Here are a couple of other examples of how this transaction recording works. In the first part of this discussion of how double-entry bookkeeping works, I describe two other transactions: purchasing $1,000 of inventory for cash and spending $1,000 in cash on advertising. Table 2-5 shows how the purchase of $1,000 of inventory for cash appears. Table 2-6 shows how spending $1,000 of cash on advertising appears.
TABLE 2-5 Journal Entry 2: Recording the Inventory Purchase
| Account | Debit | Credit |
|---|---|---|
| Inventory | $1,000 | |
| Cash | $1,000 |
TABLE 2-6 Journal Entry 3: Recording the Advertising Expense
| Account | Debit | Credit |
|---|---|---|
| Advertising | $1,000 | |
| Cash | $1,000 |
By tallying the debits and credits to an account, you can calculate the account balance. Suppose that before Journal Entries 1, 2, and 3, the cash balance equals $2,000. Journal Entry 1 increases cash by $1,000 (the debit). Journal Entries 2 and 3 decrease cash by $1,000 each (the $2,000 credits). If you combine all these entries, you get the new account balance. The following formula shows the calculation:
| Beginning balance of cash | $2,000 |
| Plus cash debit from Journal Entry 1 | $1,000 |
| Minus cash credit from Journal Entry 2 | –$1,000 |
| Minus cash credit from Journal Entry 3 | –$1,000 |
| Ending cash balance | $1,000 |
THAT DARN BANK
When I learned about double-entry bookkeeping, I stumbled over the terms debit and credit. The way I’d heard the terms used before didn’t agree with the way that double-entry bookkeeping seemed to describe them. This conflict caused a certain amount of confusion for me. Because I don’t want you to suffer the same fate, let me quickly describe my initial confusion.
If you look at Table 2-3, you see that an increase in an asset account is a debit, and a decrease in an asset account is a credit. This means that in the case of your cash account, increases to cash are debits and decreases to cash are credits.
At some time, however, you’ve undoubtedly talked to the bank and heard someone refer to crediting your bank account — which meant increasing the account balance. And perhaps that someone talked about debiting your account — which meant decreasing the account balance. So what’s up with that? Am I wrong, and is the bank right?
Actually, both the bank and I are right. Here’s why. The bank is talking about debiting and crediting — not a cash account and not an asset account, but a liability account. To the bank, the money that you’ve placed in the account isn’t cash (an asset) but a liability (money that the bank owes you). If you look at Table 2-3, you see that increases in a liability are credit amounts and decreases in a liability are debit amounts. Therefore, from the bank’s perspective, when the bank increases the balance in your account, that increase is a credit.
Your assets may represent another firm’s liabilities. Your liabilities will represent another firm’s assets. Therefore, whenever you hear some other business talking about crediting or debiting your account, what you do is exactly the opposite. If the business credits, you debit. If the business debits, you credit.
Do you see how that works? You start with $2,000 as the cash account balance. The first cash debit of $1,000 increases the cash balance to $3,000, and then the cash credit of $1,000 in Journal Entry 2 decreases the cash balance to $2,000. Finally, the cash credit of $1,000 in Journal Entry 3 decreases the cash balance to $1,000.
You can calculate the account balance for any account by taking the starting account balance and then adding the debits and credits that have occurred since then. By hand, this arithmetic is a little unwieldy. Your computer (with the help of QuickBooks) does this math easily.
Almost a Real-Life Example
To cement the concepts that I talk about in the preceding paragraphs of this chapter, I want to quickly step through the journal entries, or bookkeeping transactions, that you’d record in the case of the hot dog stand discussed in Book 1, Chapter 1. To start, you need to know that the balance sheet shown in Table 2-2 is the balance sheet at the start of the day, which means that the account balances in all the accounts appear as shown in Table 2-7. This list of account balances is called a trial balance. It shows the debit or credit balance for each account.
TABLE 2-7 A Trial Balance at the Start of the Day
| Account | Debit | Credit |
|---|---|---|
| Cash | $1,000 | |
| Inventory | 3,000 | |
| Accounts payable | $2,000 | |
| Loan payable | 1,000 | |
| S. Nelson, capital | _____ | 1,000 |