Financial Accounting/Double Entry Accounting

Required readings

Summary

Bookkeeping is the process of recording daily transactions into an accounting information system. That's just a fancy way of saying that it is recorded into accounting software (e.g. Quickbooks. Keep in mind that bookkeeping, although paramount to accounting, is one aspect of accounting. Accounting is much more than just bookkeeping.
Double entry accounting is a conceptual framework used in virtually all reliable accounting systems around the world. It helps to prevents mistakes from being made and is relatively straightforward to implement. The concept is that for any entry made to an account, an equal or opposite entry must be made to another account (or accounts). We handle these opposing entries using a system of debits and credits which will be explained below.
Accounts will have what's called a "normal balance". A normal balance is the type of balance (either a debit or a credit) that the account will have when it is positive. Assets have a debit normal balance, liabilities have a credit normal balance, equity has a credit normal balance, revenue has a credit normal balance and expenses have a debit normal balance. These will be more clear in the coming sections.
The accounting equation is an integral concept when recording transactions. The equation is what keeps the double entry accounting system in balance. The equation is:

Assets = Liabilities + Owner's Equity

This equation must always be true. Income statement account (revenues and expenses) can be thought of as increasing or decreasing equity. This is the reason that revenues have normal credit balances and expenses have normal debit balances. In practice, we display entries to be made by putting debits on the left and credits on the right. See below for some examples.

Examples

A business is started by the owner putting $1,000 of her money into the company bank account. The entry is as follows:

Cash       1,000
   Equity     1,000

As you can see, the equation is satisfied as Assets = Liabilities + Owner's Equity. Also, debit balances are displayed on the left and credit balances are displayed on the right. Both accounts have increased in this entry.

The business purchases $500 worth of equipment with cash. Let's pretend it is a lawn mower:

Equipment (lawn mower)   500
   Cash                     500

Again, the accounting equation remains true. Notice that this time, both entries were made on the asset side of the equation. One asset increased (equipment) while another decreased (cash).

The owner cuts a lawn for $100 and receives a promise to pay in a week:

Accounts receivable   100
   Revenue               100

Remember that we can consider revenue and expenses as affecting the equity portion of the accounting equation. So in this instance, the equity is increased by $100 and the receivable balance is increased by $100 as well. The equation is still true.

A week goes by and the owner collects on his $100:

Cash                  100
   Accounts receivable   100

Again, only the asset side of the equation is affected.

The owner purchases $50 worth of fuel for his lawn mower with cash:

Fuel expense   50
   Cash           50

Remember that expenses are treated as a reduction in equity.

In the next session, you will see how multiple entries are made, make some yourself and see what the cumulative effect of these entries are on the financial statements.

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