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
From the cash used for everyday transactions to inventory produced to the purchase of new equipment, accountants are primarily responsible for recording the increase and decrease in asset accounts and in the ownership claims on those assets. The asset side of the balance sheet thus becomes the focal point around which the rest of accounting revolves. From assets, we can understand what resources are currently available to the firm and what resources are owed to other parties.
Five factors contribute to the increase or decrease of assets:
| Factors | Examples |
|---|---|
| Asset exchanges | Old vehicles traded for new vehicles Cash spent on new land |
| Assets generated or lost through equity management | Cash received from the sale of common stock Cash spent purchasing treasury shares |
| Assets currently owed (or will be owed) to 3rd parties as liabilities | Cash received from a bank loan Money owed to employees for unpaid labor |
| Assets spent to pay for the company’s annual costs | Cash paid for materials sold to customers Cash paid in taxes |
| Assets earned from (or will be earned from) sales to customers (revenue) | Rental Income Sales Revenue |
The change in quantity, nature, and ownership of assets is a complex system that accountants are responsible for monitoring. Double Entry Bookkeeping is how accountants monitor the asset structure, recording carefully each ‘event‘ that alters the value or ownership of assets through shifts in assets, liabilities, or equity. When an event occurs, it is recorded in the company’s accounting books or ledgers. The entry of the event into the ledger is known as a journal entry.
The overarching goal is for the balance sheet to maintain equilibrium (Assets = Liabilities + Equity). A resource (asset) is either owned by the company itself / its owners (equity) or it is owed to third parties (liabilities). Consequently all assets are either linked to equity (internal ownership) or liabilities (external ownership), creating the equilibrium formula on the balance sheet. A properly recorded and balanced balance sheet will show the total value of the firm’s assets and how the ownership claims on those assets are divided.
Every journal entry is composed of two financial columns: the debits and the credits. It is here that double entry bookkeeping gets its name. Each event will have both a debit and a credit, and the totals for debits and credits should be equal or balanced. This will always be true.
If the total debits are $3,500, the total credits must also total $3,500 for that event.
You might break it down differently on each side (e.g., two debits and one credit), but the total debits and credits will be identical for that event. Ensuring that debits and credits are equal is known as balancing the books.
Balancing the books is fundamental to how the accounting system works. It is why assets = liabilities + equity. It accurately merges the changes shown on the Income Statement into the Balance Sheet. It also ensures that all consequences of the event are properly 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.
There are probably many questions at this point, so let’s start with a little bit about why double entry occurs before delving more into how it is done.
Why Enter Amounts Twice?
Energy does not come from nothing, and resources do not magically appear from thin air. Consequently, for every event in a company’s accounts, there will have been two sides — a cause and an effect. These mirror each other, two sides of the same coin.
The simplest example is a vehicle purchased for cash. ABC Company purchased a car for $3,500, increasing the overall value of company owned vehicles by $3,500. This was the cause.
On the other hand, the company also has to deal with the effect — ABC Company lost $3,500 in the purchase. That money was either:
– Taken from the bank
– Taken from cash on hand, or
– Borrowed from others.
That means that at the same time that vehicles increased by $3,500, either cash decreased by $3,500 (decreased assets) or debt increased by $3,500 (increased liabilities). In this example, they paid cash.
Both the change in vehicles and the money lost have to be accounted for. ABC Company thus enters the $3,500 from the purchase of the van twice into their books (double entry) — once as a debit to record the increase in vehicles’ value by $3,500 and once as a credit to record the decrease in cash by $3,500.
Note that at the end of the journal entry the total debits ($3,500) = total credits ($3,500). This is a sign that ABC Company has appropriately considered both sides of the event.
Debits & Credits in Banking (You‘ve Seen This Before!)
You might have recognized the terms ‘debit’ and ‘credit’ from your personal bank account. Many bank registers will record “deposits” as credits and “withdrawals” as debits.
This is because, banks also utilize double-entry bookkeeping. Consider the following example:
Michelle deposits $100 into First Bank of the Nation. The bank acknowledges that with this deposit two sides (cause and effect) need to be recorded. On the one hand, the bank now has more cash in its offices to invest, loan to others, etc. On the other hand, they also now owe Michelle $100 if she ever comes to withdraw it (there is a debt).
As a result, the bank is going to record the $100 in their accounting books twice. Once to acknowledge the increase in their assets (debit) and once to acknowledge the increase in their liabilities (credit).
Michelle is not privy to the bank’s personal accounting books and only sees the half that applies to her directly (the credit) — the fact that the bank now owes her $100 should she wish to withdraw it. Consequently, Michelle sees this deposit entered into her bank register as a credit of $100.
The Sign of Debits and Credits — Positive or Negative
We mention the debits and credits of banking because this initial exposure to double-entry bookkeeping may create a misconception that ‘credits’ are positive increases and ‘debits’ are negative decreases. This is not true. Or at least not always.
Debits and Credits have less to do with positive or negative and more to do with how the event impacts assets (and the balance sheet in general). We’ll start with two simple rules:
1) Debits reflect increases to assets and Credits reflect decreases to assets.
2) Increases are positive and Decreases are negative
In the example of the van, we increased the value of our vehicles (assets) so that was written down as a positive debit. We also decreased our cash (assets) so that was written down as a negative credit.
It is upon these rules that the handling of liabilities, equity, revenue, and expenses is oriented. We’ll explore the classification for these below.
Double Entry Bookkeeping and the Balance Sheet
For those familiar with the Balance Sheet formula (Assets = Liabilities + Equity), note how this system of double entry bookkeeping maintains a balanced Balance Sheet.
As with any mathematical formula, to maintain equilibrium there must always be two adjustments to the formula. You cannot increase assets and maintain equilibrium without implementing a second adjustment (e.g., increase liabilities) to bring the entire formula back into balance. The first adjustment is the debit and the second adjustment to re-establish equilibrium is the credit.
Given the equilibrium formula (Assets = Liabilities + Equity) and recalling our rule: Debits reflect increases to assets and Credits reflect decreases assets, you should start to see how this will play out for liabilities and equity.
In other words, if the company increases their assets (always a debit), they will have to adjust to equilibrium with a credit that decreases assets, increases liabilities, or increases equity. If they decrease their assets (a credit), there should be a debit that increases assets, decreases liabilities, or decreases equity.
The effect of this system is that the sign (+/-) of debits and credit for liabilities and equity are the opposite of assets. This gives us Rule #3:
3) Debits reflect decreases to equity or liabilities and Credits reflect increases to equity or liabilities.
Examples of Double Entry Bookkeeping (Balance Sheet)
Consider the following example(s):
1) ABC Company received $5,000 from the sale of old equipment
2) ABC Company purchased old equipment for $5,000 but did so on credit
3) ABC Company received $5,000 in exchange for common stocks sold at par.
The first step is to observe the two sides to each event.
The second step is to convert the sides into their impacts on the balance sheet.
The third step is to record our journal entry and assess the consequences.
Example 1: Sold Old Equipment for $5,000 cash
Increasing assets is a debit (this would apply to the increase in cash) and decreasing assets is a liability (this applies to the decrease in equipment).
We can see that from our journal entry on top, we have only affected the asset side of the balance sheet equation with this event. We have recorded the increase in cash (assets) with our debit and then adjusted for the loss of equipment as a credit to bring our balance sheet back into equilibrium.
This accounting entry shows that ABC Company increased their cash and decreased their equipment but did not alter the total value of assets held by the company. Because the company paid for the asset from their own resources, there is no change in equity or debt.
Example 2: Purchased new equipment for $5,000 on credit
We can see from our journal entry on top, that we have increased assets again which is a debit. We use our credit to increase liabilities (we borrowed the money) and restore equilibrium. In this case, both the debit and the credit were positive (liabilities and assets both increased) leading to an overall increase of $5,000 on both sides of the balance sheet equation.
Example 3: Sold common stocks for cash
Again, we have increased assets (always a debit) which has to be offset with a credit bringing the balance sheet back into equilibrium. We paid for this new asset (cash) by selling off ownership rights in the firm (common stocks) to shareholders. Both the debit and the credit were positive (assets and equity both increased) leading to an overall increase of $5,000 on both sides of the balance sheet equation.
Double Entry Bookkeeping and the Income Statement
It can be somewhat more difficult to see the relationship between the balance sheet and the income statement for double entry bookkeeping. Recall that when a company earns a profit (after dividends), that money goes into the firm’s accounts as retained earnings (money that belongs to the shareholders – equity – but is being kept to finance the firm’s future activities). If the company suffers a loss, they will have to have pulled from their retained earnings to cover that loss. The result is that Net Income (the total from the Income Statement) comes to the Balance Sheet as a change in Retained Earnings (Equity). The accountant has to record whether that change in Equity is positive (credit) or negative (debit).
The formula for Net Income is Revenue – Costs = Net Income
There are two stages involved in integrating the income statement and balance sheet. First, the accountant calculates the Net Income for the year. A positive increase in income is a net profit. A negative decrease in income is a net loss.
Because an increase in Revenue = increase in Equity (credit), the increase in Revenue is also recorded as a Credit. Conversely, an increase in Costs = decrease in Equity (debit), so a decrease in Costs is recorded as a Debit.
- Increase in Revenue (↑Equity) = Credit
- Decrease in Revenue (↓Equity) = Debit
- Increase in Cost (↓Equity) = Debit
- Decrease in Cost (↑Equity) = Credit
In this example, the firm has calculated a net increase in revenue of $100,000 (Credit) and a net increase in cost of $80,000 (Debit). The result is an overall increase in Net Income of $20,000 (Credit).
Next, the accountant needs to move that Net Income away from the income statement and onto the balance sheet. If Net Income has a Credit (Profit), you would bring it onto the Balance Sheet as a Debit. If Net Income has a Debit (Loss), you would bring it onto the Balance Sheet as a Credit.
The corresponding increase to equity shown in this transaction will have already been balanced on the Balance Sheet with the corresponding increases or decreases in assets and liabilities throughout the year. (e.g., Sales would have increased Revenue and increased Cash. That increase in Cash is balanced against the overall increase in Retained Earnings from the change to Net Income.)
Summary of the IS – BS Shift
All year long, the company brings money (or money owed) into the company. These will be recorded as events that increase Revenue on the income statement and increase Assets (e.g., cash or accounts receivable) on the balance sheet. Ultimately, this will also increase Net Income.
They simultaneously lose money (or increase debts) through operational and other expenditures. These will be recorded as events that increase Costs on the income statement and either decrease Assets (e.g., Inventory sold as cost of goods or cash used for wages) or increase Liabilities (e.g., rent owed for building rental) on the balance sheet. These help to decrease Net Income.
At the end of the period, all the gains and losses on the Income Statement are summed as Net Income to determine if the company earned money for investors or lost money for investors. If there was an overall gain for investors, the improvement to equity is recorded as a gain in Retained Earnings. If there was an overall loss for investors, equity has declined, and the overall loss is recorded as a decline in Retained Earnings.
Examples of Double Entry Bookkeeping (Income Statement)
ABC Company sold goods on credit and purchased office supplies on credit during 2021. They recorded these two events with the following journal entries.
- The company earned income (Sales Revenue increased on the income statement), simultaneously increasing the overall assets (Accounts Receivable increased on the balance sheet) of the firm. Because A/R is an increase in assets, it is recorded as a debit. This means Sales Revenue will be the offsetting credit. (Sales Revenue is increasing Net Income which is a Credit anyway).
- The company now owes more money (Accounts Payable increased on the balance sheet) in return for new office supplies used by the company (An Expense listed on the income statement). With the increase in liabilities recorded as a credit, the Expense is the offsetting debit.
The issue ABC Company faces at the end of the period is that the balance sheet is no longer in equilibrium. There was an increase in assets of $5,000 and an increase in liabilities of $4,000 but this leaves a difference of $1,000. Hopefully, you see how the same combination of events that created the disequilibrium in the balance sheet resulted in Net Profits of a matching $1,000.
To bring the balance sheet back into equilibrium, the company will close out the income statement by shifting the net profits to the balance sheet via Retained Earnings under equity.
4) A Net Profit will increase retained earnings (credit) while a Net Loss will decrease retained earnings (debit).
The terminology and actual entries may vary, but the process generally involves clearing out the Net Income account with an offsetting entry transferring the income to the Retained Earnings account. In the example given, ABC Company had a net profit of $1,000. This is cleared with a Debit to Net Profits and a Credit (increase) to Retained Earnings. With that entry, the balance sheet once more achieves equilibrium.
Once the relationship between Net Profit and Retained Earnings is understood, it is easier to think backwards to understand the debit/credit nature of Revenue and Costs.
5) A Debit records a decrease to Revenue or an increase to Cost – both decrease Net Income. A Credit records an increase to Revenue or a decrease to Cost – both increase Net Income.
Three or More Causes and Effects
There may in fact be multiple causes or multiple effects, creating more than one credit or debit on either side. The total credits or debits in this case will still be equal. Consider the following example:
ABC Company purchased a vehicle for $3,500, increasing Assets which is, as usual, a debit. The difference from our other examples is that in this case there were two sources of that money (two credits). ABC Company will have one debit recording the increase in vehicles and two separate credits reflecting the decrease in cash (Assets) and the increase in debt (Liabilities).
Again, although we classified the event differently this time, the overall sum of both Debits and Credits is $3,500. The overall impact is an increase in Assets of $1,500, financed by $1,500 in increased debt.
Eventually, ABC Company will pay the bank back the money (plus interest) for their loan. This will result in new entries showing that the loan has decreased but so too will have cash. Thus, the system of double entry bookkeeping continues.
6) Regardless of the number of debits and credits used to record an event, the total debits should equal the total credits
Summary of the Rules of Double Entry Bookkeeping
1) Increases are positive and Decreases are negative
2) Debits reflect increases to Assets and Credits reflect decreases to Assets.
3) Debits reflect decreases to Equity or Liabilities and Credits reflect increases to Equity or Liabilities.
4) A Debit records a decrease to Revenue or an increase to Costs – both decrease Net Income. A Credit records an increase to Revenue and a decrease in Cost – both increase Net Income.
5) A Net Profit will increase Retained Earnings (credit) while a Net Loss will decrease Retained Earnings (debit).
6) Regardless of the number of debits and credits used to record an event, the total debits should equal the total credits
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