Do You Know How Double-Entry Accounting Works?

The concept of double-entry accounting has been around for over five centuries.

In 1494 an Italian monk named Luca Pacioli who was also an accomplished mathematician devised a process for keeping buying and selling among fifth century merchants equitable who did business with each other.

He wrote a book on mathematics which included the double-entry postulation section which has provided the basis for all modern-day businesses who run their financial affairs.

Key to this system was that all business transactions maintain a balance that must be verified throughout the day or night regardless of how many transactions were recorded. It was often said at the time that a keeper of the transactions could not sleep at night until all the accounts were in balance.

The Fundamental Accounting Equation

As terms for the merchant transactions evolved, three vital principal accounts were identified. The key accounts merchants had to adhere to were the following:

Assets, Liabilities, and Equity.

Central to maintaining this relationship with these three terms was that all assets must equal all liabilities plus equity. This relationship became known as the fundamental accounting equation. In other words:

ASSETS=LIABILITIES + EQUITY

or as it's known by its shortened expression which is A=L+E. As a college student learning about accounting, it was easy for me to remember this equation because it mirrored the word ALE which I drank a lot of during this time in school.

This being true also meant that Assets minus Liabilities would equal Equity and Assets minus Equity would equal Liabilities. Expressed for both is as follows:

A-L=E, and

A-E=L

These three equations formed the basis for keeping all transactions in harmony or perfect balance without exception.

To illustrate these three account transactions using a company receiving $10,000 in cash with a loan from a bank, the following can be revealed:

A cash or $10,000 = L or $10,000 bank loan + E or $0. Similarly,

A cash or $10,000 – L or $10,000 bank loan = E or $0, and

A cash or $10,000 – E or $ 0 = L or $10,000 bank loan

Debits and Credits

You are no doubt familiar with the words debit and credit if you have one or both of these cards. However, these terms are not to be confused with how they apply to increases and decreases for businesses Since company's record thousands of transactions per day, week month and year, a system of increases and decreases had to be devised so a perfect balance would be maintained. This established the concept of using debits and credits to keep track of these increases and decreases. This led to the creation of the T account. The letter T allows for the way in which ups and downs occur with the name of the account and its left side and right side. T accounts for assets, liabilities and equity accounts look like this:

Notice that the left side of every account is a debit and the right side of every account is the credit. However, asset accounts are increased with a debit and decreased with a credit, liability accounts are decreased with a debit and increased with a credit while equity accounts are decreased with a debit and increased with a credit. Using the example for the fundamental accounting equation used above, the following would show this balance:

Assets are increased by $10,000

Liabilities are increased by $10,000

Equity is at $0

Thus, A=L+E

Here is a real-world example of this process:

You invest $100,000 for a new hotel. You also purchase supplies of $5,000 on account. You also pay $1,000 cash on the supplies account.

These transactions would be recorded as follows:

1. Debit cash $100,000 and credit equity at $100,000 (A or $100,000=L or $0+ E or $100,000)

2. Debit supplies $5,000 and credit accounts payable $5,000 (A or $105,000= L or $5,000 + E or $100,000)

3. Debit supplies on account $1,000 and credit cash $1,000 (A or $104,000 = L or $4,000 + E or $100,000)

It is wise to remember that the effect on the accounts are increased or decreased based on the unwavering rules regarding these differences. Also, accountants don't include T accounts in their reporting of financial matters. They are used as a training mechanism just as training wheels are used to learn how to ride a bicycle.

Journal Entries

Central to balancing all transactions for a business include recording these transactions in a journal so accountants can check on the validity of these actions and to maintain a perfect balance no matter the number of transactions made. This is called journal entry management. A system to keep track of all these accounts was devised eventually called the chart of accounts. Numbers were assigned using the following system:

Assets: 100 to 199

Liabilities: 200 to 299

Equity: 300 to 399

Revenues: 400 to 499

Expenses: 500 to 599

Journals are kept for as long as the business remains a going concern and therefore they can be relied upon for accuracy and reliance as long as the balance is maintained. An example of a journal is provided here:

As can be seen, the name of the account is clearly displayed along with the associated debit and credit entries. Once all the journal entries are recorded, a general ledger and trail balance can be calculated which demonstrates that all debits will equal all credits.

The General Ledger

Once the journal entries are recorded, accountants create a trial balance which clearly illustrates that all debits equal all credits. If there is any discrepancy, a correction can be made before the company's financial statements are prepared. So the purpose of the general ledger is to balance each individual accounts. Here is a textbook definition of a general ledger:

"A general ledger is an accounting record that compiles every financial transaction of a firm to provide accurate entries for financial statements. The double-entry bookkeeping requires the balance sheet to ensure that the sum of its debit side is equal to the credit side total. A general ledger helps to achieve this goal by compiling journal entries and allowing accounting calculations" It looks like this:

As you can see, there is a section for the date, a column for the item, its posting account reference, and columns for debit, credit and balance. Once general ledger balances are complete, a trial balance is prepared.

The Trial Balance

A trial balance is essentially a culmination of all the debits and all the credits for a business. Its sole purpose is to confirm that all debits equal all credits and there are no discrepancies as to that process. It looks like this:

Here is a textbook definition of a trial balance:

"A trial balance is an accounting report that denotes the balances of a company's ledgers. The balances of these ledgers are put into debit or credit account lists on the trial balance to have them be equal. Businesses typically perform trial balances at the end of each accounting period to ensure that bookkeeping entries are continuously correct and balanced."

The Preparation of the Financial Statements

Now that all the preparatory documents are synchronized as to their reliance and accuracy, the three major financial documents can be prepared. These three documents are the balance sheet, the income statement and the statement of cash flows.

The balance sheet organizes the accounts in a vertical or left-to-right fashion with the assets revealed first, the liabilities second and the equity accounts listed third. It looks like this:

The income statement lists the revenues and expenses for the business in descending order that looks like this:

Finally, a statement of cash flows is prepared that reveals where cash is maintained in three areas. Those areas concern the companies operating, investing and financing activities. It looks like this:

Conclusion

The double-entry accounting process has many parts and segments that must follow a logical and detailed path in order to provide a complete and accurate financial posture of a business. This system has not changed materially since its inception in medieval times and is to be considered the most trustworthy vehicle used today that cannot be matched or replaced. In fact, attempts to modify, replace or adjust this financial structure has failed. Mathematicians, scientists, engineers and scholars have tried in vain to come up with a replacement to date and have failed to do so. As one academic scholar said, why mess with perfection.

Reprinted from the Hotel Business Review with permission from http://www.hotelexecutive.com/.