The rules of money
The rules of money are rules of accounting. Arguably, they are natural laws rather than rules since everyone follows them knowingly or unknowingly. They are, at least, natural to people. The job of banking (at least retail banking) is to help people and businesses go about their everyday transactions according to these rules. How banks achieve this in practice is a technological matter, but the rules are relatively straightforward and based on simple mathematical and accounting principles. Because money is associated with banks, these principles are explained with banks in mind.
The key principles are encapsulated by:
- The accounting equation
- The account
- The double entry
- The set of accounts
- The balance sheet
The accounting equation
The accounting equation is a statement of what is owned or held and what is owed, and applies to individual businesses, people and the whole world economy as well as individual banks. The equation cannot be violated and is written as:
Assets = Liabilities + Equity
An asset is anything of value that can be exchanged or sold for money, as well as money itself. Examples are buildings, stocks and shares, bonds, a bank's loan book, gold reserves and cash reserves. Assets that are cash, whether digital or physical, or that can be easily converted to cash are termed liquid assets, whilst those that are hard to sell, illiquid. Gold and shares are easily converted to cash, whilst a mortgage loan on the books of a bank is paid back over decades and is, hence, an illiquid asset.
Liabilities are what a bank, business or person owes to others. If you have a mortgage with a bank, then that is your liability. For a bank, liabilities would include customer savings, customer deposits, and money borrowed by the bank. It is important to distinguish between money borrowed by a bank and money lent by a bank. Money borrowed by a bank is that bank's liability, whilst money lent by a bank is that bank's an asset. The same applies to people and businesses.
Finally, equity is the difference between assets and liabilities. It represents what a bank or other business is worth to its stakeholders, or what the nett worth of a person is. It is what would be left if a bank, business or person settled all of their liabilities. Types of equity at a bank or business include capital paid in from the owners or shareholders and earnings retained from profits made. If liabilities exceed assets, then that bank, business or person would have negative equity and be technically bankrupt. Therefore, another way of writing the accounting equation is
Equity = Assets - Liabilities
An account is a record of the changes in a specific asset, liability or equity, ordered chronologically. Today, this would most likely be a digital record stored on a computer system. Examples of accounts include: mortgage loan accounts, deposit accounts, an account for government bonds, an account for a bank's earnings, and for a bank's cash reserves. An example of an individual deposit account as presented to a customer by their bank in the UK is shown in Figure 2.1.
Ignoring the starting balance, there are four entries recorded on the account: a payment of £100 is entered into the account leaving it in credit; £50 is withdrawn leaving it still in credit; £100 is withdrawn leaving it overdrawn by £50; and finally £50 is paid in leaving the account with a balance of £0 again.
The double entry
However; the above example only tells one side of the transaction story. This is because it is not possible to debit or credit a single account without violating the accounting equation. A credit entry in one account must have a corresponding debit entry in a different account and vice versa, and the sum of all credits must always equal the sum of all debits. This is the double entry principle, and is fundamental to accounting and bookkeeping as well as money and banking.
CR and DR
In the last example, the balance column is shown with the abbreviations CR and DR, which are short for credit and debit. (CR) means the balance is a credit balance, whilst (DR) means the balance is a debit balance. It is important not to take credit to mean positive and debit to mean negative since this actually depends on the type of account. For a liability or equity account, a credit increases the liability or equity and a debit decreases it. For an asset account a debit increases the asset whilst a credit decreases the asset. This is a natural consequence of assets being on the other side of the accounting equation to liabilities and equity, and it means a double entry can be made between any two accounts without violating the accounting equation.
Sometimes the same account can be either a liability or an asset account depending on whether it has a (DR) balance or a (CR) balance. A customer deposit account may be overdrawn, in which case it will have a (DR) balance and be considered an asset account to the bank. Later it could be in credit, in which case it will have a (CR) balance and be a liability account. An equity account with a (DR) balance always indicates negative equity, since equity is always the difference between assets and liabilities.
Double entry examples
To understand how double entries record transactions whilst satisfying the accounting equation it's best to look at a selection of examples. We will use the pound (£) as the unit of account, and assume all accounts start with a zero balance. In fact, this is true of all accounts since, otherwise, the accounting equation would be violated.
Example 1. A double entry between an asset and equity account.
Consider that the owner of a bank adds 10 bars of gold valued at £10,000 to the bank's gold reserves. Gold is an asset, and because it is owned by the bank it represents paid-in capital and increases the equity of the bank. The double entry corresponding to this is carried out between an asset account and an equity account, which we will call Gold Account and Capital Account respectively. This double entry is shown in Figure 2.2.
The double-headed green arrow is used to show that the entries in the separate accounts form part of the same double entry. The accounting equation is satisfied because (Assets + £10,000) = Liabilities + (Equity + £10,000) (recall a DR increases an asset account balance whilst a CR increases an equity account balance).
Example 2. A double entry between an asset and liability account.
Next, consider a customer deposits £500 worth of silver coins with the bank. The double entry is carried out between an asset account, which we will call Silver Account, and the customer's deposit account, which we will call Deposit Account #1 (# being short for number). This is shown in Figure 2.3.
This again satisfies the accounting equation since (Assets + £5000) = (Liabilities + £5000) + Equity, with the DR increasing the asset account balance and the CR increasing the liability account balance.
Example 3. A double entry between two liability accounts.
Finally, consider that the same customer transfers £500 from their deposit account to another deposit account, Deposit Account #2, belonging to a different customer at the same bank (perhaps for payment of goods or services). This is the kind of double entry we are most familiar with in our day to day banking and is shown in Figure 2.4.
This again satisfies the accounting equation since Assets = (Liabilities - £500 + £500) + Equity, and we are debiting one deposit account and crediting another with the same amount. A single-headed arrow can be used in situations where it can be thought of as value moving between accounts.
The set of accounts
All assets, liabilities and equities are recorded in accounts, and the accounts taken together are referred to as a set of accounts. From the set of accounts, a bank would be able to generate transaction histories, customer statements, balance sheets and financial reports — all from the raw recorded data. Since individual double entries satisfy the accounting equation, all double entries taken together across a set of accounts must also satisfy the accounting equation.
The balance sheet
The balance sheet is a statement of the balances of all accounts grouped by account type (asset, liability and equity) for a set of accounts. This is used to report the financial position of a bank, business or person. The balance sheet based solely on the above double entry examples is shown Figure 2.5.
Notice that the balance sheet totals satisfy the accounting equation, since £15,000 = £5,000 + £10,000.back to Part 1