Double Entry Accounting
July 31, 2022
The rules are deceptively simple.
Rule #1: Assets = Liabilities + Equity
This equality must hold after you close the period.
Rule #2: Debits = Credits for every transaction.
This is why this is called “double-entry” accounting. Every time money moves, there is one entry for the account that is debited and one entry for the account that is credited.
A double-entry transaction is represented as a “T chart”, with debits on left and credits on the right.
Debits | Credits --------+-------- | | |
Rule #3: A credit does not always increase an account’s balance.
Whether the balance goes up or down depends on the type of account.
|Account||Increased By||Decreased By||Examples|
|Assets||Debit||Credit||cash, checking account, real estate|
|Expenses||Debit||Credit||food, entertainment, interest payments, etc.|
|Liabilities||Credit||Debit||mortgage principle, credit card balance|
|Equity||Credit||Debit||your net worth|
|Revenue||Credit||Debit||paycheck, interest earned, bond dividends|
Book of Accounts (more commonly called “the books”)
Let’s walk through an example—on December 1, 2022 your parents loan you $3,000 for first and last month’s rent (which you pay on the 20th) and on December 25, 2022 you get your first weekly paycheck with the following amounts on your paystub:
1,000 Gross wages 120 Federal income tax 60 State income tax 15 Medicare tax 62 Social Security tax 50 401k savings ------ 693 Net pay 50 401k employer matches your 401K contribution
All this stuff is automated with accounting software, but I find it instructive to work through these old-school books.
The General Journal (the “book of original entry”)
Date Accounts & Description Debit Credit 12/01/2022 Checking account 3,000 Liabilities 3,000 Loan from parents for rent 12/20/2022 Rent 3,000 Checking account 3,000 First and last month's rent 12/25/2022 Checking account 693 Federal income tax 120 State tax 60 Social security tax 62 Medicare tax 15 401K Savings Account 100 Income 1,000 Employer 401K match 50 My first paycheck!
The general journal records transactions in date order. Each journal entry is a T-chart with a date and an optional description.
The general journal is sometimes called the “the book of original entry.”
The other journals that a business would keep are
- cash receipt journal
- cash disbursement journal
- sales journal (for any sales made on credit)
- purchase journal (for any purchases bought on credit)
The General Ledger (the “book of final entry”)
Account: Checking Account Date Description Debit Credit Balance 12/01/2022 Loan 3,000 3,000 12/20/2022 Rent 3,000 0 12/25/2022 Paycheck 693 693 Account: 401K Date Description Debit Credit Balance 12/25/2022 Paycheck 50 50 12/25/2022 Employer match 50 100 Account: Liabilities Date Description Debit Credit Balance 12/20/2022 Loan 3,000 3,000 Account: Income Date Description Debit Credit Balance 12/25/2022 Paycheck 1,000 1,000 12/25/2022 Employer match (non-taxable) 50 1,050 Account: Expenses Date Description Debit Credit Balance 12/20/2022 Rent 3,000 3,000 12/25/2022 Federal income tax 120 3,120 12/25/2022 State tax 60 3,180 12/25/2022 Social security tax 62 3,242 12/25/2022 Medicare tax 15 3,257
The general ledger contains one or more pages per account. It is sometimes called the “book of final entry” because this is the book from which the financial statements are created.
Speaking of financial statements …
The Balance Sheet
Balance Sheet As of December 31, 2022 Assets Checking 693 401K 100 ------- 793 Liabilities Loan 3,000 ------- 3,000 Equity (2,207) =======
The balance sheet is a snapshot at a given point in time.
The Income Statement
Income Statement For the period from 12/1 through 12/31/2022 Income 1,050 Expenses 3,257 Net Income (2,207) =======
The income statement covers a period, in this example, one month.
A basic financial control
equity_start is the equity at a start of a period net_income is the net income over that period equity_end is the equity at the end of a period equity_end = equity_start + net_income
If not, someone is cooking the books.
In our example,
equity_start = 0 net_income = -2,207 equity_end = -2,207
Which matches our equity on 12/31.
Closing the year
Income and revenue accounts are reset to zero at the beginning of each year. To reset them, you “close” the year.
We add a transaction to the general journal,
Date Accounts & Description Debit Credit 12/31/2022 Income 1,050 Equity 2,207 Expenses 3,257
update the income and expenses accounts in the general ledger,
Account: Income Date Description Debit Credit Balance 12/25/2022 Paycheck 1,000 1,000 12/25/2022 Employer match (non-taxable) 50 1,050 12/31/2022 Close year 1,050 0 Account: Expenses Date Description Debit Credit Balance 12/20/2022 Rent 3,000 3,000 12/25/2022 Federal income tax 120 3,120 12/25/2022 State tax 60 3,180 12/25/2022 Social security tax 62 3,242 12/25/2022 Medicare tax 15 3,257 12/31/2022 Close year 3,257 0
and add an Equity account page to the ledger.
Account: Equity Date Description Debit Credit Balance 12/31/2022 Close year 2,207 -2,207
The earliest written account of double-entry accounting that I could find a reference to was Luca Pacioli’s Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportion and proportionality), published in Venice, Italy in 1494.
This was a summary work of existing knowledge, so this system was in use before this book was published.
An interesting side note is that after Venice, Luca Pacioli went to Milan to publish his second book. The illustrator for his book was none other than Leonardo da Vinci, whom Luca had befriended in Milan!
This taken from the MacTutor History of Mathematics Archive.