Double-entry accounting at its simplest is the accounting equation:
Assets = Liabilities + Equity
Accounts are created that fall under one of these three categories. Each account has its own ledger to book transactions, and each ledger flows into a general ledger that keeps track of the account balances at a higher level.
Every transaction that is booked in a ledger must balance by issuing a debit and a credit.
Take Cash as an example. Cash is normally considered an asset account. Suppose you receive $10 in Cash temporarily from financing but you have an obligation to pay it back in the future. That obligation can be represented by a liability account called Accounts Payable. When receiving the cash, the following entry should be booked:
Cash $10
Accounts Payable $10
Here we have debited $10 to the Cash account and credited $10 to the Accounts Payable account. Both accounts balance. Revisiting the accounting equation, we can see how it still balances:
Assets = Liabilities + Equity
10 = 10 + 0
Now if we dive into the Cash account at a deeper level, we can represent it with a t-chart:
Cash
---------
10 |
Similarly for Accounts Payable (A/P)
A/P
---------
| 10
Both Cash and Accounts Payable carry a balance of $10. Since Cash is an asset account that carries a debit balance, we represent it in t-chart form by adding 10 to the left side of the t-chart (matching up with assets being on the left side of the accounting equation). Accounts Payable carries a credit balance since it is a liability account, so we represent it by adding the 10 to the right side of the account (matching up with liabilities being on the right side of the accounting equation).
Next, lets look at what happens when we pay back $5 of our obligation. First, we book the following entry:
Accounts Payable $5
Cash $5
Now we have debited Accounts Payable and credited Cash, which is the opposite of their account types. This reduces the balance of the accounts, as demonstrated by their t-charts:
Cash A/P
--------- ---------
10 | | 10
| 5 5 |
The accounting equation is now:
Assets = Liabilities + Equity
5 = 5 + 0
Finally, let's look at an equity account. Suppose when the business was formed, we gave it $10 of widgets (Inventory asset account) in exchange for equity in the business:
Pretending that the founding equity has now been introduced (because it would have normally been the first entry in the company's books), the accounting equation is updated as so:
Assets = Liabilities + Equity
15 = 5 + 10
Now suppose we receive $20 in cash from the sale of all of our widgets valued at $10. Our business was formed to sell these widgets, so the sale is revenue. Revenue is an equity account. The sale would be booked with the following entry:
Cash $20
Inventory $10
Revenue $10
Since Revenue is an equity account, we have increased its balance by crediting it $10, which is the difference between the cash received and the value of the widgets we sold. The t-charts for the account balances in the transaction are the following:
At this point, the accounting equation remains perfectly balanced still:
Assets = Liabilities + Equity
25 = 5 + 20
From here, we could create a Balance Sheet (B/S), which is a look at the balances of our accounts at a point in time.
---------------
Balance Sheet
---------------
Assets:
Cash 25
Inventory 0
---------------
Total $25
---------------
Liabilities:
A/P 5
---------------
Total $5
---------------
Net assets: $20
---------------
Equity:
Equity 10
R/E 10
---------------
Total $20
We can see a shift of the accounting equation on the B/S with the net assets equaling the equity (Assets - Liabilities = Equity).
Hold on. Where did R/E come from? That stands for Retained Earnings and represents the net profit as the end of the period measure by the Income Statement (I/S). Similarly, the movement of Cash would be measured during the period in the Statement of Cash Flows (C/F) with the ending cash position flowing into the Cash balance on the B/S.
Accounting is more complex in reality of course, but I hope this provides a demonstration of how double-entry accounting works and how accountants think when performing bookkeeping functions. It's really sort of a fun practice in a geeky way. It's all about the flow of balancing things. Everything is accounted for, and these practices demonstrate how business resources are used.
Every transaction that is booked in a ledger must balance by issuing a debit and a credit.
Take Cash as an example. Cash is normally considered an asset account. Suppose you receive $10 in Cash temporarily from financing but you have an obligation to pay it back in the future. That obligation can be represented by a liability account called Accounts Payable. When receiving the cash, the following entry should be booked:
Here we have debited $10 to the Cash account and credited $10 to the Accounts Payable account. Both accounts balance. Revisiting the accounting equation, we can see how it still balances: Now if we dive into the Cash account at a deeper level, we can represent it with a t-chart: Similarly for Accounts Payable (A/P) Both Cash and Accounts Payable carry a balance of $10. Since Cash is an asset account that carries a debit balance, we represent it in t-chart form by adding 10 to the left side of the t-chart (matching up with assets being on the left side of the accounting equation). Accounts Payable carries a credit balance since it is a liability account, so we represent it by adding the 10 to the right side of the account (matching up with liabilities being on the right side of the accounting equation).Next, lets look at what happens when we pay back $5 of our obligation. First, we book the following entry:
Now we have debited Accounts Payable and credited Cash, which is the opposite of their account types. This reduces the balance of the accounts, as demonstrated by their t-charts: The accounting equation is now: Finally, let's look at an equity account. Suppose when the business was formed, we gave it $10 of widgets (Inventory asset account) in exchange for equity in the business: Pretending that the founding equity has now been introduced (because it would have normally been the first entry in the company's books), the accounting equation is updated as so: Now suppose we receive $20 in cash from the sale of all of our widgets valued at $10. Our business was formed to sell these widgets, so the sale is revenue. Revenue is an equity account. The sale would be booked with the following entry: Since Revenue is an equity account, we have increased its balance by crediting it $10, which is the difference between the cash received and the value of the widgets we sold. The t-charts for the account balances in the transaction are the following: What do you think the accounting equation looks like at this point? Think on it for a second.Let's close out our accounts before answering that question.
Assets:
Equity: At this point, the accounting equation remains perfectly balanced still: From here, we could create a Balance Sheet (B/S), which is a look at the balances of our accounts at a point in time. We can see a shift of the accounting equation on the B/S with the net assets equaling the equity (Assets - Liabilities = Equity).Hold on. Where did R/E come from? That stands for Retained Earnings and represents the net profit as the end of the period measure by the Income Statement (I/S). Similarly, the movement of Cash would be measured during the period in the Statement of Cash Flows (C/F) with the ending cash position flowing into the Cash balance on the B/S.
Accounting is more complex in reality of course, but I hope this provides a demonstration of how double-entry accounting works and how accountants think when performing bookkeeping functions. It's really sort of a fun practice in a geeky way. It's all about the flow of balancing things. Everything is accounted for, and these practices demonstrate how business resources are used.
Any questions?
Adapted from this blog post: https://www.winstoncooke.com/blog/2023-10-20-a-basic-introdu...