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4 September 2017

Balancing Your Books Every Time

Have you been puzzled in how to use Credits and Debits when creating transaction records?
Maybe you have an account that is showing the incorrect amount and don't know how to fix it.
We trust this document will explain it a little better.


Debit and Credit
Business transactions are events that have a monetary impact in your financial records. When recording these transactions in what we refer to as a “Double Entry Accounting System” such as Xero, MYOB etc, we assign the transaction value to two or more Accounts (Eg Bank and  Purchase Of Stock), where the Debit column is on the left and the Credit column is on the right.


The net result is the total of all Credits must equal to the total of all Debits.  Eg $100C = $100D  It is said to be "In Balance."

Now the logic is a little misplaced when it comes to the terms Credit and Debit so the table below will help you to identify which Account Types will increase or decrease in value when assigning the Debit or Credit side of your transaction.


Hint for Xero Users -  To create a Journal transaction, select Adviser -> Manual Journal.  If Advisor is not show in the menu, go to Settings -> General Settings -> Users -> select you name -> change from Standard to Advisor ad.  If you can not access your setting, you need to contact the subscriber of the Xero application to make the changes.

Transaction
Accounting principles for most business people is somewhat of a mystery so I hope this next section will make the process a little clearer.

To start with, you need to identify with two main accounting reports.  

Balance Sheet (Statement of Financial Position) - The Balance Sheet is a snapshot of your business Equity or Net Worth at a given time.  Eg “Today my business is worth $....”  

The Balance Sheet has three main Account Types:-  

  • Assets are items of property owned by the business.  (Bank accounts, Equipment, Inventory, Money owing by clients a.k.a. Trade Debtors)
  • Liabilities are things for which the business is responsible to cover. (Loans, GST, Staff PAYG, Superannuation, Outstanding Bills to Suppliers a.k.a Trade Creditors)
  • Equity is basically the difference between the total value of Assets and total value of Liabilities.

Profit & Loss Report (Income Statement) - The P&L is a statement of business performance.  Where the Balance Sheet is at a given point in time, the P&L is over time.  Eg “The business achieved a 20% Net Profit over the past 12 months”

The P&L has three main Account Types:-

  • Income (Revenue, Sales) are areas in which the business generates income from the supply of products, services and interest received on bank accounts.
  • Cost Of Goods (Direct Cost, Variable Costs) are cost directly associated with the supply of products and services.  Eg. Material and Sub Contractors.  These cost are also considered as variable cost as they are driven by the level of income.  Eg. Generate twice as many sales so you can expect your Cost of Goods to double too.
  • Expenses (Overheads, Fixed Cost) are cost associated with keeping the business open. Think of them as overheads like salaries, rent, power, insurance etc.  They are not directly linked to your income and remain relatively fixed even if you double your business.

Note - While Cost Of Goods and Expenses are in effect expenses, they are separated to determine the price tag on products and hourly rates along with your break even point.  That’s another topic for another time.

Putting It Together
The illustration on the following page shows two boxed regions representing the two business reporting areas (Balance Sheet & Profit and Loss Report)

A range of typical Accounts have also been included for further clarity. (Bank Account, Rent etc)

The first illustration includes three transactions:

  1. EFT Product Sale for $1000
  2. EFT Payment of Rent for $400
  3. Order on Credit Terms for $300

Each transaction has an Credit and a Debit Value and are the same value (“In Balance”).  As stated above each Transaction must have at least two balancing values.

  • The EFT Sale to Mr Jones increases the Bank and Income accounts by $1000.  (Assuming No GST)
  • The Payment of Rent decreases the Bank account by $400 and increases the cost to the business in the Rent & Outgoings account by the same amount. (Assuming No GST)
  • The purchase of products from ABC Building Suppliers on a 7 day term account, increases the Material Cost Of Goods by $300 and money owing in Trade Creditors by the same amount. (Assuming No GST).  The second illustration show the payment of this outstanding amount.
The next illustration shows that the outstanding account for “ABC Building Suppliers” is paid from the Bank Account.  In doing so, the Liability is reduced by $300 and the Bank Account is reduced by $300.

A new sale transaction for $550 is created including $50 GST.  This customer has a 7 day trading account with the business and is paid a few days later by Mrs Smith.  

Notice that the GST of $50 is not allocated to the Profit & Loss as an Income rather as a GST liability.  It is still connected with Mrs Smith as an amount owing in the Trade Debtors with the $500 for a total of $550.

Only $500 of the sales is contributed to Income.

The Profit and Loss report never includes GST collected on sales or paid on purchases.

When Mrs Smith pays her outstanding account for $550, the Bank Account increases by $550 and the Trade Debtors are reduced by $550.  Mrs Smith debt to the business is now $0.

The Payment to ABC Building Suppliers reduces the Bank Account balance and the Liability account, Trade Creditors is also reduce.

Notice that after making $800 in profit that the business equal position is also $800.


When To Create a Transaction or Journal Entry
When every money moves in your business from one location to another, that’s when a transaction entry is created.


“Follow The Money!”


The money comes from somewhere and ends up somewhere.  That’s the Double Entry, the “From” and the “To”.  The Transaction must be in balance, that is the Credits = Debits.


Example - So if someone pays in cash, have an account called “Cash Drawer” ready.  The two transaction entries are Sales and Cash Drawer.  At the end of the day, you deposit the cash in your bank account so the two transaction entries are Cash Drawer and Bank.  Each time the money moves, so a transaction record is created.


Some One Line Systems Appear One Sided

You may have notice that when using an Accounting package to raise an invoice or to reconcile a bank transaction that one account is entered.  The reality is the application is creating the second transaction account.  For example, when you reconcile a bank transaction, the Bank is one account and then you select the other.

Table Talks
The Adelaide Hills Business Centre conducts a number of Table Talks on Accounting Basics, Budgeting and Determining the price tag on goods and services.  It’s a great way to hone your financial knowledge.


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