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Thursday, September 1, 2011

Double Entry Accounting System Design For Single-Entry Folks


Businesses and nonprofit entities use double-entry accounting.
But I’ve never met an individual
who uses double-entry accounting in personal bookkeeping. Instead, individuals use single-entry accounting. For example,
when you write a check to make a payment on your credit card balance, you undoubtedly
make an entry in your checkbook to decrease your bank balance. And
that’s it. You make just one entry — to decrease your checking account balance.
It wouldn’t occur to you to make a second, companion entry to
decrease your credit card liability balance. Why? Because you don’t keep a
liability account for what you owe on your credit card. You depend on the
credit card company to make an entry to decrease your balance.

Businesses and nonprofit entities have to keep track of their liabilities as well
as their assets. And they have to keep track of all sources of their assets.
(Some part of their total assets comes from money invested by their owners,
for example.) When a business writes a check to pay one of its liabilities, it
makes a two-sided (or double) entry — one to decrease its cash balance and
the second to decrease the liability. This is double-entry accounting in action.
Double-entry does not mean a transaction is recorded twice; it means both
sides of the transaction are recorded at the same time.

Double-entry accounting pivots off the accounting equation:

Total assets = Total liabilities + Total owners’ equity

The accounting equation is a very condensed version of the balance sheet.
The balance sheet is the financial statement that summarizes a business’s
assets on the one side and its liabilities plus its owners’ equity on the other
side. Liabilities and owners’ equity are the sources of its assets.

One main function of the bookkeeping/accounting system is to record all
transactions of a business — every single last one. If you look at transactions
through the lens of the accounting equation, there is a beautiful symmetry in
transactions (well, beautiful to accountants at least). All transactions have a
natural balance. The sum of financial effects on one side of a transaction
equals the sum of financial effects on the other side.

Suppose a business buys a new delivery truck for $65,000 and pays by check.
The truck asset account increases by the $65,000 cost of the truck, and cash
decreases $65,000. Here’s another example: A company borrows $2 million
from its bank. Its cash increases $2 million, and the liability for its note
payable to the bank increases the same amount.

Just one more example: Suppose a business suffers a loss from a tornado
because some of its assets were not insured. The assets destroyed
by the tornado are written off and the amount of the loss decreases
owners’ equity the same amount. The loss works its
way through the income statement but ends up as a decrease in owners’
equity.

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