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= liabilities + owner's equity

      If you think about this for a moment and flip back to Table 2-2, you see that this formula summarizes the organization of a business’s balance sheet. Conceptually, the formula says that a business owns stuff and that the money or the funds for that stuff comes either from creditors (such as the bank or some vendor) or the owners (either in the form of original contributed capital or perhaps in reinvested profits). If you understand the balance sheet shown in Table 2-2 and discussed here, you understand the first core principle of double-entry bookkeeping. This isn’t that tough so far, is it?

      Here’s the second thing to understand about the basic accounting model: Revenues increase owner’s equity, and expenses decrease owner’s equity. Think about that for a minute. That makes intuitive sense. If you receive $1,000 in cash from a customer, you have $1,000 more in the business. If you write a $1,000 check to pay a bill, you have $1,000 less in the business.

      Another way to say the same thing is that profits clearly add to owner’s equity. Profits get reinvested in the business and boost owner’s equity. Profits are calculated as the difference between revenues and expenses. If revenues exceed expenses, profits exist.

      Let me review where I am so far in this discussion about the basic accounting model. The basic model says that assets equal liabilities plus owner’s equity. In other words, the total assets of a firm equal the total of its liabilities and owner’s equity. Furthermore, revenue increases owner’s equity, and expenses decrease owner’s equity.

      At this point, you don’t have to intuitively understand the logic of the accounting model and the way that revenues and expenses plug into the owner’s equity of the model. If you do get it, that’s great but not necessary. However, you do need to memorize or remember (for at least the next few paragraphs) the manner in which the basic model works.

      

This may seem like a redundant point, but note that a balance sheet is constructed by using information about a firm’s assets, liabilities, and owner’s equity. Similarly, note that a firm’s income statement is constructed by using information about its revenues and its expenses. All this discussion – all this tediousness – is really about how you collect the information necessary to produce an income statement and a balance sheet.

      Now I come to perhaps the most important point to understand in order to get double-entry bookkeeping. Every transaction and every economic event that occurs in the life of a firm produces two effects: an increase in some account shown on the balance sheet or on the income statement, and a decrease in some account shown on the balance sheet or income statement. When something happens, economically speaking, that something affects at least two types of information shown in the financial statement. In the next few paragraphs, I give you some examples so you can really understand this concept.

      Suppose that in your business, you sell $1,000 worth of an item for $1,000 in cash. In the case of this transaction or economic event, two things occur from the perspective of your financial statements:

      ✔ Your cash increases by $1,000.

      ✔ Your sales revenue increases by $1,000.

      Another way to say this same thing is that your $1,000 cash sale affects both your balance sheet (because cash increases) and your income statement (because sales revenue is earned).

      See the duality? And just a paragraph ago, you were thinking this might be too complicated for you, weren’t you?

      Here’s another common example: Suppose that you buy $1,000 worth of inventory for cash. In this case, you decrease your cash balance by $1,000, but you increase your inventory balance by $1,000. Note that in this case, both effects of the transaction appear in sort of the same area of your financial statement: the list of assets. Nevertheless, this transaction also affects two accounts.

      

When I use the word account, I simply mean some value that appears in your income statement or on your balance sheet. If you look at Tables 2-1 and 2-2, for example, any value that appears in those financial statements that isn’t simply a calculation represents an account. In essence, an account tracks some group of assets, liabilities, owner’s equity, contributions, revenues, or expenses. I talk more about accounts in the next section, where I get to the actual mechanics of double-entry bookkeeping.

      Here’s another example that shows this duality of effects in an economic event: Suppose that you spend $1,000 in cash on advertising. In this case, this economic event reduces cash by $1,000 and increases the advertising expense amount by $1,000. This economic event affects both the assets portion of the balance sheet and the operating expenses portion of the income statement.

      And now – believe it or not – you’re ready to see how the mechanics of double-entry bookkeeping work.

       Talking mechanics

      Roughly 500 years ago, an Italian monk named Pacioli devised a systematic approach to keeping track of the increases and decreases in account balances. He said that increases in asset and expense accounts should be called debits, whereas decreases in asset and expense accounts should be called credits. He also said that increases in liabilities, owner’s equity, and revenue accounts should be called credits, whereas decreases in liabilities, owner’s equity, and revenue accounts should be called debits.

      Table 2-3 summarizes the information that I just shared. Unfortunately – and you can’t get around this fact – you need to memorize this table or dog-ear the page so you can refer to it easily.

Table 2-3 You Must Remember This

      In Pacioli’s debits and credits system, any transaction can be described as a set of balancing debits and credits. This system not only works as financial shorthand, but also provides error checking. To get a better idea of how it works, look at some simple examples.

      Take the case of a $1,000 cash sale, for example. By using Pacioli’s system or by using double-entry bookkeeping, you can record this transaction as shown here:

      Cash $1,000 debit

      Sales revenue $1,000 credit

      See how that works? The $1,000 cash sale appears as both a debit to cash (which means an increase in cash) and a $1,000 credit to sales (which means a $1,000 increase in sales revenue). Debits equal credits, and that’s no accident. The accounting model and Pacioli’s assignment of debits and credits mean that any correctly recorded transaction balances. For a correctly recorded transaction, the transaction’s debits equal the transaction’s credits.

      Although you can show transactions as I’ve just shown the $1,000 cash sale, you and I may just as well use the more orthodox nomenclature. By convention, accountants and bookkeepers show transactions, or what accountants and bookkeepers call journal entries, like the one shown in Table 2-4.

Table 2-4 Journal Entry 1: Recording the Cash Sale

      See how that works? Each account that’s affected by a transaction appears on a separate line. Debits appear in the left column. Credits appear in the right column.

      

You actually already understand how this account business works. You have a checkbook. You use it to keep track of both the balance in your checking account and the transactions that change the checking account balance. The rules of double-entry bookkeeping essentially say that you‘re going to use a similar record-keeping system not only for your cash account, but for every other account you need to prepare your financial statements, too.

      Here are a couple of other examples of how this transaction recording works. In the

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