The double entry accounting concept was first published by Luca Pacioli in 15th Century. It was based on a simple mathematical equation.
Asset = Liability + Equity
The equation was originally thought out as Equity = Assets – Liabilities.
Like all other things there are Basics and Principle to learn in first go. Followed by how to record the things. The next one is types of accounts that play a major role. Followed by evaluating performance.
Double Entry Accounting Basics
In above accounting equation, the Left Hand Side i.e. Asset Side increases its value with a debit, and Right Hand Side i.e. Liabilities and Equities side increases in value with credit. Cash is an example of Asset, Loans are example of Liabilities. Equity also means owner’s fund, in field of personal finance its called as Net Worth. Its customary to write To in front of accounts being debited, and From in front of accounts being credited. It means value flows from the account being credited, into account being debited. So whenever an Expense is incurred value flows from cash account, into expense account(debit). Similarly in case of incomes the value flows into cash account, from an income account(credit). Since there are 2 accounts involved in an transaction, this accounting system got its name as Double Entry Accounting.
Recording in Double Entry Accounting
All the transactions of Double Entry Accounting System are recorded in a special log which is called as Journal. All the entries in Journal stored in Double Entry Format with a Credit and Debit sides. The Debit side account is written first and Credit Side account is normally indented a bit and is the last one to get entered.
In case of GNU Cash, instead of journals – you are shown a list of Accounts. Where in you open the account Ledger and Enter transaction. Also it has account hierarchy where in accounts can be nested like Assets:Liquid:Cash.
Types of Account in Double Entry Accounting System
In any financial transactions, there are 5 types of accounts, out of which at least 2 types of accounts will take play in transaction. The 5 types of accounts are.
Asset is pool where value resides, these are the things you own. There are different classes of assets like Bank, Cash, House, Car, Mutual Funds, Shares and Debentures, etc… The main criteria to identify certain thing as asset is it should generate monetary value for you. In case of companies assets are called as “Uses of fund”. Its called ‘uses‘ because money given by shareholders and debenture holders are used to purchase these machineries. In personal finance assets are pool of money you own. For that reason GNU cash provides with different asset classes like Bank, Cash, Shares, Mutual Fund, and Generic Asset. The generic asset is used to include assets like rare paintings, house, car etc..
Tip: Assets increase their value with Debit and decrease in value with Credit.
Liabilities are the things you owe to others. The different classes of liabilities are credit card, issued debentures, and loans. Liability is the money you owe to an external party which may be a bank, institution or a lender. In personal finance landscape liabilities can be student loan, home loan, car loan, credit card debt, etc… GNU Cash has 2 types of liabilities classes called as Credit Card and Liabilities.
Tip: Liabilities increase their value with Credit and decrease their value with Debit.
Equities are what is left after you subtract Liabilities from an asset i.e. Equity = Assets – Liabilities. IN case of companies the shares of the company are called as equity. In personal finance the equity is called as Net worth. GNU Cash shows equity as Retained Earnings in Balance Sheet. The Net worth is calculated by
Current Net worth = Previous Net worth + Income – Expenses
Tip: Equities like liabilities increase in value with Credit and decrease in value with Debit.
Income is the inflow of the value from the environment. Its too difficult to keep track of outer environment, which creates and takes value out of our accounts. Hence Income is interface which brings in value. In personal finances Income increases the value of assets.For example, our employers books of account are of no concern to us, but they give us inflow of value, hence Salary Income account is created to deal with this inflow of value.
Tip: Income increases an asset hence asset gets debited and Income gets credited. So incomes increases with credit. It is debited in correction entries only.
Expense is the outflow of value into the environment. For example, grocery store is not part of our internal account structure, the grocery purchase is shown as Expense. In personal finance expenses take out value from assets or increase our liabilities. If you make purchase using credit card then Credit card debt is going to increase. If you make purchase by paying cash the cash account gets credited as it looses value.
Tip: Expenses decreases an asset or increase an liability, hence Expenses are debited to indicate increase of it. Crediting expense is like Rebate, and it happens only in correction entries.
After the the types of expenses its necessary to know the health of our fiances.
The performance evaluation
The 3 main reports to know an individuals personal finance health are
- Balance Sheet
- Income Statement
- Cash flow Statement
Balance sheet indicates the asset liabilities positions. Based on this you can make some decisions on a person’s cash position, how much maneuvering room a person has regarding his money. Balance Sheet tells about value or money being present in Assets, Liabilities and Equities on a particular date. For Example If there is credit card debt outstanding on end of that month, its shown in Balance Sheet as liability. The cash balances are shown in asset side.
This report details levels of cash and assets, liabilities as on particular date.
The equities goes by another name of “Net Worth” in Personal Finances.
Income Statement tells how much income and expenses a person has received in given period such as a year or month. This report first lists all our sources of income. Some examples of income are house rent received,salary, dividends, interest on deposits etc.. Below income the expenses are listed.
The difference between income and expense is called as Net Income.
If net income is positive its called as profit, if its negative its called as loss.
Net Income tells about how fast the assets of the person can grow. If profit is small then asset growth minimal. Net profit can be seen as extra cash that is left in your bank account compared to last month. Incase of investors its report of how well your investments are performing. For example, it tells – is your investment in ITC stock or GOI Bonds is yielding good incomes for you or not?
Cash flow is akin to income statement but it tells how money got flowed into or out of your bank and cash accounts. This is report of how well you can manage your cash and bank balances. It tells from where the money is entering into your accounts and from where it is exiting your account. If the money comes only from salary then report is not going to be any different from Income Statement. If you lend money to your friends, then this report will show EMI’s your friends are giving as money inflows. In GNU Cash one has to adjust this report’s options to show data from liquid cash and bank accounts each time you run this report.
Always make sure to select only operative bank accounts and cash accounts in this report.
Don’t include your bank account supposed to hold accidental expenses in this report. It must appear in money outflow section of this report.
If you want to learn all the basics of using GNU Cash, refer to GNU Cash Tutorials and Concepts Guide here.