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 flow and valuation 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.

If a company were to liquidate its assets and pay out all of the money to whom it was owed, third parties to whom the firm owes debts are paid first with all remaining funds paid to the owners of the firm.

Another way to say this is that the value of the firm’s assets is either:

• Linked to a Debt owed to Third Parties (Liability)
• A Return on the Owner’s Investment, aka the Owner’s Profits (Equity)

Example:  Abbott Company has carefully identified the value of all assets held by the company to be at $100,000. The firm currently owes $60,000 to third parties in unpaid debts while the remaining $40,000 technically belongs to the shareholders.

On one side of the Balance Sheet, the company will list the total value of their assets (e.g., $100,000) and on the other how much of that would go to third parties (liabilities) and how much would go to the owners (equity) should the firm liquidate.

• Liabilities: the value that would be paid to cover the company’s debts to third parties
• Owner’s Equity: the value that would be paid out to the firm’s owners.

This creates the Balance Sheet Equation:

The goal for accountants in creating the balance sheet is to maintain equilibrium where one side of the statement equals the other; a properly recorded and balanced balance sheet will show the total value of the firm’s assets and how ownership rights are divided between equity and liabilities.

In this article, we will examine what types of transactions might change the ownership, quantity, or value of our assets and how the balance sheet might see changes occur.

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Changes to the Balance Sheet

There are five types of events that may alter the ownership, quantity, or value of a firm’s assets, each subsequently impacting the Balance Sheet and requiring careful documentation.

Ignore why something is a debit or credit for now. The purpose of these examples is to demonstrate how changes to the ownership, quantity or value of assets will occur and how both sides of the balance sheet equation is affected.

Assume that Abbott Company starts out their firm with $100,000 in assets.  $60,000 is owed in liabilities and the remaining $40,000 belongs to the owners.

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Asset Exchange

The first is the equal exchange of one asset (A) for another (B), common in bartering or like-kind exchanges. 

Abbott Company trades $1,500 worth of inventory for $1,500 in cash.

The impact of this type of transaction is as follows:

• The quantity & value of individual assets changes (+$1,500 Inventory, -$1,500 Cash)
• The total value of the assets is unaltered (+$1,500 Inventory – $1,500 Cash = $0 Net Change)
• There is no change in liabilities or equity because there was no change in Total Assets

Abbott Company still has a net total of $100,000 in assets with $60,000 still owed to liabilities and $40,000 in equity.

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Owner Contribution or Distribution

The second is where new assets are received from the owners (contributions) or where assets are paid out to the owners (distributions).

Abbott Company sells Common Stock in exchange for $1,500 in Cash Investments.

The impact of this type of contribution transaction is as follows:

• The quantity & value of individual assets changes (+$1,500 Cash)
• The total value of assets increased (+$1,500 Cash)
• No change in Liabilities means the $1,500 belongs to the owners in Equity.

Abbott Company now has $1,500 in new assets (cash). That money has no attached debt (no liabilities) and belongs to the owners (increased equity).

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Abbott Company pays the Owners $1,500 in cash dividends for the year.

The impact of this type of distribution transaction is as follows:

• The quantity & value of individual assets changes (-$1,500 Cash)
• The total value of assets decreased (-$1,500 Cash)
• No change in Liabilities means the $1,500 came from the Owners’ Equity.

Abbott Company now has on hand $1,500 less cash. If the firm were to liquidate, that money has not paid off any debt (same liabilities). The owners received their money now, so there is less available for them to receive in the future (less equity).

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New Debts or Debt Repayment

The third is where new assets are received borrowed or purchased on credit from third parties or where assets are spent to pay off existing debts.

New Liabilities Example: Abbott Company borrows $1,500 from the bank.

The impact of this type of transaction is as follows:

• The quantity & value of individual assets changes (+$1,500 cash)
• The total value of assets increased ($1,500 cash)
• There is an increase in liabilities (-$1,500 notes payable). There is no change in equity.

New Liabilities Example: Abbott Company now has on hand $1,500 in new assets (cash). If the firm were to liquidate, that money would be repaid to the bank (liabilities) and none would be left to be paid to the owners (no change in equity).

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Debt Repayment Example: Abbott Company uses $1,500 in cash to repay a loan they borrowed for equipment last year.

The impact of this type of transaction is as follows:

• The quantity & value of individual assets changes (-$1,500 Cash)
• The total value of assets decreased (-$1,500 Cash)
• The company has paid a debt and now owes less in liabilities (-$1,500 Notes Payable), but there is no change to equity.

Debt Repayment Example: Abbott Company now has on hand $1,500 less cash. If the firm were to liquidate, there would be less debt to pay later (fewer liabilities). The owners do not see any change as there is neither more nor less money available to them (no change in equity).

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Value Appreciation or Depreciation

The fourth is where there is no change in the quantity or nature of assets, but assets already held begin to increase or decrease in value over time.  There are a variety of reasons why this may occur: they decline in value as they expire, they increase in value due to new popularity in the market, inflation occurs, exchange rates change, etc. 

Change in Asset Value Example: Abbott Company purchased a vehicle for $15,000 several years ago and it is included in the $100,000 original total for assets. This year, they find that it has aged and is not worth as much money on the market.  As a result, they determine that the value of the vehicle has declined this year by $1,500.

The impact of this type of transaction is as follows:

• The quantity & value of individual assets does not change
• The total value of assets has declined (-$1,500 Vehicles via Depreciation)
• There is no change in liabilities, but there is less equity available.

Change in Asset Value Example: Abbott Company will adjust the value of the vehicle and show a decrease in their total assets.  If the company were to liquidate, less money would be available for the owners (they would receive less for the truck) so there is less equity as well.

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A Debt to the Owners (or a Paid Debt to the Owners)

The final (less common) example occurs when there is an existing debt to the owners themselves (a problem involving both liability and equity).  This is a debt that is not waiting for the theoretical liquidation. . . it is owed to the owners now.

Debt to Owners Example:  Abbott Company has promised to pay the owners $1,500 in dividends but has not yet done so.

The impact of this type of transaction is as follows:

• The quantity & value of individual assets does not change
• The total value of assets has not changed
• There is an increase in liabilities (+$1,500 Dividends Payable) and a decrease in equity (-$1,500 Retained Earnings).

Debt to Owners Example: This transaction is essentially changing the $1,500 from something that is paid to the owners “after debts” (equity) to a debt that is currently owed (liabilities). The $1,500 remains in the firm but the ownership type has changed from equity to a liability.

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Paid Debt to Owners Example:  Abbott Company later pays the $1,500 dividends to the owners

The impact of this type of transaction is as follows:

• The quantity & value of individual assets changes (-$1,500 Cash)
• The total value of assets decreases (-$1,500 Cash)
• There is a decrease in liabilities (-$1,500 Dividends Payable) but no change to equity

Paid Debt to Owners Example: Abbott Company is now involved in a Debt Repayment Transaction and it will be recorded as such. The combined end result of these two events is the same as a Distribution to an Owner transaction (Assets Decreased and there is less Equity – note the company is now back to their original $60,000 in liabilities).

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Combination Example

All transactions involving resources will create some combination of these four changes to the balance sheet. The accountant is responsible for documenting:

1. The impact on the quantity and/or value of the assets
2. The impact on the ownership of the assets (equity and liabilities)

The asset side of the balance sheet thus becomes the focal point around which the rest of accounting revolves.

Combination Example: 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 (-$500 Cash, +$2,000 Equipment)
• The total value of assets has increased (-$500 Cash + $2,000 Equipment = +$1,500)
• Liabilities increase (+$1,500 Notes Payable). There is no change in Equity.

 Combination Example: This is a combination of an asset exchange ($500 cash for equipment) and new debts ($1,500 borrowed for equipment)

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One Entry, Multiple Impacts

As demonstrated in the examples above, the balance sheet remains in equilibrium because every event is linked to two or more (potentially opposing) changes to the ownership, quantity, or value of the firm’s assets.

Changing Event	What Happened	Who is Impacted
Asset Exchange	Asset ⟷ Asset Asset traded for Asset	Two Assets Impacted
New Debt / Debt Repayment	Asset ⟷ Liability Assets increase through borrowing or decrease through repayment	Asset and Liability Impacted
Owner Contribution / Owner Distribution	Asset ⟷ Equity Assets increase through contributions or decrease through distributions	Asset and Equity Impacted
Value Appreciation / Depreciation	Asset ⟷ Equity Assets increase through appreciation (more value for owner) or decrease through depreciation (less value for owner)	Asset and Equity Impacted
Debt to Owners	Debt ← Equity Temporary shift in ownership structure for equity to a liability	Equity and Liability Impacted

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Maintaining Equilibrium

Where all of the impacts occur on the same side of the equation (e.g., asset exchange or debt to owners), there is no change to the total value of assets or the total value of (liabilities + equity).

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When the changes are occurring on both sides of the balance sheet (e.g., new debt or owner contributions / distributions), both sides of the equation will typically see either an increase or decrease.

The GAAP requires that public corporations publish their Balance Sheets to the public annually, documenting how assets have change in quantity and value but also how those changes will impact the owner’s equity.

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Debits & Credits

Accountants are careful to classify changes in the company’s financial records as pointing towards either an increase in assets (Debit) or a decrease in assets (Credit) that the company will hold in the future.

Changes to Liabilities and Equity have both current and future impacts on assets.

Transactions that increase liabilities involve an increase in current assets (Debit) and a future decrease in assets when the liability has to be paid (Credit). Transactions that decrease liabilities involve a decrease in current assets (Credit) but also allows the company to keep and accumulate more of their future assets (Debit).

Transactions that increase equity involve an increase in current assets (Debit) but also a future decrease in assets when the owners are repaid for their investments (Credit). Transactions that decrease equity involves a decrease in current assets (Credit) but means there is less that needs to be repaid to the owners on their investments in the future (Debit).

One rule in accounting is that the absolute value of Total Debits must equal the absolute value of Total Credits. This is because any change in assets will be offset by a corresponding equal change in other assets, liabilities, or equity

Rule: |Total Debits| = |Total Credits| for each event.

Even in the Combination Example where more than two changes occurred in the same transaction, the rule applies.

The rules for classifying a change as a debit or credit are discussed more depth in the article: “Double-Entry Bookkeeping Made Simple(ish)“

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