How Double-Entry Bookkeeping Works

After you conclude that the fiddle-faddle method is for the birds, you're ready to absorb the necessary accounting theory and learn the bookkeeping tricks required to employ double-entry bookkeeping. Essentially, you need two things in order to work with double-entry bookkeeping. First, you need an understanding of the accounting model. And second, you need a grasp of the mechanics of debits and credits. Neither of these things is difficult. If you flip ahead a few pages, you can see that I am going to spend only a few pages talking about this material. How difficult can anything be that can be described in just a few pages? Not very, right?

The Accounting Model

Here's the first thing to understand and internalize in order to use double-entry bookkeeping: Modern accounting uses an accounting model that says assets equal liabilities plus owner's equity. The following formula expresses this in a more conventional, algebraic form:

assets = liabilities + owner's equity

Conceptually, the formula says that a business owns stuff and that the money or the funds for that stuff come either from creditors (such as the bank or some vendor) or the owners (either in the form of original contributed capital or perhaps in reinvested profits). If you understand the balance sheet discussed here, you understand the first core principle of double-entry bookkeeping. This isn't that tough so far, is it?

Here's the second thing to understand about the basic accounting model: Revenues increase owner's equity and expenses decrease owner's equity. Think about that for a minute. That makes intuitive sense. If you receive $1,000 in cash from a customer, you have $1,000 more in the business. If you write a $1,000 check to pay a bill, you have $1,000 less in the business.

Another way to say the same thing is that profits clearly add to the owner's equity. Profits get reinvested in the business and boost owner's equity. Profits are calculated as the difference between revenues and expenses. If revenues exceed expenses, profits exist.

Let me review where I am so far in this discussion about the basic accounting model. The basic model says that assets equal liabilities plus owner's equity. In other words, the total assets of a firm equal the total of its liabilities and owner's equity. Furthermore, revenue increases the owner's equity and expenses decrease the owner's equity.

At this point, you don't have to intuitively understand the logic of the accounting model and the way that revenues and expenses plug into the owner's equity of the model. If you do "get it," that's great, but not necessary. However, you do need to memorize or remember (for at least the next few paragraphs) the manner in which the basic model works.

Remember

This may seem like a redundant point, but note that a balance sheet is constructed by using information about a firm's assets, liabilities, and owner's equity. Similarly, note that a firm's income statement is constructed by using information about its revenues and its expenses. Remember that all this discussion, all this tediousness, is really about how you collect the information necessary to produce an income statement and a balance sheet.

Now I come to perhaps the most important point to understand in order to "get" double-entry bookkeeping. Every transaction and every economic event that occurs in the life of a firm produces two effects: an increase in some account shown on the balance sheet or on the income statement, and a decrease in some account shown on the balance sheet or income statement. When something happens, economically speaking, that something affects at least two types of information shown in the financial statement. In the next few paragraphs, I give you some examples so you can really understand this.

Suppose that in your business, you sell $1,000 of an item for $1,000 in cash. In the case of this transaction or economic event, two things occur from the perspective of your financial statements:

• Your cash increases by $1,000.

• Your sales revenue increases by $1,000.

Another way to say this same thing is that your $1,000 cash sale affects both your balance sheet (because cash increases) and your income statement (because sales revenue is earned).

See the duality? And, just a paragraph ago, you were thinking this might be too complicated for you, weren't you?

Here's another common example: Suppose that you buy $1,000 of inventory for cash. In this case, you decrease your cash balance by $1,000, but you increase your inventory balance by $1,000. Note that in this case, both effects of the transaction appear in sort of the same area of your financial statement — the list of assets. Nevertheless, this transaction also affects two accounts.

Here's another example that shows this duality of effects in an economic event: Suppose that you spend $1,000 in cash on advertising. In this case, this economic event reduces cash by $1,000 and increases the advertising expense amount by $1,000. This economic event affects both the assets portion of the balance sheet and the operating expenses portion of the income statement.

And now — believe it or not — you're ready to see how the mechanics of double-entry bookkeeping work.

Talking Mechanics

Roughly 500 years ago, an Italian monk named Pacioli devised a systematic approach to keeping track of the increases and decreases in account balances. He said that increases in asset and expense accounts should be called debits, whereas decreases in asset and expense accounts should be called credits. He also said that increases in liabilities, owner's equity, and revenue accounts should be called credits, whereas decreases in liabilities, owner's equity, and revenue accounts should be called debits.

Table 1 summarizes the information that I just shared. Unfortunately — and you can't get around this — you need to memorize this table or dog-ear the page so you can easily refer to it.

Table 1 You Must Remember This

Account	Debit	Credit
Assets	Increase	Decrease
Expenses	Increase	Decrease
Liabilities	Decrease	Increase
Owner's equity	Decrease	Increase
Revenues	Decrease	Increase

Using Pacioli's debits and credits system, any transaction can be described as a set of balancing debits and credits. Not only does this system work as financial shorthand, but it also provides error checking. To get a better idea of how this works, look at some simple examples.

Take the case of a $1,000 cash sale, for example. Using Pacioli's system, or by using double-entry bookkeeping, you can record this transaction as shown here:

Cash	$1,000	debit
Sales revenue	$1,000	credit

See how that works? The $1,000 cash sale appears as both a debit to cash (which means an increase in cash) and a $1,000 credit to sales (which means a $1,000 increase in sales revenue). Debits equal credits, and that's no accident. The accounting model and Pacioli's assignment of debits and credits mean that any correctly recorded transaction balances. For a correctly recorded transaction, the transaction's debits equal the transaction's credits.

Although you can show transactions as I've just shown the $1,000 cash sale, you and I may just as well use the more orthodox nomenclature. By convention, accountants and bookkeepers show transactions, or what accountants and bookkeepers call journal entries, like this one shown in Table 2.

Table 2: Journal Entry 1: Recording the Cash Sale

Account

Debit

Credit

Cash

1,000

Sales revenue

1,000

Tip

See how that works? Each account that's affected by a transaction appears on a separate line. Debits appear in the left column. Credits appear in the right column.

You actually already understand how this account business works. You have a checkbook. You use it to keep track of both the balance in your checking account and the transactions that change the checking account balance. The rules of double-entry bookkeeping essentially say that you are going to use a similar record-keeping system not only for your cash account, but for every other account you need to prepare your financial statements, too.

Here are a couple of other examples of how this transaction recording works. In the first part of this discussion of how double-entry bookkeeping works, I describe two other transactions: the purchase of $1,000 of inventory for cash, and spending $1,000 in cash on advertising. Table 3 shows how the purchase of $1,000 of inventory for cash appears. Table 4 shows how spending $1,000 of cash on advertising appears.

Table 3: Journal Entry 2: Recording the Inventory Purchase

Account	Debit	Credit
Inventory	1,000
Cash		1,000

Table 4: Journal Entry 3: Recording the Advertising Expense

Account	Debit	Credit
Advertising	1,000
Cash		1,000

By tallying the debits and credits to an account, you can calculate the account balance. For example, suppose that before Journal Entries 1, 2, and 3, the cash balance equals $2,000. Journal Entry 1 increases cash by $1,000 (this is the debit). Journal Entries 2 and 3 decrease cash by $1,000 each (these are the $2,000 credits). If you combine all these entries, you get the new account balance. The following formula shows the calculation:

Beginning balance of cash	$2,000
Plus cash debit from Journal Entry 1	$1,000
Minus cash credit from Journal Entry 2	–$1,000
Minus cash credit from Journal Entry 3	–$1,000
Ending cash balance	$1,000

Do you see how that works? You start with $2,000 as the cash account balance. The first cash debit of $1,000 increases the cash balance to $3,000, and then the cash credit of $1,000 in Journal Entry 2 decreases the cash balance to $2,000. Then, finally, the cash credit of $1,000 in Journal Entry 3 decreases the cash balance to $1,000.

You can calculate the account balance for any account by taking the starting account balance and then adding the debits and credits that have occurred since then. By hand, this arithmetic is a little unwieldy. Your computer (with the help of QuickBooks) does this math easily.