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Understanding the Principles of Double-entry Bookkeeping - Minority#

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We are not financial professionals and do not aspire to be, so why learn double-entry bookkeeping?

For ordinary people, learning double-entry bookkeeping helps better manage personal finances and improves the accuracy and efficiency of financial decision-making. Although it is most commonly found in corporate accounting, understanding double-entry bookkeeping can help us better tackle financial challenges in life. Whether dealing with tax issues, understanding loan interest rates, or financial planning, ordinary people can face various financial situations with more confidence and make wiser financial decisions.

Double-entry bookkeeping may sound a bit complex, but for personal and family accounting, it does not require following many cumbersome regulations like businesses do. Compared to corporate accounting, personal bookkeeping is simpler and more flexible; you can handle it in your own way. Double-entry bookkeeping involves many specialized accounting concepts, and I believe the difficulty lies in the fact that discussions about double-entry bookkeeping often revolve around corporate practices, which are filled with accounting concepts that differ significantly from our everyday understanding and are quite distant from daily life. This leads to ordinary people finding that they recognize every word when learning double-entry bookkeeping but cannot grasp what is actually being discussed.

I hope this article can use simple and understandable language to help you easily grasp the core concepts of double-entry bookkeeping.

The math knowledge that modern elementary school students learn was once only accessible to a few elites or professional mathematicians hundreds of years ago. However, today's elementary school students can master it. Are we smarter than before? I don't think so; it's more likely that this knowledge is now widely available. I believe that in the future, double-entry bookkeeping will also be like this. Having developed over four to five hundred years, double-entry bookkeeping is already a very mature discipline. It is a sophisticated way of bookkeeping and thinking that we modern people should all master. Martin Blais, the author of Beancount, also believes that students should be taught double-entry bookkeeping methods starting in high school.

Barter Transactions#

Ellie

In primitive societies, people had not yet invented currency, and transactions were conducted through barter within small groups.

Ellie is a female artisan from a tribe, and she is very skilled at making pottery. The pottery she creates is both beautiful and practical, and people love it. Bao Bo is a young man from another tribe, skilled at crafting stone knives. The people in his tribe greatly appreciate the stone knives he makes. Ellie has ten chickens, and Bao Bo has a cow; these are their respective possessions. They both hope to accumulate more wealth through their labor to improve their living conditions.

Whenever Ellie has free time, she starts making pottery in her workshop. Whenever Bao Bo has time, he goes out to find suitable stones to craft stone knives. They can exchange their goods in the small market of the tribe. Ellie wants a stone knife to help her carve patterns on her pottery, making it more beautiful and appealing to more people. Bao Bo also wants a pottery jar to store the various strange stones he collects.

One day, they went to the small market and happened to find each other's goods, so they started chatting. After communicating and bargaining, Ellie ended up with two exquisite and sharp stone knives, while Bao Bo received a sturdy pottery jar. Additionally, Bao Bo wanted to exchange a chicken to help his mother regain her health, so he shared his idea with Ellie. However, Ellie felt she didn't need more stone knives, and since Bao Bo had nothing else to offer in exchange, she declined his proposal.

But Bao Bo did not give up; he took out his best five stone knives and told Ellie he could exchange these five best knives for one chicken. Although Ellie currently has no use for them, she could surely trade them for something she needs back in the tribe. Ellie looked at the knives, which were indeed exquisite and sharp, and thought that a few people in her tribe would definitely need them, so she agreed to Bao Bo's request. In the end, they were both very satisfied with the items they exchanged and returned to their respective tribes. During this process, two transactions occurred for Ellie:

For Bao Bo:

After completing these two transactions, Ellie's and Bao Bo's assets changed to:

Both Ellie and Bao Bo increased their assets, which came from their hard work. If we were to record this process using modern accounting terminology and according to the principles of double-entry bookkeeping, it could be recorded as follows.

Beginning Assets: The assets they each owned at the start of an accounting period.

According to accounting terminology, assets refer to resources formed by past transactions or events that are owned or controlled by an entity and are expected to bring economic benefits. In simple terms, only those things that can bring future benefits can be called assets.

For Ellie, the transactions that occurred:

Ending Assets: The assets they each owned at the end of an accounting period.

Why is only five knives recorded instead of seven? This requires us to clarify our actual situation; two of the seven knives are for personal use, and as they wear down, they will not hold much value. Stone knives are relatively inexpensive and do not have much value as a store of wealth, so these two knives are considered as costs for maintaining one's survival and are thus not recorded on the asset sheet. However, the other five are intended for exchange with others, capable of acquiring assets or the labor of others, and since they are in greater quantity, they are temporarily placed in the asset category. From this, we can also see that whether an item is recorded as an asset or as a cost of maintaining one's survival depends on the actual situation, thus carrying a degree of subjectivity.

The absence of the chicken obtained from the exchange in Bao Bo's assets is due to a similar reason. Bao Bo needed to consume the chicken to maintain his family's health, so the chicken was consumed and thus did not accumulate as an asset. If Bao Bo bought many chickens for egg production to exchange for more goods, then those chickens would need to be recorded as assets. Therefore, bookkeeping itself has a degree of subjectivity; corporate bookkeeping is the same, except that corporate bookkeeping must adhere to many legal and regulatory requirements, while personal and family bookkeeping can be determined based on one's own purposes, allowing for great flexibility.

"For every debit, there must be a credit, and debits must equal credits."

The core and fundamental principle of double-entry bookkeeping is "For every debit, there must be a credit, and debits must equal credits." Here, "debit" and "credit" do not mean borrowing or lending in the usual sense; they are merely bookkeeping symbols with no special meaning. In my learning and practice, I have found it helpful to understand "debit" as "I received" and "credit" as "I gave." Thus, "For every debit, there must be a credit, and debits must equal credits" can be understood as when I engage in a transaction with someone, the value of what I give to them and what I receive from them must be equal. This is essentially the principle of equivalent exchange. In the earlier story, for Ellie, the two stone knives she received from Bao Bo represent "I received," or "debit," while the pottery jar she gave Bao Bo represents "I gave," or "credit."

Of course, this is an inappropriate example because, in an accounting system, everything must have a monetary price, and currency did not exist in primitive societies. For instance, in our daily life, if I buy an ice cream for 10 yuan, what I receive is an ice cream priced at 10 yuan, and what I give is a 10 yuan bill; these two are equal in price. This actually records both sides of the transaction, as a transaction requires two parties to occur, thus making the information recorded in double-entry bookkeeping more complete.

Currency-mediated Transactions#

Bao Bo

Fast forward to modern times, our transactions use paper currency, which is credit money, greatly facilitating our transactions. Not only do we have currency, but we also have lending services. This means that even if a person lacks funds, if they have a great idea, they can borrow a large sum of money from others to start a business. The emergence of lending has made the entire economy more vibrant while also amplifying prosperity and recession.

In civilized society, Ellie and Bao Bo have more choices and ways to accumulate wealth. Bao Bo currently has 10,000 yuan in cash, and his car is worth 100,000 yuan, of which 50,000 yuan is a bank loan, and he needs to repay the bank 1,000 yuan monthly (equal principal and interest). Therefore, his current net worth (here, owner's equity) is 60,000 yuan, which reflects his current financial situation.

Beginning Assets and Liabilities: At the start of an accounting period, Bao Bo's assets and liabilities. Here is the situation at the end of June.

He currently works at a logistics company, earning a monthly salary of 6,000 yuan, with monthly food expenses of 1,000 yuan, rent of 1,000 yuan, communication fees of 100 yuan, and car loan repayments of 1,000 yuan.

Transactions need to be fair, so what I receive and what I give should be equal in monetary terms. This means that the total of all "debits" must equal the total of all "credits," thus satisfying the core requirement of double-entry bookkeeping: "For every debit, there must be a credit, and debits must equal credits." With the above journal entries, we can further derive the ledger, which is based on the journal to aggregate accounts of the same type together. For example, the following "Expenses," "Income," "Cash" (which belongs to asset accounts), and "Loans" (which belongs to liability accounts).

The above income and expense accounts are virtual accounts. At the end of each accounting period, the difference between income and expenses can be used to calculate profit, which for individuals is net income. Afterward, the income and expense accounts will be reset to zero, preparing to start recording for the next accounting period. Therefore, at the beginning of each accounting period, the balances of the income and expense accounts are always zero, and you can think of these two accounts as pipes supplying water.

The cash and loan accounts above belong to asset and liability accounts, while asset, liability, and owner's equity accounts belong to real accounts, as the numbers in these accounts are continuously accumulated. Therefore, at the beginning of an accounting period, the balances of the remaining accounts are not zero, and you can think of these three accounts as water storage pools.

Based on the ledger, we can derive Bao Bo's Income and Expense Statement for the month, also known as the Profit and Loss Statement.

The income account represents what you need to give up to acquire and accumulate assets, whether it be your products or services you provide to others. The expense account represents the products or services you need to purchase from others to maintain your living and regenerative capabilities. The prices recorded in these two accounts only reflect the cost of products or services. Every expense you incur corresponds to someone else's income, and conversely, every income you receive corresponds to someone else's expense; they are two sides of the same coin.

Ending Assets and Liabilities: At the end of an accounting period, Bao Bo's assets and liabilities. Here is the situation at the end of July.

Based on the ledger, we update Bao Bo's Balance Sheet, reflecting his asset and liability situation at the end of July. Here, the owner's equity is the beginning owner's equity balance plus net income. In this case, one month is treated as an accounting period. It can be seen that his net worth increased by 3,880 yuan, all of which came from his net income.

Assets = Liabilities + Owner's Equity

The balance sheet fully reflects another fundamental principle of double-entry bookkeeping, which is the accounting equation: Assets = Liabilities + Owner's Equity. The asset account represents what you own that can be used for production and further income generation, primarily cash, real estate, and vehicles for individuals and families, but it can also include stocks and other financial products. Liabilities represent the assets, services, or labor you have claimed from others without providing an equivalent in return, essentially promising to repay later. This account records the value of the promise to return that debt. Owner's equity represents what you truly own; for personal and family bookkeeping, it can be understood as the difference between assets and liabilities, which is net worth. Every asset you have corresponds to someone else's liability, and every liability you have corresponds to someone else's asset; they are also two sides of the same coin. For example, the cash you have in the bank is an asset for you but a liability for the bank. The debt on your credit card is a liability for you but an asset for the bank.

About "Debit" and "Credit"#

"Debit" and "Credit" are perhaps the most challenging concepts to understand in double-entry bookkeeping. This is partly because we tend to associate "debit" and "credit" with borrowing and lending, trying to find a pattern, but in double-entry bookkeeping, these two terms have no practical meaning, so there is no need to associate them; rote memorization is the best approach.

Of course, I have found a better method by replacing "debit" and "credit" with "I received" and "I gave," and remembering their positions in my mind. "I received" is always recorded on the left side, while "I gave" is always recorded on the right side.

When recording a specific account, this approach makes it easy to distinguish which should be recorded as "debit" and which as "credit." Once this challenge is resolved, another challenge arises when creating the ledger from the journal, which involves summing the amounts in each different type of account. For example, when summing all income accounts, you may encounter a problem: when both "debit" and "credit" have numbers in the same account, which should be considered an increase and which a decrease? There is no good method for this; it is simply a matter of rote memorization: In income and liability accounts, "debit" is a decrease, while "credit" is an increase; conversely, in expense and asset accounts, "debit" is an increase, while "credit" is a decrease.

This handling is to ensure that each account normally has a positive balance, aligning with people's daily habits. However, if we do not handle it this way, we could completely disregard the related content of "debit" and "credit." Remember, we previously mentioned that income and expenses are two sides of a coin, and assets and liabilities are also two sides of a coin. Using my previous framework, when bookkeeping, only consider "I received" and "I gave." All numbers recorded under "I received" should be positive, while all numbers recorded under "I gave" should be negative, which is easy to remember: "I received" is what I gain, thus positive, while "I gave" is what I give away, which should be deducted from what I own, thus recorded as negative.

| | Balance+ | Balance- | |
| --------- | ------- | -- |
| Real Accounts | Assets | Liabilities |
| Virtual Accounts | Expenses | Income |

Among the four accounts of assets, liabilities, income, and expenses, assets are positive when acquired, while the corresponding liability on the other side is negative; in the expense account, what I receive is positive, while the corresponding income on the other side is negative. This is also inspired by the thinking of Beancount. Thus, it is only necessary to remember that asset and expense accounts normally have positive balances, while liability and income accounts normally have negative balances. Coupled with the earlier "I received" recorded as positive and "I gave" recorded as negative, relevant calculations can be performed. All previous records and reports were created according to traditional accounting requirements; if following the rules of recording "I received" as positive and "I gave" as negative, with asset and expense balances being positive and liability and income account balances being negative, readers can try to visualize what all records and reports would look like.

Chart of Accounts#

The chart of accounts can be understood in a non-professional sense as the totality of all accounting accounts used in bookkeeping, of course, this is a structured table with classifications. For individuals and families, the main categories are four: income, expenses, assets, and liabilities. These four belong to primary accounts, and under each account, one can set up secondary, tertiary, or even more levels of accounts as needed. However, it is recommended that for personal and family bookkeeping, dividing into three levels of accounts is generally sufficient; overly detailed classifications can hinder management and long-term recording.

How to set up more detailed accounts under these four categories is subjective; everyone has different needs and concerns, so the setup of accounting accounts is highly flexible. Among these four categories, the expense account is the one most commonly used by ordinary people, so the classification under the expense account becomes particularly important, and many people often get stuck here. A good account classification can save the bookkeeper a lot of trouble, but there is indeed no unified standard. Below is a summary of my own classification into two levels; more detailed principles and explanations can be written in another article.

Chart of Accounts

Ideally, the accounting subjects should be defined at the beginning of bookkeeping, but in reality, our understanding evolves as we delve deeper into bookkeeping. Therefore, we can initially refer to others' account definitions combined with our current understanding to create a suitable chart of accounts for ourselves, and then continuously improve it.

I believe that readers who have managed to read this far must have a high level of patience. If you have never been exposed to financial knowledge before, you might still feel confused and think it is too difficult to understand. Trust me, you are not alone. In fact, double-entry bookkeeping is not difficult, but because it involves many concepts that differ from our everyday understanding, it can be challenging to grasp all the concepts at once. It takes time to become familiar with these concepts. The simplest way is to read this article several times, occasionally revisit it, and ideally, try to practice recording yourself. With learning, practice, reflection, and feedback, I believe you will master the methods of double-entry bookkeeping in no time.

After long-term bookkeeping practice, I feel that the philosophy of bookkeeping and the choice of bookkeeping tools are both important, but in the long run, the philosophy of bookkeeping is more crucial than the tools used. Double-entry bookkeeping is a method commonly used by businesses today, so individuals who master the principles of double-entry bookkeeping can theoretically record any accounts. For personal and family bookkeeping, the complexity of specific bookkeeping can be entirely controlled by oneself; it can be very simple or very detailed and complex, depending entirely on one's needs. Therefore, its flexibility and scalability are excellent. Learning the principles and philosophy of double-entry bookkeeping is far more useful than spending the same amount of time learning a bookkeeping tool.

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