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).
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.
Five factors contribute to the increase or decrease of assets:
|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 on 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|
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 balance sheet 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 properly recorded and balanced balance sheet accounts for all assets held by the company and documents all potential ownership claims (whether by shareholders or 3rd parties).
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 debits are $3,500, the 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, from cash on hand, or borrowed from others. That means that at the same time that vehicles increased by $3,500, either money 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 in the books. 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.
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 part 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 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 is the credit.
Recalling our rule: Debits reflect increases to assets and Credits reflect decreases assets, you should start to see how this will work for liabilities and equity.
In other words, if the company increases their assets (always a debit), they will have to return 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
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.
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 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 have increased equity by adding new common stocks outstanding in the market. Both the debit and the credit were positive (equity and assets 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. Key is to remember that Net Income = Revenue – Expenses and that Net Income impacts the Balance Sheet via Retained Earnings (equity) at the end of the period.
There are two stages involved in integrating the income statement and balance sheet.
- Calculate the Net Income (Revenue – Cost) — A Net Credit is a Net Profit. A Net Debit is a Net Loss.
- At the end of the period, a Net Profit (Credit on the Income Statement) will be cleared with a Debit to Net Income and a Credit to Retained Earnings. A Net Loss (Debit on the Income Statement) will be cleared with a Credit to Net Income and a Debit to Retained Earnings.
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.
- 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 different 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