An Introduction to Dual-Entry the Balance Sheet Approach

Dear Fellow Youngsters,

Today we are going to learn the foundations of good book-keeping. No it’s not keeping a cheque-book register, google it if you don’t know how, but dual-entry accounting! Mastering this system of accounting is important to keeping things in balance and accounts well groomed. While I by no means expect any of you to quit your day-job and become accountants from this information—if you are an accountant why are you reading this material?—but I do expect you to grasp the understanding of how to enter your own expenses into accounts and keep your books BALANCED! Typically this subject is wrought with wrong directions, errors, and omissions that can make the student helpless as to determine what goes where, what is a debit and credit, and is that a liability or an equity…. Or even an asset!?

Luckily, I have tutored enough introductory accounting students to have surmised a egregious problem in our teaching of dual-entry accounting. The concept itself is actually VERY simple, and requires little to no memorization—here’s to looking at you Professors of Accounting who demand you memorize what gets debited and credited! The only thing I want you to memorize right the moment is a balance sheet’s format. Now it won’t be a cascading balance sheet it will be a two-sided balance sheet. Conveniently, it looks like a great big ‘F’ (F for Fluharty, F for Finances, F for failu… I mean FANTASTIC! ), here ladies and gents is the balance sheet–the only true financial statement as I will get into at a later post: all else is derived from this ‘master’ sheet), In basic form, I want you to become familiar with it! Nothing should surprise you:

     Balance Sheet 1

Alrighty, (I hope a certain grammarian friend of mine sees this) let’s dissect this a little further. We have the assets on the left, liabilities and equities (Net worth for personal accounting) on the right. (MEMORIZE THE POSITIONS) If we were a business Equity would include the value of our Common Stock (the same stock on the stock market you hear about daily), but we individuals have no such luxury of being invested into in the same way corporations do—so we get to omit that detail.

Assets

Coming down through here we have current assets and long-term assets. The difference? Current assets are either used up or available to use (or expected to be used) within 1–year. Think about it, do you expect to sell your car or house within a year? Not usually, so they go under long-terms. Same as your retirement accounts, investments you want to hold for more than a year, etc. Whereas cash, short-term investments and any loans you swore you told your siblings they HAD to pay back, and gave them a due date that whooshed by, that you expect to be paid back within a year or that you will use the asset within a year—so they go under current assets.

Notice the Accumulated Depreciation ( Accum. Depr.) I don’t want to get into this too much but this is what is known as a contra-asset. It reduces the net value of your fixed assets (houses, cars, boats, pools, barns, etc.) It is the sum of the annual depreciation on those assets. We always record the value above ‘at cost’ i.e. what you paid for it, and the net value is what it is actually worth net of depreciation. Unfortunately for us—depreciation on fixed assets are not tax-deductions unlike corporations. You may write to your local congressional representative to discuss this issue. Net fixed assets in this specific case is the sum of fixed assets, home and car, minus the accumulated depreciation. It is best for most personal assets—except cars—to depreciate using a straight-line method, or a fixed amount every year for a set number of years. We will discuss depreciation later. While not a cash expense, depreciation is still VERY MUCH an expense—one many people don’t think about or recognize. But your hard earned cash is vanishing right before your eyes. Depreciation is the reason cars are rarely an investment—particularly new ones.

Liabilities

Ahh, liabilities. Loans, IOUs, debts, and those “mom can I have 2000 dollars, I’m short this month I’ll pay you back later…” incidentals. This is where all the money you owe people, institutions, even back taxes to the government go. The current and long-term headers there are the same as in the assets: pay off within a year is current; pay off longer than a year: long-term. You will want to collect your credit-statements and list the balances directly off the most recent statement. We will get into later how to update these as interest payments and the calculation of carry-value of loans… can be a P.I.T.A. For now write them down and sum them up to Net Liabilities. Congrats—that is the dollar figure of how much you would need to pay in cash today to clear your debt—well almost—there are likely pre-payment penalties so it’s about 5-10% lower than what you will actually pay if you had the cash but again topics for later.

Equities (Net Worth)

The Equities section, the place where all the money happens. The true value of the firm/person. The part we all worry about day in and day out (sic: Stock market) but we never truly pay attention to on the personal end. Yes that is right, the equity section is where the common stock, preferred stock, and retained earnings (net income) of a corporation goes. These items are integral to the valuation of corporate stock, the really juicy financial stuff people love to gossip about and blow wind up each other’s nether-regions as to how much they made trading or investing in XYZ Corporation last month.

In reality, most people have less than a glimmer of knowledge about how these things work, so in that regard always take investment suggestions with a spoon full of salt—yes a spoon full. You’ll think twice about putting your hard-earned cash where you haven’t investigated the company or don’t know how. Salt burns, particularly if you have ulcers, and you know what causes ulcers….? Watching your retirement account go to $0.00 as quickly as the stock’s price. We will discuss the tenants of good investing at a much later date. You need a foundation, both educationally and financially, before you even touch the stuff.

Anyway, were corporations typically would have “Retained Earnings” or the sum of all past Net Incomes, you have a “Net Worth” situation—which is ALSO the sum of all past Net Incomes. When you first construct the Balance Sheet, your starting net income will be a squeeze number. I.e. Sum up your assets, sum up your liabilities and subtract them (Assets – Liabilities = Starting Net Worth). That is your starting Net Worth. Going forward, your Net Worth will vary by a simple equation:

Starting or Previous Net Worth+ Net Income – Gifts = Ending Net Worth

Now some people may throw a hissy-fit as to me including ‘Gifts’. Why do I include them? Well in corporate accounting that place-holder is filled by ‘Dividends’. It doesn’t make sense to pay a dividend to yourself—but what do individuals do that are effectively not expenses but do remove money from their accounts?? GIFTING! And that’s how I would like you to think of gifts—a direct reduction of your Net Worth. I will do an entire post on why gifting is evil (yes I’m the guy who says gifting is in-efficient and not Pareto-Optimal, expect to your spouse in which case… it’s really just spending).

Why am I focusing on the equities/net worth section instead of the rest of the balance sheet? Well I want you to pay attention to this: many, many, many accounting students never come to this realization and they constantly want to do the wrong thing (debit income). You need to look here and see that Income is under the Equity/Net Worth section of the Balance Sheet. The same in the corporate sense where Net Income sums to Retained Earnings—and Retained Earnings is on the Equities section (right side). Therefore Income/Revenue is and always will be an Equity/Net worth account. Expenses—the reverse of an Income–are still an equity account, but we call them contra-equities. They reduce the Income account when summed to Net Income. In financial accounting we use a slight of hand and just report the “Retained Earnings” on the Balance Sheet, which is calculated from:

 Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings

Students rarely or never make the conscious connection that since Net Income = Revenue – Expenses, what we have here is this (compare to the vertical form I have in the Equities/ Net Worth Section):

Beginning Retained Earnings +(Revenue-Expenses) – Dividends = Ending Retained Earnings

And so they continue to make the wrong choice to debit revenue even though revenues are on the right side of the balance sheet and should be credited when increasing them! Expenses which are the reverse, thereby, get debited! (It is not hard to see why this might be confusing. Income SEEMS like it would be an increase to an asset, so a debit, but it is not. The cash from the income is the asset if concern–be mindful how of how this works.)

Dual Entry: Debits and Credits

Now you are going, “whoa, Mr. Fluharty, you just said a whole lot of stuff I don’t understand, what are debits and credits?” Yes, yes, I know, listen here a bit more and then go back and re-read the Equities (Net Worth) section header. So without further ado, what are debits and credits anyway—I know my bank uses them!

That is exactly right, your bank DOES use them. Although I want you to partially sever that mental relationship immediately. A bank holds the counter Balance Sheet to your Balance Sheet. That is: assets for them are loans, and liabilities for them are savings and checking deposits they hold. Therefore when they ‘credit’ your account they are increasing your bank account, when they debit your account they are reducing it—this is the opposite from our point of view. But before we jump into that—a bit of history.

Luca Pacioli

Friar Pacioli—long since dead and turned to dust—developed in his treatise Summa de arithmetica, geometria, proportioni et proportionalita (1494) [1]
the system of double-entry accounting. Debits and credits were born—although they were used previously, Pacioli was the first to standardize and publish the system. The work not only propelled him to fame as a mathematician but also brought about a banking and accounting revolution in renaissance Italy (D’Medici, Sforza, etc.).

While many accounting professors will know the story of Pacioli, and all teach Debits and Credits, few ever read the Summa and because of this few know WHY we debit certain accounts and WHY we credit others. The reason, as I have presented to you before, is that all items lying on the left side of the Balance Sheet (assets) get debited to increase them and credited to decrease them. All items laying on the right side of the balance sheet (liabilities and equities) get credited to increase them and debited to decrease them. The exact reverse of a bank, and the necessary entries to ensure perfect balancing every time. There is a rule in accounting known as the accounting equation:

Assets = Liabilities + Equities 

It should not be difficult to see that the way we have structured the balance sheet we have assets on the left and liabilities and equities make up the full on the right. While it is not necessary that they be visually proportional—I always make mine so because I am pedantic in that regard and I want them to fall in line with the equality both numerically and visually. Because of the equation you have to have TWO entries. Every debit gets a credit, and every credit gets a debit. In other words, you cannot have an increase to an asset (left side so debit for increase) without an increase to either liabilities or equities/ net worth (right side, so credit for increase).  Now going back to what I was saying before about the income being an equities section. Suppose we get a paycheck:

Journal 1

That is your journal entry: plain and simple. As you can see, we received cash, we increased our cash account—it is an asset: on the left side, so we debited to increase it. It was income to us so we need to increase our income account as well—income is an equity: on the right side, credit to increase it. Traditionally, we write debits first, and we indent credits to the right to show that it is a credit. But once again you can see, we have Debits on the left and Credits on the right as the headers—this is for a reason. Now you don’t have to memorize anything except what are assets, what are liabilities and what are equities! If you can identify what it is, you know if you need to debit or credit to increase, or vice-versa to decrease.

As another example, let’s suppose we wanted to take a loan—for a car! But keep in mind we often have to make some-sort of down payment. Let’s assume the car MSRP was $30,000 and we paid that amount, and we took an auto-loan for $25,000. That means we made a down payment (or trade in) of $5,000 dollars. For our sake let’s make that cash.  Now let’s identify what is going on. We are getting a car—so we are getting an asset, worth $30,000. Therefore we are increasing an asset—left side: debit to increase. And we are taking a loan to pay for it, so we are increasing our liabilities. Liabilities are right side, so credit to increase, for $25,000. Hmm, okay now we have one more item, and we would know we were missing something because if we didn’t yet include the cash—debits would not equal credits, and they ALWAYS have to equal each other. In this case, yes, as previously stated we have a down-payment of $5,000 in cash. Cash is an asset, we are making a down-payment so we are reducing the cash we have on hand, therefore reducing an asset. Assets are left side: decrease left side means CREDIT! So our journal entry would look like:

Journal 2

Now you see if you sum down the column, debits are 30,000 and credits are 30,000 so we know we have now made a balanced entry, and thanks to knowing what is increasing and decreasing/right side or left side we have made probably the correct entry. Now the most significant error you should ever make is putting things in accounts they don’t belong in, but this is largely arbitrary as long as you have the correct type of account (asset, liability, or equity) you will be good to go.

Give it a play around, try and make some journal entries yourself. The typical accounting student goes through thousands of entries before they get it right. I don’t expect you to be experts but you should generally know what’s going on. When using the accounting systems from the previous post, they will use the same dual-entry provisions. As always, feel free to ask questions, and if you want you can send me—privately to my email-address found on the site—(DO NOT POST THEM IN THE COMMENTS) your balance sheet and I can make corrections if need be. Good luck, and happy balancing.

In Deepest Regards,

Yours and C.

Mr. Fluharty


[1] This text was originally translated by Professor Jeremy Cripps for the Pacioli Society in 1994. I invite you to read the forward and excerpt on page 8 ( viii) of this manuscript. The translation was no doubt an arduous task and any academician can respect the time and care in its construction.

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