One of the more difficult concepts for those launching into the world of accounting is the fascinating practice of Double Entry Bookkeeping. This is the system by which accountants trace the movement of assets throughout the company as well as shifts in ownership claims on those assets (liabilities and equity).
Introduction
Accountants are primarily responsible for recording changes in the ownership, quantity, or value of the resources (assets) that the firm owns. These changes are carefully observed and recorded in the financial statements, with the balance sheet serving as a summary of the firm’s asset situation on a specific date.
There are five key events that accountants must monitor for changes to the ownership, quantity, or value of assets, events that we have covered in-depth in a separate article: “Changes to the Balance Sheet: Asset-Based Transactions.” It is highly recommended that you review that article first as it demonstrates how each of these types of business transaction impacts the balance sheet.
Double Entry Bookkeeping
Double Entry Bookkeeping is the method by which accountants monitor the asset structure, recording carefully each ‘event‘ that alters the quantity, value, or ownership of assets through shifts in assets, liabilities, or equity.
When such an altering event occurs, it is recorded in the company’s accounting books or ledgers. The entry of a single event into the ledger is known as a journal entry.
Every journal entry is composed of five main columns:
- The Date of the Event
- A List of the Effected Accounts and a Description of the Event
- The Account # for the Effected Accounts (for cross referencing)
- The Debits
- The Credits
It is from the Debit/ Credit system that double entry bookkeeping gets its name. Each event will have both a debit and a credit, and the absolute values for the total debits and credits should be the same. There may be more than one debit or credit per event; each will be listed on a separate row. Typically, you will indent the Credits to contrast them from Debits. Ensuring that debits and credits are equal is known as balancing the books.
If the total debits are $3,500, the total credits must also total $3,500 for that event.
|Total Debits| = |Total Credits|
This double entry system has many purposes:
- It allows the firm to integrate the other financial statements into the balance sheet
- It ensures that the total value of assets is correctly assigned to either liabilities or equity
- It ensures that all of the effects of an event are appropriately adjusted for
Failure to manage the double entry system is to create issues within the accounts at large and leaves the company vulnerable to not understanding its own asset situation properly.
Why Enter Amounts Twice?
The reason for double entry has to do with the Balance Sheet Equation (Assets = Liabilities + Equity).
If a firm were to liquidate their assets, turning them all into money and then pay that money to the appropriate owners, it would either go to:
- Third Parties to whom the firm owes money (liabilities)
- Owners / Shareholders to whom the firm owes a return on investment, aka everything else (equity)
Example: Assume that Abbott Company starts out their firm with $100,000 in assets. $60,000 is owed in liabilities and the remaining $40,000 is the owners’ as a return on their investment.
Should the company increase its total assets to $150,000, then there will be a corresponding change in liabilities or equity. Either the additional $50,000 is linked to a new debt that has to be paid (Liabilities increased), or the firm has an extra $50,000 that now goes into Equity and the owners see a greater return for their investment.
Presuming they sold off some common stock to get the money (no new debt), we can balance our two sides on the Balance Sheet with two changes:
- First, adding the $50,000 to the Assets (whether that be in equipment, cash, etc)
- Second, adding the $50,000 to the Equity (through common stocks)
These two changes accomplish several tasks:
- Returns the Balance Sheet to Equilibrium (+$50,000 on both sides)
- Notes the increase in assets overall
- Notes the ownership of those new assets
- Demonstrates to investors that the firm has increased the profitability for them (encourages new investments).
Double Entry Bookkeeping is simply the process of documenting in the firm’s accounts BOTH changes, once listed as a Debit and once listed as a Credit.
Because of how the balance sheet is designed as a balanced equation, there are always a minimum of two changes for each event in order to maintain the equilibrium. There are three potential combinations of changes with each event:
- Two opposing changes to the same side of the equation (+ Assets, – Assets or +Liabilities, – Equity)
- A gain on each side of the equation (+Assets, + Liabilities)
- A loss on each side of the equation (-Assets, – Equity)
The accountant is responsible for reviewing each transaction, identifying the corresponding changes, and recording them in the various financial statements.
As previously discussed, there are five key events that create changes to a balance sheet, each involving a change in the ownership, quantity, or value of a company’s assets.
| Factors | Examples | Impact |
|---|---|---|
| Asset Exchanges | Old vehicles for New vehicles Cash For New land | Asset ⟷ Asset Two Assets Impacted |
| Owner Contribution / Owner Distribution | Cash for Common Stock Cash spent on Treasury Shares | Asset ⟷ Equity Assets and Equity Impacted |
| New Debt / Debt Repayment | Cash Received from a Bank Loan Unpaid Wages | Asset ⟷ Liability Assets and Liabilities Impacted |
| Value Appreciation / Depreciation | Vehicle Declines in Value Investment Increases in Value | Asset ⟷ Equity Asset and Equity Impacted |
| Debt to Owners | Dividends are Owed to the Owners | Debt ← Equity Liabilities and Equity Impacted |
You can find examples of each of these transactions under “Changes to the Balance Sheet: Asset-Based Transactions.” We will cover both a simple and more complex example of these below.
Double Entry Asset Exchange (Simple)
ABC Company purchased a car for $3,500. In this trade of a vehicle for cash, ABC Company has completed an asset exchange.
The accountant for ABC Company needs to record the fact that in one event (asset exchange), two separate changes have occurred:
- (a) an increase in vehicles of $3,500
- (b) an decrease in cash of $3,500
The impact of this type of transaction is as follows:
- The quantity & value of individual assets changes ($3,500 more vehicles, $3,500 less cash)
- The total value of the assets is unaltered (+$3,500 – $3,500 = $0 total change).
- There is no change in liabilities or equity
The firm still has $100,000 worth of total assets, $60,000 of which is owed to debtors and $40,000 of which is owner’s equity.
To record this situation, we will use double entry bookkeeping to record the increase to our assets (Debit) and the decrease to our assets (Credit). We then post (record) both of these on our balance sheet.
Our balance sheet is still in equilibrium, we have carefully recorded the change to the value of both our cash and vehicles, and we have shown that there are no new debts or equity associated with this event.
Ignoring why one is a debit and the other is a credit, you can still see that |Total Debits| = |Total Credits| which maintains a balanced equation.
Double Entry Combination Event (Complex)
Abbott Company purchases new equipment by borrowing $1,500 from the bank and using $500 of their own cash.
The impact of this type of transaction is as follows:
- The quantity & value of individual assets has changed (+$2,000 vehicles, -$500 cash)
- The total value of assets has increased (+$2,000 vehicles – $500 cash = $1,500 net change)
- The firm owes more money in debts (liabilities, +$1,500 loan) but there is no change in equity.
This is a combination of an asset exchange ($500 cash for equipment) and new debts ($1,500 borrowed for equipment). You can see that the absolute value of debits and credits for the asset exchange are equal (|$500 Cash| and |$500 Vehicles|) and debits and credits for the new debt are equal (|$1,500 Notes Payable| and |$1,500 Vehicles|).
Of course, the balance sheet will only show the total balance in the account, so instead of vehicles having two lines ($1,500 + $500), you will just see the total $2,000. But the concept remains the same.
The Income Statement – Balance Sheet Relationships
Not all of a company’s transactions is directly related to selling products to customers, for example:
- Corporate Investments
- Selling Stocks to Shareholders
- Borrowing Money from Lenders
The above are all useful activities for companies, but are not actually reflective of the income from selling assets to customers. This is why companies use the Income Statement or Profit & Loss Statement (P&L), to document the inflow and outflow of assets linked directly to their primary task of selling goods and services. The income statement is also based on an equation:
Revenue – Expenses = Net Profit (Loss)
- Revenue: Assets earned from (or that will be earned from) the company’s sale of assets to third parties
- Expenses: Assets spent on (or that are owed for) the company’s continued operations.
- Net Profit: Occurs when Revenue > Expenses
- Net Loss: Occurs when Revenue < Expenses
Revenue and Expenses are just a second way to classify certain asset transactions; every event recorded on the income statement will also be reflected on the balance sheet. It is easiest to examine this relationship with an example.
Note: We will discuss why entries are debits versus credits later. For now, just recognize that the |TOTAL DEBITS| = |TOTAL CREDITS|
Income Statement (Simple Sale with a Net Profit)
Abbott Company purchases inventory for $500 and the resells it to their clients for $750. As a consequence of this event, the company earned assets (cash) and lost assets (inventory) in an asset exchange
The impact of this type of transaction is as follows:
Income Statement:
- Assets earned from the customers (cash) are classified as Revenue (specifically Sales Revenue).
- Assets spent in the course of selling things to customers (inventory) are classified as Expenses (specifically Cost of Goods Sold or COGS).
- Revenue ($750) – Expenses ($500) = Net Profit ($250).
Balance Sheet:
- The quantity & value of individual assets has changed (-$500 inventory, +$750 cash)
- The total value of assets has increased (+750 cash – $500 inventory = $250 net change)
For each change to the Income Statement, there is a corresponding change on the Balance Sheet:
- +$750 (Sales Revenue) = +$750 (Cash)
- -$500 (Cost of Goods Sold) = -$500 (Inventory)
Again, using double entry bookkeeping, we can record both the changes to the Income Statement and the Balance Sheet.
This creates an accounting issue however in that (1) the $250 in Net Profits is money belonging to the owners and needs to be recorded on the balance sheet and (2) the balance sheet is no longer in equilibrium.
To rectify the situation, the firm recognizes that the $250 in Net Profits belongs in owner’s equity and they will transfer the amount from the Income Statement onto the Balance Sheet using double entry bookkeeping. Specifically, net profits that the firm retains rather than paying to the owners in dividends are called Retained Earnings.
The impact of this transaction is as follows:
- Net Profits are reduced to $0. The firm can start a new period from scratch.
- The Firm has increased Total Assets by $250, also noted as an increase in Equity by $250.
- The balance sheet is in equilibrium.
- The Income Statement and the Balance Sheet are properly integrated.
Income Statement (Simple Sale with a Net Loss)
The process is the same when the firm experiences as Net Loss (Revenue < Expenses); however, it will be recorded on the Balance Sheet as a decrease in Equity (Retained Earnings).
Abbott Company purchases inventory for $750 and the resells it to their clients for $500. As a consequence of this event, the company earned assets (cash) and lost assets (inventory) in an asset exchange
Debits & Credits in Banking (You‘ve Seen These Terms Before!)
For those of you with a bank account, you may be familiar with the terms ‘debit’ and ‘credit’ from your personal account register. When you deposit money into the bank account, the statement will often label it a Credit; when you withdraw money from the bank account, the statement will often label it a Debit.
This is because banks also utilize double-entry bookkeeping. Consider the following example:
Michelle deposits $100 into First Bank of the Nation.
From the bank’s perspective, this event has the follow impact on their balance sheet
- The quantity & value of individual assets has increased (+$100 cash)
- The total value of assets has increased (+$100 cash)
- The firm owes more money in debts (liabilities, $100 owed to Michelle should she attempt a withdrawal) but there is no change in equity.
This is an example of a new debt event ($100 borrowed from Michelle). You can see that the absolute value of debits and credits for the new debt are equal (|$100 Cash| and |$100 Liability|).
To record both changes to the balance sheet, the bank will use double entry bookkeeping and document the $100 twice:
- Increase in their assets (debit)
- Increase in their liabilities (credit).
Unfortunately, the bank’s customer are not privy the the full balance sheet or accounting books; consequently, bank statements only show half of the entry to customers. In this case, Michelle’s bank statement will document the deposit as money now owed to her via a positive credit.
Debits and Credits (Assets)
This initial exposure to double entry bookkeeping via banking may create a misconception that credits are positive and debits are negative. This is not true — debits and credits can be either negative or positive.
Whether or not a Debit or Credit is positive or negative is based on the ultimate impact on the ownership, quantity, or value of total assets. Let’s start with one simple, fundamental rule:
First Rule: Increase in Assets (Debit) | Decrease in Assets (Credit)
ABC Company purchased a car for $3,500. In this trade of a vehicle for cash, ABC Company has completed an asset exchange.
- (a) an increase in vehicles (assets) of $3,500 (Debit, Positive)
- (b) an decrease in cash (assets) of $3,500 (Credit, Negative)
It is upon this foundation that the rules for equity, liabilities, revenue, and expenses are based.
Debits and Credits (Liabilities & Equity)
Recall that an increase in total assets will also signify an increase in either liabilities or equity as the second change. If the increase in assets was a debit, then the offsetting increase in liabilities or equity is a credit.
Second Rule: Decrease in Liabilities or Equity (Debit) | Increase in Liabilities or Equity (Credit)
Abbott Company purchases new equipment by borrowing $1,500 from the bank.
- The quantity & value of individual assets has increased (+$1,500 Equipment)
- The total value of assets has increased (+$1,500 Equipment)
- The firm owes more money in debts (liabilities, +$1,500). No change in equity.
To record the two changes (assets & liabilities)
- (a) an increase in equipment (assets) of $1,500 (Debit, Positive)
- (b) an increase in notes payable (liabilities) of $1,500 (Credit, Positive)
Because both the debit and credit are positive, this signifies an increase to total assets on the balance sheet.
Observe that by increasing their liabilities, the firm has (in the long term) guaranteed a future decrease in assets. Recall that decreases to assets are included in credits, another reason why the increase in notes payable is written in the credit column.
Similarly, an increase in equity guarantees a future decrease in assets (once return on investments are paid out), thus increases to equity are also written as a credit.
Debits & Credits – Balance Sheet Examples
Abbott Company sells old equipment worth $5,000 for $5,000 (no profit, simple asset exchange)
- The quantity & value of individual assets has changed (+$5,000 cash, -$5,000 Equipment)
- The total value of assets has not changed (+$5,000 cash, -$5,000 Equipment)
- No change in Liabilities or Equity
To record the two changes (+assets, – assets)
- (a) an increase in cash of $5,000 (Debit, Positive)
- (b) a decrease in equipment of $5,000 (Credit, Positive)
Abbott Company purchases equipment for $5,000 on credit (they have the equipment but have not yet paid for it)
- The quantity & value of individual assets has changed (+$5,000 equipment)
- The total value of assets has has increased (+$5,000 equipment)
- There is a $5,000 increase in Accounts Payable (liabilities). No change in Equity.
To record the two changes (+assets, +liabilities)
- (a) an increase in equipment of $5,000 (Debit, Positive)
- (b) an increase in accounts payable of $5,000 (Credit, Positive)
Abbott Company sells common stocks (at par) to new shareholders for $5,000.
- The quantity & value of individual assets has changed (+$5,000 cash)
- The total value of assets has has increased (+$5,000 cash)
- There is a $5,000 increase in common stocks (equity). No change in liabilities.
To record the two changes (+assets, + equity)
- (a) an increase in cash of $5,000 (Debit, Positive)
- (b) an increase in common stock of $5,000 (Credit, Positive)
Debits and Credits (Revenue & Expenses)
Recall from our previous examples that the income statement comes onto the balance sheet as a change in Retained Earnings (Equity). A Net Profit increased Retained Earnings (Equity) and a Net Loss decreased Retained Earnings (Equity).
In dealing with equity, the Second Rule applies:
Second Rule: Decrease in Liabilities or Equity (Debit) | Increase in Liabilities or Equity (Credit)
Based on this rule, a Net Profit would increase equity and thus is recorded as a Credit. A Net Loss would decrease equity and thus is recorded as a Debit.
Third Rule: Decrease in Net Income – Net Loss (Debit) | Increase in Net Income – Net Profit (Credit)
Based on the Income Statement Equation (Revenue – Expenses = Net Income), an increase in Revenue creates a Net Profit while an increase in Expenses creates a Net Loss.
Fourth Rule: Decrease in Revenue / Increase in Expenses – Net Loss (Debit) | Increase in Revenue / Decrease in Expenses – Net Profit (Credit)
Debits & Credits – Income Statement Example
Abbott Company sells $20,000 worth of inventory to customers for $75,000. $30,000 was paid to Abbott Company immediately; $45,000 was sold on credit (remains unpaid)
Income Statement:
- Assets earned from customers (cash and accounts receivable) are classified as Revenue.
- Assets spent in the course of these sales to customers (inventory) are classified as Expenses.
- Revenue ($75,000) – Expenses ($20,000) = Net Profit ($55,000)
Balance Sheet:
- The quantity & value of individual assets has changed (+$30,000 cash, +$45,000 accounts receivable, -$20,000 inventory)
- The total value of assets has has increased (+$30,000 cash + $45,000 A/R – $20,000 Inventory = +$55,000 net change in assets)
- There is no change in Liabilities, so that $55,000 must be Equity when the records are done.
For each change to the Income Statement, there is a corresponding change on the Balance Sheet:
- +$75,000 (Sales Revenue) = +$30,000 (Cash) + $45,000 (Accounts Receivable)
- -$20,000 (Cost of Goods Sold) = -$20,000 (Inventory)
We can record both the changes to the Income Statement and the Balance Sheet.
| Balance Sheet | Income Statement |
|---|---|
| (a) Cash +$30,000 (Debit) (b) Accounts Receivable +$45,000 (Debit) | Sales Revenue $75,000 (Credit) |
| Inventory -$20,000 (Credit) | Cost of Goods Sold -$20,000 (Debit) |
Summary of the Rules for Double Entry Bookkeeping
First Rule: Increase in Assets (Debit) | Decrease in Assets (Credit)
Second Rule: Decrease in Liabilities or Equity (Debit) | Increase in Liabilities or Equity (Credit)
Third Rule: Decrease in Net Income – Net Loss (Debit) | Increase in Net Income – Net Profit (Credit)
Fourth Rule: Decrease in Revenue / Increase in Expenses – Net Loss (Debit) | Increase in Revenue / Decrease in Expenses – Net Profit (Credit)
Fifth Rule: |Total Debits| = |Total Credits| for each event.
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