At this point, you don’t have to intuitively understand the logic of the accounting model and the way that revenue and expenses plug into the owner’s equity of the model. If you do get it, that’s great but not necessary. But you do need to memorize or remember (for at least the next few paragraphs) the manner in which the basic model works.
Now I come to perhaps the most important point to understand 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 in the balance sheet or income statement and a decrease in some account shown in 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 that 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 that this topic 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.
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 Luca 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 that you can refer to it easily.
TABLE 2-3 You Must Remember This
| Account | Debit | Credit |
|---|---|---|
| Assets | Increase | Decrease |
| Expenses | Increase | Decrease |
| Liabilities | Decrease | Increase |
| Owner’s equity | Decrease | Increase |
| Revenue | Decrease | Increase |
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. 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
| Account | Debit | Credit |
|---|---|---|
| Cash | $1,000 | |
| Sales revenue | $1,000 |
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.