Why should engineers bother with business accounts?
Engineers often start and run SMEs. For such businesses not to have their performance capped, it is important that technical leaders understand business accounting thoroughly.
Accounts is taught using the wrong language!
Nearly everyone faced with getting to the bottom of debit and credit bookings is baffled on first meeting the concept. In fact, the author was once regaled by another engineer with the advice that one should use ruthless logic to decide whether a booking is debit or credit, and then put it on the other side – invariably the right answer! Obviously not, but this tale doubtless chimes with many.
Accounts is taught using the wrong language! Accounts is governed by one basic linear mathematical equation from which all its concepts and methods can be explained in less than one page. Maths is the right language. Unfortunately reams and reams of verbal, ambiguous, cryptic English is used to train people for accounting disciplines. Can you imagine an English course covering Shakespeare being delivered using mathematics? Or, Einstein’s theory of relativity being explained in English only? It just doesn’t make sense to do either, but it is nevertheless a fact that an essentially mathematical discipline is taught by a convoluted method that makes understanding an order of magnitude harder.
So, here follows what to those with mathematical training will be straightforward, and for those with less training, a modest bolstering of mathematical knowledge coupled with what’s below will lead to a profound understanding of accounts.
Accountancy all in one equation
Assets(A) = Liabilities(L) + Equity(E)
This is the canonical equation of accounts, and it is called the Accounting Equation. Its form will be embellished with descriptions so that the meaning of debit and credit become obvious later in this article.
Rule 1: the company must be thought of as an entity in its own right. It can be thought of like a person. When making logical judgements from the Accounting Equation, always remember it is the company and not you or the owner of the company that the issue relates to.
Rule 2: Assets are what the company owns. These can be physical items or ones that have yet to be realised as cash. Some examples are bank balance, debtors (entities that owe the company money), fixed assets, stock.
Rule 3: Liabilities are what the company owes. These items/entries may be long or short term. A long term liability might be something like a loan being paid back over years, and a short term liability entry could be something like an owing electricity bill.
Rule 4: Equity is what the company owes its owner/s. This concept is somewhat notional because the real value of a company to an owner is what he/she can sell it for: lock, stock, barrel, and liabilities. The Equity as defined by the Accounting Equation is the money an owner would have after selling all the company’s assets and settling all its bills and loans.
So, what is the primary aim of accounts? It is to place a value on a business, which is expressed through the balance sheet. The balance sheet is a direct expression of the Accounting Equation presented vertically as at a stated date (every day the values change) transposed such that E is the subject. The left hand side of the equation is known as the Net Asset Value and is exactly equal to Equity (E).
Assets(A) – Liabilities(L) = Equity(E)
Turning this into a balance sheet:
Assets: £ £
Premises 20,000
Bank 200
Debtors 1,000 21,200
Liabilities:
Long term liabilities (loans) 500
Short term owing (suppliers) 100 600
£NAV (A – L) 20,600
Equity:
Share Capital 20,000
Earnings 600
20,600
Note that, as is consistent with the Accounting Equation, the net asset value (£NAV) is equal to Equity E.
The Wider World: Everyone has an Accounting Equation and Balance Sheet
It is essential to grasp that all entities have their own Accounting Equation. The company has one and the owner one with different values. The value of E for the company is part of the owner’s A. A liability entry for one company (L) must have a corresponding entry for another entity’s A. Every company has its own A = L + E with its own values. The company is not its owner in accounting terms. The two are separate entities.
Enhancing the Accounting Equation to include Profit and Loss
A little bit of maths comes in here. We need to enhance the Accounting Equation such that it covers profit and loss. The result will be stated first and then followed by its derivation. If the maths isn’t clear it is worth having someone explain it – it will allow you to work out how to treat any accounting entry from first principles. It can be left and only the first line (equation) used, but this isn’t recommended. Find someone who understands a little maths and have it explained or Contact Us.
Assets + Expenses(EX) = Liabilities + RetainedEarnings(RE) + Sales(S)
Equity (E) is made up of RetainedEarnings(RE), which are monies earned in the past, plus whatever the profit or loss is for the last accounting period, which is Sales(S) – Expenses(EX). Note that Sales(S) – Expenses(EX) for a period is the profit or loss for that period. Expressed as a formula:
Equity(E) = RetainedEarnings(RE) + Sales(S) – Expenses(EX)
Substituting this into the Accounting Equation:
A = L + RE + S – EX
Transposing such that positive items are on the left and negative on right – reason for this will become clear in the section that explains allocating debit or credit.
A + EX = L + RE + S [Key equation]
Allocating a Journal entry as Debit or Credit
The Journal is a day book/s (imagine it literally along with a clerk filling it out using a quill pen) in which every transaction the business makes is recorded. There could be thousands – hence rows of clerks in a Dickensian business. To really appreciate the accounting system, one must put computers in the bin. Computers do this kind of thing automatically, but they have led to generations of workers not understanding accounts from first principles and becoming consequently dumbed down. Allow yourself to bin computers until all these concepts are understood and then return to the modern digital world to find the nuances of accounts no longer a mystery.
The essential entries of an accounting transaction in a Journal are:
- Date
- Description
- Account – needed for translation to the relevant Ledger (explained later).
- Amount recorded as either debit or credit
- Identification of the person making the entry
Now comes the bit that puts students in a flat spin, and that many experienced accountants only really know through experience and gut feel.
Is a given entry debit or credit?
To answer this just three questions need to be answered before it is allocated as either debit or credit.
Journal Entry Rules
- Is the entry an increasing or decreasing one?
- Does the entry relate to an asset (A), Liability (L), Equity (E), Sales (S), Retained Earnings (RE), or Expenses (EX)? An example follows to clarify this.
- Use the Key Equation above to determine a credit or debit entry according to the following rules:
- If on the left of the equation (A or EX), an increase is booked as a debit and decrease a credit.
- If on the right of the equation (RE, L, E, or S), an increase is booked as credit and decrease as a debit.
An example should establish this method in the mind of the reader.
Mr Ledge, a company accounts clerk, records that the company pays Supplier Ltd. £500 to settle Invoice XXX on 30/6/25 in the Journal. The double entry system is covered later in this article, but for now note that there are always 2 entries. One must be debit and the other credit. This is to comply with the double entry book keeping system. So, an entry must be made for the bank and the supplier.
The bank:
- A payment is being made, so the bank balance is decreasing because of the transaction.
- The bank is an asset (A) – the company owns it.
- As it is an A and decreasing (see Journal Entry Rules), it must be a credit entry.
Supplier Ltd:
- Supplier Ltd. is receiving a payment against it so its balance is decreasing. The amount owing is decreasing.
- Suppliers are liabilities (L). The company doesn’t own them, but it can certainly owe them. Suppliers are owed money when used.
- According to the Journal Entry Rules, a liability, L, that is decreasing is booked as a debit.
It is worthy of note that this example is just a snapshot entry of a dealing with a supplier for operations. A full set of transactions would have involved the initial entry being one that was an entry on the Purchase Ledger with a credit entry allocating the amount owing on Supplier Ltd.’s account.
The above is entirely logical and straightforward, but it does pay to embed it with practice. All accounts training texts are riddled with examples. After a number have been done the above will become second nature. Reading this article and practice will leave the reader with the skill to make standard journal entries without difficulty and have the tools necessary to reason a more complex example from first principles.
The System (Dickensian – Real World)
If it is desired to understand the underlying principles and terminology in accounts, the accoutrements of the modern digital age must be temporarily binned. They are a distraction that can be re-introduced once there is understanding.
Imagine a 19th century business that just has a pile of receipts, a bank account, and little else. It is necessary to make sense of this and establish a system that means reliable and accessible record keeping is the method of the future.
The answer lies in the following:
Journal to Ledger Accounts to Year End Accounts.
The first thing to do is establish a proper diary entry of every accounting transaction the business has had and currently has. This is the Journal. Imagine rows of accounts clerks making journal entries with quill pens in impressive atlas sized books with incredibly neat writing, and painstaking records of when, who and how much are involved for every transaction. A question:
If there are 20 accounts clerks all working on separate piles of receipts, how likely is it that errors will be made? Almost certain!
This is where double entry book keeping and debit and credit entries in the Journal come in. As will be shown in the following section, in the double entry system the sum of the debit entries must equal the sum of the credit entries. Every time an accounts clerk enters a transaction he/she knows that the two entries must be equal and opposite (credit/debit). This is the first check. The second check is a sum of complete entries for each page of the Journal. These must also be equal and opposite. The third check is a sum of all entries in the journal that must also be equal and opposite. This last check is known as a Trial Balance, which is covered in a later section of this article. A very neat system. This is what the Journal is all about. An entry of every accounting transaction in the business using double entry such that most errors will immediately become evident via the summing of debit and credit entries.
The next stage is to construct Ledger Accounts. We may now have thorough record keeping, but imagine the mayhem when a client writes to request a statement of his account. The information is all in the journal, but how long will it take to extract the entries for just that client from 20 atlas sized books? So, ledger accounts are created for every relevant entity and transactions recorded concurrently, or maybe at the day’s end for Oliver Twist, such that any entity (supplier or client particularly) can instantly see his or her financial position relative to the company. For students, these may be equated with the T accounts that are requested in accounting questions. These aren’t populated until the Journal is complete. The three usual Ledgers are:
- Debtors Ledger (Accounts Receivable)
- Purchases Ledger (Accounts Payable)
- Nominal Ledger
Accounts courses and modern systems don’t use the journal because computers deal with its process, but this leads to fundamental misunderstanding of accounts and unfortunate dumbing down.
Year End Accounts are compiled from Ledgers. It is beyond the scope of this article to cover them – unless requests to do so are received. The output from Year End Accounts are Balance Sheet and Profit and Loss statements.
Double Entry
As always, everything comes from the Accounting Equation
Assets(A) = Liabilities(L) + Equity(E)
A – L – E = 0
A – (L + E) = 0
Debit (Dr) and credit (Cr) were created to create absolute values that didn’t, other than under exceptional circumstances, create negative numbers. The double entry book keeping system is essentially an absolute number system in which:
Dr is positive
Cr is negative
Applying this to the Accounting Equation we get:
- if an asset A is increasing, it is getting more positive and is therefore a debit entry
- If an asset A is decreasing, it is getting more negative and is therefore a credit entry
- If a liability L or equity E is increasing, it is getting more negative and is therefore credit entry
- If a liability L or equity E is decreasing, it is getting more positive and is therefore a debit entry.
Trial Balance
Getting back to the mathematical basis of accounts and transposing the Accounting Equation such that the essential balance of debit and credit is exposed:
Assets(A) = Liabilities(L) + Equity(E)
A – L – E = 0
A – (L + E) = 0
Under normal circumstances A is positive in value and debit, and L and E are negative and credit. This shows that if we sum all the debits and subtract all the credits, it must result in zero. Another equally valid approach is to state debit sum must equal the credit sum. Again, in days gone by trial balances were regularly calculated, but modern computers effectively do a trial balance of the whole system every time a transaction is entered. This is functionally superior but it obfuscates a critical principle.
I suspect the phrase trial balance will pass out of use, but it is far from useless to understand its origin and application.
The System (Modern World)
If all the foregoing has been read and understood, it is now okay to return to the modern world of digital computers. Journals, trial balances, debit, credit, and much else are all automatically handled with modern software, but to anyone trained the modern SME software packages are irritating. Someone who knows how to treat a financial transaction is only irked by the extensive lengths the likes of Xero go to in order to insulate the uneducated. It is fine as long as there aren’t problems, but it ironically returns you to the pile of receipts at the beginning of this article if trying to unravel basics. I asked an accountant that I know well what she thought of modern accounting packages. I thought her answer eloquent and revealing:
- if you have no knowledge of accounts use Xero. It dumbs down to the greatest extent. (I would argue learn something about accounts because your business may be suffering from your ignorance). She finds Xero irritating because a skilled accountant has to try and work out how the untrained would treat a given transaction.
- Sage is the opposite. Unfriendly to those without training, but accurate and useful to those with it.
The author has no idea how this article will be received. It could be there will be an angry backlash. Equally, the essential challenge may chime with many and more material in this vein may be needed. If this article is of interest or more is required, please don’t hesitate to Contact Us.