Understanding double-entry bookkeeping

Understanding double-entry bookkeeping

Understanding double-entry bookkeeping

Sir Isaac Newton’s third law of motion, the law of reciprocal action, states that for every action there is an equal and opposite reaction. The same can be said for accounting. Every financial transaction has two sides. There is a debit side and a credit side. For each transaction, these sides must be equal in order for your books to balance.

To understand double-entry bookkeeping, you must first understand what a debit is and what a credit is. Simply put, a debit is something you own or money owed to you, and a credit is money you owe someone else. Let’s look at this in terms of the different types of accounts a business has.

Assets – these are debit items because they are items that are owned by the company. An increase in assets is a debit and a decrease in assets is a credit.
Accounts Payable – These are credit items because they are items that the business owes to someone else. An increase in liabilities is a credit and a decrease in liabilities is a debit.
Owner’s Equity – This is a credit account because the owner’s account balance is the money owed by the business to the business owner. An increase in equity is a credit and a decrease in equity is a debit.
Expenses – These are debit items because the purchase of an expense item reduces an active item (eg cash in bank) that is the credit point of the transaction.
Revenue – These are credit items because the receipt of revenue increases an asset item (eg cash in bank) that is the debit side of the transaction.

Let’s look at a simple example:

Let’s say you want to go to the store to buy a bottle of milk that costs $3. Your purchase of milk is a financial transaction. Before entering the store, you own $3, so this is a debit item that is balanced by the owner’s equity.

When you go into the store and pick up the bottle of milk, you now have a bottle of milk that costs $3, and you owe $3 to the store owner. Therefore, the bottle of milk is a debit and the $3 you owe is a credit.

When you pay the store owner for the bottle of milk, you are reducing the amount of money you own (a debit item will be credited) as well as reducing the amount of money you owe (a credit item will be debited).

Note that at each step of the transaction, the debit and credit sides of the transaction are equal and the balance of all accounts have equal debit and credit sides.

So what happens when you drink the bottle of milk? You no longer have a $3 bottle of milk; you have an empty bottle worth nothing! That’s why we have expense accounts. Assets that are debit items are things that a business has owned for a long period of time. Expenses, which are also debit items, are things that a business owns for a short period of time before they are spent.

That’s why we have two separate major business reports. The balance sheet is used for those items that are constant in the business. The profit and loss statement (or income statement) is used for those items that come in and out of the business on a regular basis. The resulting balance of the profit and loss statement is placed in the equity section of the balance sheet to balance things out.

Another report you may have heard of is the trial balance. This is used to make sure you haven’t made a mistake before you prepare the balance sheet and profit and loss statement. At the end of the accounting period, the closing balance of all your accounts (assets, liabilities, equity, expenses, and income) is placed on this statement to ensure that your debits equal your credits. If they don’t, you know you’ve made a mistake somewhere and you’ll need to find your mistake before preparing the main reports. The total amount in the debit column must equal the total amount in the debit column.

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