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.
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 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. By using Pacioli’s system or by using double-entry bookkeeping, you can record this transaction as shown here:
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.
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
TABLE 2-6 Journal Entry 3: Recording the Advertising Expense
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 is not 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.
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:
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