Did you ever wonder why balance sheets balance or think about the beauty of the “Double-Entry System”. I would be shocked if you did, but Accumentix’s team of CPAs think about this stuff and nearly 700 years later we are still in awe of its beautiful simplicity and the impact it has had on the world. The double-entry system helps Accumentix do what we do and we are grateful.
Let’s go back in history. Before the double-entry system there was no good way to track goods and services. Trade was severely limited and knowing for certain the success of your operations was difficult.
The double-entry system took a murky fog of scribbles and receipts and began neatly pairing them as “debits” and “credits”. The impact was astonishing. Businesses flourished, fueled by newfound financial insights. Trade blossomed as trust in accounting records facilitated complex commercial exchanges. Governments rose to a new level of fiscal sophistication, levying taxes efficiently with the ability to manage budgets. The rise of double-entry coincided with the dawn of capitalism, and it’s no coincidence. This system provided the essential infrastructure for a world built on intricate financial relationships.
At its core, the double-entry system ensures that every dollar spent has a home expressed as a debit or a credit. Every time you make a “debit” it must have a corresponding “credit”. In its most simplest form every payment made from cash (credit) must either create an asset (debit), reduce a liability (debit) or pay an expense (debit). Consider the following two scenarios.
Let’s start with the simplest transaction. A company buys a computer for $3,500. An asset (computer) goes on to the balance sheet and an asset (cash) comes off the balance sheet.
Debit Credit
Asset $3,500
Cash $3.500
Debits = Credits. All is good
Now let’s look at this same transaction where the computer is purchased through debt. An asset is created (debit) and a debt is incurred (credit)
Debit Credit
Asset $3,500
Accounts Payable $3.500
Debits = Credits. All is good.
The account payable must be paid. The liability is reduced (debit) since the debt was and cash is reduced (credit) to pay the debt.
Debit Credit
Accounts Payable $3,500
Cash $3.500
The transactions above are balance sheet transactions. We used one asset (cash) to create another asset (computer). But now let’s look at the income statement. Remember that when you spend money it either creates an asset, reduces a liability or pays an expense.
Paying expenses are an income statement transaction (as is recognizing revenue). A company pays its monthly lease expense of $4,900. An expense is recorded on the income statement (office rent) and cash comes off of the balance sheet.
Debit Credit
Office Rent $4,900
Cash $4,900
Debits = Credits. All is good.
Financial Statements record all transactions on the balance sheet or the income statement. They work together to complete the financial picture.
At the end of each month the net impact on the income statement gets recorded on the balance sheet; this net impact (net income) is recorded on the balance sheet in the equity section. This ensures that all income earned and all expenses incurred are reflected on a balance sheet and that the balance sheet balances.
The ability to pay bills come from investor’s money (equity), money loaned to the company through notes or accounts payable (debt) or the net income generated by revenue less expenses.
Using the balance sheet and income statement transactions from above gives us the following. Note that the ability to pay expenses or buy assets in this example comes from investment reflected in equity.
Balance Sheet
| Assets | Beginning | Activity | Ending |
| Cash | $10,000 | $ -8,400 | $1,600 |
| Computer | $ 0 | $ 3,500 | $3,500 |
| Total Assets | $10,000 | $-4,900 | $5,100 |
| Liabilities + Equity | Beginning | Activity | Ending |
| Liabilities | $ 0 | $ 0 | $ 0 |
| Equity | $10,000 | $-4,900 | $5,100 |
| Total Liabilities + Equity |
Income Statement
| Revenues | $ 0 |
| Office Rent | $-4,900 |
| Net Income | $-4,900 |
We realize that this all seems a bit geeky (and it is) but the double-entry system is beautiful (at least in the minds of accountants). As your company grows the number of debits and credits and complexity of the transactions also grow. The ability to comply with accounting rules to deliver meaningful information to management and investors becomes more and more difficult. It is not long before this beautiful concept become a hideous beast; the “Accounting Monster”
Accumentix can help you tame the beast. Through expertise, best of breed technology and deep startup experience our team will free you from fighting the Accounting Monster allowing you to focus on the battles that matter most.
In summary, the double-entry system appears deceptively simple. Yet, its elegant logic and unwavering focus on balance have carved a lasting mark on the world. It transformed opaque transactions into illuminating narratives, shaping the course of commerce, government, and even our cultural values. In the grand ledger of history, the double-entry system holds a prominent place, its credits far outweighing its debits.
