The Theory Behind Double-Entry Bookkeeping
At the core of double-entry bookkeeping is the concept that every transaction will involve at least two accounts, if not more. If a company takes out a loan, for example, its cash account will increase with the funds from that loan, but its liability account will also increase under the account category, known as loans payable. Similarly, if a company purchases a print ad, its cash account decreases while its expense account, under the account category of advertising expense, increases.
The main idea is to always keep a balance, so the double entry bookkeeping system can use what is known as the accounting equation. I like to call this “the financial compliance” equation. The equation looks like this:
Liabilities + Owner’s Equity = Assets
Let’s look at the equation in the context of the aforementioned print ad example. The expense of the ad—a liability—led to a decrease in owner’s equity through the disbursement of cash to pay for the ad.
Another component of the double-entry concept is that amounts that are entered as debits must equal those added as credits within general ledger accounts.
In each of these components, the overall idea is that every transaction results in two effects that must be accounted for, which is also known as the Duality Principle. This principle means that, even though a company is spending cash out of their accounts, they are gaining something in return, such as the ad, or something else (e.g. office equipment, supplies). Without acknowledging that there is an asset gained for every expense, an accounting system would only provide a very limited view of how a company manages its money.
Every transaction is entered into a general ledger sheet or document—a balance sheet ledger account (asset, liability, and equity components) or income statement ledger account (income and expenditures) — which has columns for debit entries and credit entries:
- Debit entries, which are on the left side of a transaction, create certain effects, such as an increase in expenses or assets and a decrease in income, equity or liability.
- On the credit entry side, which is on the right side of a transaction, other effects occur, including a decrease in expenses or assets and an increase in income, equity or liability.