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.

Double-Entry Bookkeeping

In truth, financial statements are pretty straightforward. An income statement, for example, shows a firm's revenues, expenses, and profits. A balance sheet itemizes a firm's assets, liabilities, and owner's equity. So far, so good.

Unfortunately, preparing traditional financial statements is more complicated and tedious. The work of preparing financial statements — called accounting or bookkeeping — requires either a whole bunch of fiddle-faddling with numbers or learning how to use double-entry bookkeeping.

I start by describing the fiddle-faddle method. This isn't because I think you should use that method. In fact, I assume that you eventually want to use QuickBooks for your accounting and, by extension, for double-entry bookkeeping. However, if you understand the fiddle-faddle method, you'll clearly see why double-entry bookkeeping is so much better.

After I describe the fiddle-faddle method, I walk you through the steps to using and understanding double-entry bookkeeping. After you see all the anguish and grief that the fiddle-faddle method causes, you should have no trouble appreciating why double-entry bookkeeping works so much better. And I hope you'll also commit to the 30 or 40 minutes necessary to learn the basics of double-entry bookkeeping.

The Fiddle-Faddle Method of Accounting

Most small businesses — or at least those small businesses where the owners aren't already trained in accounting — have used the fiddle-faddle method. For example, take a peek at the financial statements shown in Table 1 and 2. Table 2 shows the balance sheet at the start of the first day of operation.

Table 2-1: A Simple Income Statement for the Hot Dog Stand

Sales revenue	$13,000
Less: Cost of goods sold	3,000
Gross margin	$10,000
Operating expenses
Rent	$1,000
Wages	4,000
Supplies	1,000
Total operating expenses	6,000
Operating profit	$4,000

Table 2-2: A Simple Balance Sheet for the Hot Dog Stand

Assets
Cash	$1,000
Inventory	3,000
Total assets	$4,000
Liabilities
Accounts payable	$2,000
Loan payable	1,000
Owner's equity
S. Nelson, capital	1,000
Total liabilities and owner's equity	$4,000

With the fiddle-faddle method of accounting, you individually calculate each number shown in the financial statement. For example, the sales revenue figure shown in Table 1 equals $13,000. The fiddle-faddle method of accounting requires you to somehow come up with this sales revenue number manually. You may be able to come up with this number by remembering each of the sales that you made over the day. Or, if you prepare invoices or sales receipts, you may be able to come up with this number by adding all the individual sales. If you have a cash register, you may also be able to come up with this number by looking at the cash register tape.

Other revenue and expense numbers get calculated in the same crude manner. For example, the $1,000 of rent expense gets calculated by either remembering what amount you paid for rent, or by looking in your checkbook register and finding the check that you wrote for rent.

The balance sheet values get produced in roughly the same way. You can deduce the cash balance of $1,000, for example, by looking at the checkbook or, in a worst case scenario, the bank statement. You can deduce the inventory balance of $3,000 by adding the individual inventory item values. You can calculate the liability and owner's equity amounts in similar fashion.

Some of the values shown in an income statement or on a balance sheet get plugged — meaning that they're calculated using other numbers from the financial statement. For example, you don't look up the profit amount in any particular place; instead, you calculate profit by subtracting expenses from revenue. You can also, of course, calculate balance sheet values, such as total assets, owner's equity, and total liability of owner's equity.

Okay, I admit it: The fiddle-faddle method of accounting works reasonably well for a very small business as long as you have a good checkbook. So, for a very small business, you may be able to get away with this crude, piecemeal approach to accounting.

But unfortunately, the fiddle-faddle method suffers from three horrible weaknesses for a firm that doesn't have super-simple finances:

• It's not systematic enough to be automated. Now, admittedly, you may not care that the fiddle-faddle approach isn't systematic enough for automation. But this point is an important one. A systematic approach like double-entry bookkeeping can be automated, as QuickBooks does. This automation means that the task of preparing financial statements requires — oh, I don't know — maybe five mouse clicks. Because the fiddle-faddle approach can't be automated, every time you want to produce financial statements, you or some poor co-worker goes to an enormous amount of work to collect the numbers and all the raw data necessary to produce information like that shown in Table 2 and Table 2. In reality, of course, with more complicated financial statements, someone does much, much more work.

• It's very easy to lose details. This sounds abstract, but let me give you a good, concrete example. If you look at Table 1, you see that the hot dog stand business incurs only three operating expenses: rent, wages, and supplies. If you know the operating expense categories that the business incurs, it's fairly easy to look through the check register and find the check or checks that pay rent, for example. You can use a similar approach with the wages and supplies expenses. However, what if you also have an advertising expense category or a business license expense, or some other easy-to-forget category? If you forget a category, you miss expenses. For example, if you forget that you spent money advertising and, thereby, forget to tally your advertising expenses, that whole category of operating expense gets omitted from your income statement.

• It doesn't allow rigorous error checking. This business about error checking seems, perhaps, nit-picky. However, error checking is important with accounting and bookkeeping systems. With all the numbers and transactions floating around, errors easily creep into the system. Let me give you an example of the sort of error checking an accounting system can (and should) perform. Take a look at the example of the sales transaction. If you sell an item for $1,000, you can actually check that amount by comparing it to your record of what the customer paid. This makes sense, right? If you sell me an item for $1,000, you actually should be able to compare that $1,000 sale to the amount of cash that I pay you. A $1,000 sale to me should correspond to a $1,000 cash payment from me. The fiddle-faddle method can't make these comparisons. However, double-entry bookkeeping can.

You see where I'm at now, right? I've admitted that you can construct financial statements using the fiddle-faddle method. But I hope I've also convinced you that the fiddle-faddle method suffers from some really debilitating weaknesses. I'm talking about something as important as how you can best manage the financial affairs of your business. These weaknesses indicate that you need a better tool. Specifically, you need double-entry bookkeeping, which I discuss next.

The Philosophy of Accounting

Maybe the phrase philosophy of accounting is too strong, but accounting does rest on a rather small set of fundamental assumptions and principles. People often refer to these fundamentals as generally accepted accounting principles.

I want to quickly summarize what these principles are. I find — and I bet you'll find the same thing — that understanding the principles gives context and makes accounting practices more understandable. With this in mind, let me go through the half dozen or so key accounting principles and assumptions.

These are the basic accounting principles that underlie business accounting. It's no exaggeration to say that they permeate almost everything related to business accounting.

Revenue Principle

The revenue principle, also known as the realization principle, states that revenue is earned when the sale is made. The sale is made, typically, when goods or services are provided. A key component of the revenue principle, when it comes to the sale of goods, is that revenue is earned when legal ownership of the goods passes from seller to buyer.

Note that revenue isn't earned when you collect cash for something. It turns out, perhaps counterintuitively, that counting revenue when cash is collected doesn't give the business owner a good idea of what sales really are. Some customers may pay deposits early, before actually receiving the goods or services. Often customers want to use trade credit, paying a firm at some point in the future for goods or services. Because cash flows can fluctuate wildly — even something like a delay in the mail can affect cash flow — you don't want to use cash collection from customers as a measure of sales. Besides that, you can easily track cash collections from customers. So why not have the extra information about when sales actually occur?

Expense Principle

The expense principle states that an expense occurs when the business uses goods or receives services. In other words, the expense principle is the flip side of the revenue principle. As is the case with the revenue principle, if you receive some goods, simply receiving the goods means that you've incurred the expense of the goods. Similarly, if you received some service — services from your lawyer, for example — you have incurred the expense. It doesn't matter that your lawyer takes a few days or a few weeks to send you the bill. You incur an expense when goods or services are received.

Matching Principle

The matching principle is related to the revenue and the expense principles. The matching principle states that when you recognize revenue, you should match related expenses with the revenue. The best example of the matching principle concerns the case of businesses that resell inventory. In the hot dog stand example, you should count the expense of a hot dog and the expense of a bun on the day when you sell that hot dog and that bun. Don't count the expense when you buy the buns and the dogs. Count the expense when you sell them. In other words, match the expense of the item with the revenue of the item.

Tip

Accrual-based accounting, which is a term you've probably heard, is what you get when you apply the revenue principle, the expense principle, and the matching principle. In a nutshell, accrual-based accounting means that you record revenue when a sale is made and record expenses when goods are used or services are received.

Cost Principle

The cost principle states that amounts in your accounting system should be quantified, or measured, by using historical cost. For example, if you have a business and the business owns a building, that building, according to the cost principle, shows up on your balance sheet at its historical cost. You don't adjust the values in an accounting system for changes in a fair market value. You use the original historical costs.

Objectivity Principle

The objectivity principle states that accounting measurements and accounting reports should use objective, factual, and verifiable data. In other words, accountants, accounting systems, and accounting reports should rely on subjectivity as little as possible.

An accountant always wants to use objective data (even if it's bad) rather than subjective data (even if the subjective data is arguably better). The idea is that objectivity becomes a protection against the corrupting influence that subjectivity can introduce into a firm's accounting records.

Continuity Assumption

The continuity assumption — accountants call it an assumption rather than a principle for reasons unbeknownst to me — states that accounting systems assume that a business will continue to operate. The importance of the continuity assumption becomes most clear if you consider the ramifications of assuming that a business won't continue. If a business won't continue, it becomes very unclear how one should value assets if the assets have no resale value. This sounds like gobbledygook, but think about the implicit continuity assumption built into the balance sheet for the hot dog stand at the beginning of the day.

Implicit in that balance sheet is the assumption that hot dogs and hot dog buns have some value because they can be sold. If a business won't continue operations, no assurance exists that any of the inventory can be sold. If the inventory can't be sold, what does that say about the owner's equity value shown in the balance sheet?

You can see, I hope, the sorts of accounting problems that you get into without the assumption that the business will continue to operate.

Unit-of-Measure Assumption

The unit-of-measure assumption assumes that a business's domestic currency is the appropriate unit of measure for the business to use in its accounting. In other words, the unit-of-measure assumption states that it's okay for U.S. businesses to use U.S. dollars in their accounting. And it's okay for U.K. businesses to use pounds sterling as the unit of measure in their accounting system. The unit-of-measure assumption also states, implicitly, that even though inflation and occasionally deflation change the purchasing power of the unit of measure used in the accounting system, that's still okay. Sure, inflation and deflation foul up some of the numbers in a firm's financial statements. But the unit-of-measure assumption says that's usually okay — especially in light of the fact that no better alternatives exist.

Separate Entity Assumption

The separate entity assumption states that a business entity, like a sole proprietorship, is a separate entity, a separate thing from its business owner. And the separate entity assumption says that a partnership is a separate thing from the partners who own part of the business. The separate entity assumption, therefore, enables one to prepare financial statements just for the sole proprietorship or just for the partnership. As a result, the separate entity assumption also relies on a business being separate and distinct and definable as compared to its business owners.