Cover image credit: “Accounting” by 401(K) 2012 is licensed under CC BY-SA 2.0.

We’ve already seen some of the common pitfalls of traditional budgeting practice, including the limitations of single entry budgeting. In this post, we’ll describe some best practices of the mechanics of creating and maintaining an accurate budget

Double-entry budgeting

How you can overcome the shortcomings of the single-entry method of accounting? By using, what’s appropriately named as, the "double-entry" accounting method. As the name suggests, the main difference between double-entry and single-entry accounting is that each transaction is recorded twice, in two separate “accounts”. Here, accounts refer to not just your bank or credit card accounts, but also your income and expenses. The two entries for each recorded transaction are called “debit” and “credit”.

Double-entry accounting is akin to the standard practice of entering your chosen password twice when you’re creating a new account online.

This prevents errors arising from typos, and can even catch missing transactions. How does this work in practice?

Let’s take the earlier example of dining out. Say that you paid your bill using your credit card. Then, you’d enter the dining expense as a “debit” entry in your “expense” account, and the same amount as a “credit” entry in your credit card account. Later, you can check your credit card account statement with the entries in your budget, and catch any typos you may have made in entering those transactions in your personal budget.

Debits and credits

In the beginning, it may be a bit hard to remember which entry should be a debit one, and which one should be a credit one. To alleviate this, the following rule can be helpful.

Debit transactions add to assets and expenses and reduce liabilities and income. Inversely, credits transactions add to liabilities and income, and reduce from assets and expenses.

Following this rule, in the previous example, the expense entry was a debit entry, whereas the credit card entry was a credit entry.

While double-entry accounting may seem a bit more complex at the beginning, it’s not really that complicated once you get the hang of it. The benefits of automatic checks and balances that this method provides more than makes up for the increased effort in setting up your budget this way. In fact, this is the gold standard of professional accounting practice, and is legally required for most businesses in many countries.

No one ever said that you shouldn’t think of your personal finances as a business would think about its finances. In fact as you can see, using the same techniques as businesses do for bookkeeping, is really not a bad idea!

Fundamental rule of double-entry budgeting

Double-entry accounting provides automatic checks and balances to your budget due to the following fundamental rule of this technique:

The sum of all debit amounts must equal sum of all credit amounts.

Each of your income and expense transactions should be associated with a corresponding entry in your bank statements¹. So, if you make a mistake in entering your expenses, it will not match the corresponding credit entry (that you obtain from your bank statements), which makes it much easier to spot and correct the error, as we saw in the example above. Similarly, you can spot missing transactions by comparing the transactions you’ve recorded in your budget vs. what appears on your bank statements. If, for example, there’s a transaction in your credit card statement associated with an expense you forgot to record in your budget, you can easily figure out the missing expense². In this way, this system is robust against errors arising out of typos or omission.

Protection against fraud

In fact, the system of double-entry budgeting confers another side-benefit. In today’s age, it’s becoming increasingly easy to fall prey to financial scams thanks to the rise of technology and sophisticated methods of scamming. Say, your credit card information somehow got into the hands of scammers. In order to not get exposed, scammers will sometimes make small-value transactions on your credit card in the hope that you won’t notice them. However, if you diligently follow the double-entry budgeting method, you’ll find that your recorded statement balance would be higher than what’s accounted for in your budget. You can use this valuable information to spot fraudulent transactions on your account, and then request your card to be blocked thereby stopping the scammers in their tracks before they can wreak serious financial damage on you. In this way, double-entry budgeting can be an invaluable defence mechanism for you against financial scams.

In summary, the double-entry method of accounting can help you keep an accurate personal budget, which is ultimately crucial in painting your personal financial picture, and its evolution over time realistically.