Accounting 102...Using the Double Entry System

To every action there is an equal and opposite reaction. - Newton

*To better prepare for the concepts explained in this article, please read the previous article "Personal Accounting 101...Understanding the Basics to Accounting"*

As mentioned in the previous article, I am planning on taking on my personal finances from a different perspective in 2009. I want to become my own personal accountant and understand my finances at a higher level to track each and every dollar that I spend. In order to do this, there are some accounting principles that must be understood to ensure proper accounting of my money.

The latest principle that I have learned about is the "Principle of Balance" in accounting. This principle seems necessary to me because I want to know where each dollar comes from and goes to in my personal finances. Knowing this information will help with identifying any kind of holes that my money seems to disappear into. In addition to that, it will help identify my spending trends and adjust finances according to the previous trend so that I can better eliminate unexpected expenditures.

The "Principle of Balance" is implemented in a accounting method called Double Entry Accounting. Below is a definition of what exactly this is:

Double Entry Accounting: A standard accounting method that involves each transaction being recorded in at least two accounts, resulting in a debit to one or more accounts and a credit to one or more accounts.

Although this seems like a lot of overhead for tracking your personal finances, it offers several benefits:

1. Accounting Trail
• Using Double Entry accounting allows you to track where the money originates from as well as where it ends up at. This way each dollar can be tracked and it is easier to identify when money is being wasted.
  
2. Automatic System of Checks
• Since every transaction is being recorded twice, it provides an automatic system of mathematical checks to make sure that all money is being accounted for. With this method, all credits have to match all debits in a transaction.
  

For further clarification, let's take real world example of this scenario. For instance, if an employee has their paycheck deposited directly into their checking account from an employer, then the money has been withdrew from the employer's account in the form of a paycheck and deposited in the employee's checking account in the form of increased funds. Using the double entry method of accounting, the journals that record this entry would look to be the following:

Income: Paycheck (-$500) -> Asset: Employee's Checking (+$500)

To make this a little more complicated, let's look at the terms debit and credit to understand this in more formal accounting terminology.

A quick explanation of how debit and credit works is listed below:

Debit
Money is recorded in the debit column, which is always the left column, when it is being transferred to an account. Also referred to as depositing into an account. (Citation)

Credit
Money is recorded in the credit column, which is always the right column, when it is being transferred from an account. Also referred to as withdrawing from an account. (Citation)

Applying this new terminology to our current real world example, you get the following:

Debit:Employee's Checking - 500
Credit: Income Paycheck - 500

*I know this seems a little backwards and is a bit to wrap your head around due to the nature of Credit and Debit cards, and how they work, but once you start thinking in terms of deposits and withdrawals, it will be easier to understand*

Now the previously referred to benefits of this method are obvious because all debits (deposits) have to equal all credits (withdrawals). However, recording each transaction and then performing calculations seems to be a complicated and tedious task. This would be true if we did not have computers, however there is free software that handles most of this for us. All that is required from the user is to save receipts and enter them into the software.

Doing a quick Google search for "Accounting Software" can turn up many choices, however I plan on using GNUCash. Not only is it free, but it is very feature rich allowing the user to create charts, graphs and reports.

What are some of the financial resolutions you are going to make for 2009? Do you have better ways for money management? Let us know!

Stay Disciplined!