1.05 – Getting to Know Double-Entry Bookkeeping
Double-entry bookkeeping is essential for all businesses, regardless of whether they use cash-basis or accrual accounting. This method minimizes errors and ensures that your books balance by recording each transaction twice.
Understanding the Balance Sheet Formula
The balance sheet formula (Assets = Liabilities + Equity) is the foundation of double-entry bookkeeping. Adjusting account balances involves using debits and credits, which can be a bit confusing at first. Contrary to common belief, a debit in bookkeeping doesn’t always mean a subtraction, nor does a credit always mean an addition.
In bookkeeping, a debit is recorded on the left side of a transaction, and a credit is on the right. Let’s break down a practical example.
Example: Purchasing Office Furniture
Suppose you buy a new desk for $1,500. This transaction involves two parts: spending cash (an asset) to buy furniture (another asset). You’ll adjust both the Cash and Furniture accounts in your books.
Here’s what the entry looks like:
Account | Debit | Credit |
Furniture | $1,500 | |
Cash | $1,500 |
Explanation
To purchase a new desk for the office.
In this example, the debit increases the Furniture account, and the credit decreases the Cash account. The balance sheet equation shows the following effect:
Assets = Liabilities + Equity
Furniture increases
Cash decreases
Both sides of the equation remain balanced since the increase in the Furniture account is offset by the decrease in the Cash account.
Example: Purchasing Inventory on Credit
Now, let’s look at a transaction that impacts both sides of the balance sheet. Suppose you purchase $5,000 worth of widgets on credit. This transaction increases your Inventory account (an asset) and your Accounts Payable account (a liability).
Here’s the entry:
Account | Debit | Credit |
Inventory | $5,000 | |
Accounts Payable | $5,000 |
Explanation
To purchase widgets for sale to customers.
In this case, the balance sheet equation reflects:
Assets = Liabilities + Equity
Inventory increases
Accounts Payable increases
The books stay balanced because both sides of the equation increase by $5,000.
Keeping Your Books Balanced
These examples illustrate how double-entry bookkeeping helps maintain balance in your books. While these entries seem straightforward, bookkeeping can become complex when multiple accounts are involved in a transaction. By carefully recording each transaction and ensuring balance, double-entry bookkeeping provides a reliable framework for managing your business finances.
