Written by Stephen Beard, Managing Director of Plyo Bookkeeping, a Vancouver-based bookkeeping firm.

If you own a small business then you’ve probably heard the term double entry bookkeeping thrown around, but what is double entry bookkeeping? Put very simply, it means that every single transaction recorded in your accounts must be entered in two separate accounts. For example if you buy a new laptop then your bank account will go down (be credited) and your computer equipment account will go up (be debited). It sounds simple, but there is a lot more to unpack.

Debits and Credits – Double Entry Bookkeeping

You probably noticed that I snuck in the phrases debit and credit when I was giving the above example. Debits and credits are the names given to the two sides of a transaction that are entered into your accounting system, and there is a golden rule you need to remember – whenever you’re posting a transaction, the value of your debits has to equal the value of your credits. This makes sense, especially if we take our example again. If you buy a computer for $100, then your bank account decreases by $100 (credited) and your computer equipment account increases by $100 (debited).

But the rule that debits must equal credits doesn’t just apply to a single transaction, it applies to your entire accounting system. The total value of all debits in your system must equal the total value of all credits in the accounting system. This may seem obvious, but it’s worth keeping in mind for later.

Debits and Credits Behave Differently Depending on The Account Type

To answer what is double entry bookkeeping, you’re going to need to understand the rather confusing behaviour of debits and credits. Firstly, you need to understand what they are not – debits are not positive numbers and credits are not negative numbers. It’s very easy to treat them like this, but that’s wrong and it won’t work. Think of double entry accounting as Sudoku, it has its own set of simple rules, and you have to play by those rules.  
Debits and credits behave differently depending on the type of account that they’re being used in, but before I can explain that, you need to understand the different account types.

Account Types

Accounts (also known as ledgers) are just a way of grouping similar transactions together. For example, all of you travel expenses would be grouped under a travel account (type expense), and all of your office furniture would be grouped under a furniture account (type asset). There are five types of account, and when doing double entry bookkeeping, the type of account will alter how you interpret the debits and credits contained within.

• Expense accounts, such as your ‘Cost of Goods Sold’, ‘Wages’ and ‘travel’ accounts. A debit here represents an expense, so you expect these accounts to have debit balances. You can post credits against them, but this will reduce the total amount of expense in the account.
• Income accounts, such as you main ‘Sales’ account. Whenever you sell something, this account will be credited, so we expect this account to have a credit balance.
• Asset accounts, such as your ‘Inventory’, ‘Computer Equipment’ and ‘Bank’ accounts. Here a debit balance means you have more of the asset. So if you sell a product for cash, your cash balance will be debited (go up).
• Liability accounts, such as ‘Loans’, ‘Wages Payable’ and ‘Taxes payable’ accounts. Liability accounts are normally in a credit position, which means that you owe someone some money. If you take out a new loan you’d credit the loan account, and if you repay that loan then you’d debit the loan account.
• Equity accounts, such as ‘Shares’, ‘Retained Earnings’ and ‘Current Year Profit’ accounts. These also normally have a credit balance, and it can be helpful to think of Equity as just another form of liability. You could start a company by putting your own money into the business (via buying shares) or you could have taken out a loan (liability) to get your business off the ground. In either case, the company owes that money back to either the lender (liability) or the owner (equity). The key difference is that lenders usually get their money back before owners, but from a double entry bookkeeping perspective, they are very similar.   

So debits and credits mean different things depending on the type (e.g. Asset, liability, Income, Expense, Equity) of account they are posted to. But how do you know whether it should be a debit or credit? This comes with a lot of practice, but here are some tips for working it out and improving your double entry bookkeeping.

How to Figure Out Whether it’s a Debit or a Credit

It depends on the transaction type, but a lot of the time, you’ll have spent or received money to your bank account, so the bank account will be one of the two accounts in the transaction. The bank account is an asset account, so if you get more cash then you would debit the bank account, and if you paid for an expense then you’d have less cash, so you’d credit the bank account. You then know that the other account has to have the opposite posting.

For example, if you sold some inventory for $100 (paid in cash), then you would debit your cash bank account by $100, and thus credit your sales account (an income account) by $100. Thinking about debits and credits from the banks perspective helps explain why income accounts are credited when something is sold.

Debits and Credits for Accrual Accounting

So far, I’ve limited our discussion on double entry bookkeeping to simple examples, where the bank account is usually involved. But for most businesses there are lots of transactions that occur where no money changes hands (at least not at the moment the transaction is created). The main example of this are sales invoices and purchase invoices.

When you create a sales invoice, your customer may not actually pay you immediately, for example you might offer 30 day credit terms. When you create an invoice, you actually create a new asset. This asset is an ‘account receivable’, and hence your accounts receivable asset will increase by the value of the invoice. The other side of this transaction is a credit to the sales account.

When your customer pays your sales invoice, you’re not recognizing any income, because that happened when you created the invoice. Rather, you are recognizing that one asset (accounts receivable – money owed to you) is being exchanged for another asset (physical cash). So the entry here is credit (e.g. lower) the accounts receivable asset, debit (e.g. increase) the bank asset.

You Mostly Won’t See Debits and Credits in a Modern Accounting System

We’ve answered the question of what is double entry bookkeeping, but if you’re doing your own bookkeeping using a modern cloud based accounting software (which you should) then you mostly won’t see debits and credits. That’s because software like QuickBooks Online do most of these posting in the background, and it’s only when you do a manual journal entry that you really get to post directly into the system with debits and credits.

But it’s still hugely important to understand double entry bookkeeping, as it’s essential when more complex transactions arise, or when somethings gone wrong and you have to figure it out.