Double Entry Accounting
Double entry accounting is an accounting framework to keep track movements on the balance sheet:
- It facilitates the understanding of the relationship between assets (resources) and liabilities/equity (funding) of a company.
- The income statement, balance sheet, and cash flow statement are interrelated; the relationship between these three statements and their effects on each other can often be “illustrated” by debits and credits.
Here, we will use uncomplicated way to illustrate high-level concept of double entry accounting and how this relates to the accounting equation. If you would like to learn double entry accounting in more comprehensive, I recommend you visit Statement of Cash Flows, Double-Entry System, Sample Transaction #1.
Recap the accounting equation: Total assets always equal total liabilities plus total equity. So, if a company’s assets increase from one period to the next, you can be sure that the company’s liabilities and equity have also increased by the same amount.
In nutshell, every single transaction can be viewed as having two sides – the source of funds, and the way the funds were used (use of funds). Double entry accounting records the two sides of every economic event:
- the funding source
- how the funds are used.
Each transaction is recorded by using a “credit” (source of funds) and an offsetting “debit” (use of funds), so that the sum of the debit amounts is always equal to the sum of the credit amounts. Below are few examples.
| Business Activity | Use of Funds | Source of Funds |
|---|---|---|
| Build a new $10 million factory with $3 million in cash and $7 million in debt | Assets ⬆️ because Property, Plant and Equipment: +$10 million Cash: -$3 million | Liabilities ⬆️ because Debt: +$7 million |
| Repay debt with $3 million cash | Assets ⬇️ because Cash: -$3 million | Liabilities ⬇️ because Debt: -$3 million |
| Net Income +$2 million | Assets ⬆️ because Cash: +$2 million | Equity ⬆️ because Retained Earnings: +$2 million |