Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double entry is that a single transaction, to be recorded, will hit two accounts.
Quick history of modern accounting
In a globalized world, where change happens so quickly that companies that existed for centuries – such as Lehman Brothers, founded in 1850, bankrupted in 2008 – just few things stick for centuries.
The current accounting system is one of the few survivors. Born in 1494, when a Venetian Merchant, Luca Pacioli, in his “Summa de Arithmetica, Geometria, Proportioni et Proportionailta”, described for the first time the double entry-system. This practical manual gave official birth to a system that is still used in current accounting.
Even people who hate accounting recognize the importance of it. If you either own a small business, or you are a CFO, CEO, COO, a common citizen, you have to understand accounting to recognize what is behind each one of the 14 trillions transactions per day, just in US.
Although, the fundamental accounting system hasn’t changed, the principle and rules applying today have been updated in the last century.
Today we have two main accepted frameworks, globally: GAAP and IFRS; in this chapter I will focus mainly on GAAP. Indeed, after the 1929 market crash,
American government felt the necessity to create a set of rules to discipline and conform the accounting system, and avoid what had happened. In the decade after the 1929 market crash institutions such as the Securities and Exchange Commission were created.
In 1934, the SEC, assisted by the American Institute of Accountants (AIA), started to work on the GAAP.
The AIA subsequently instituted an organism to specifically create these principles: The Committee on Accounting Procedure (CAP). Finally, the first set of GAAP was created and in 1973 and the CAP board was substituted by the Financial Accounting Standards Board (FASB).
From this work came out 10 basic principles, that are the foundation of the modern accounting system in US:
- Economic entity assumption: If you have a business, even if you are a sole proprietor, the accountant will consider yourself separately from your business.
- Monetary Unit Assumption: The Business activity you undertake is considered in US Dollars.
- Time Period Assumption: Business activity you undertake can be reported in separated time intervals, such as weeks, months, quarters or fiscal years.
- Cost Principle: If you buy an item in 1980 at $100, it will be reported on your balance sheet as worth $100 today, independently on inflation or appreciation of the asset.
- Full Disclosure Principle: You have to report all the relevant information of the business in the financial statements or in the footnotes.
- Going Concern: The accountant assumes that your business will continue its operations in the foreseeable future.
- Matching Principle: If you incur an expense, it should be matched with the revenues, according to the accrual principle. If you decide to pay your employees a bonus related to 2015 but you pay it in 2016, you still will report it as 2015. You will report the expense when it was recognized and not when actual cash disbursed (accrual principle).
- Revenue Recognition Principle: if you sell a product in January 2015 but you will receive the money from the customer in April 2015, you will report the sale in January, since it was the period when the actual sale was realizable.
- Materiality Principle: when you report the financials, it will be allowed to round them, since if an amount is insignificant can be neglected by your accountant.
- Conservatism Principle: When in doubt between $80 and $100 loss, your accountant has to choose the most conservative alternative, report $100.
These principles are the “ten commandments” for the accountant. Keep them in mind.
They will guide you throughout the book. In addition, the accrual principle in practical terms states: “Revenues and expenses are recognized when occurred, independently from cash disbursement.”
This principle is crucial to build our main financial statements, in particular the Income Statement and Balance Sheet.
Double-entry system explained
Double entry means that each single transaction needs to be recorded twice, on the left side if debited and on the right side if credited.
Usually, when you think of debit or credit in real life is different compared to debit or credit in accounting. In fact, debit does not mean that you have a debt to be paid back; neither credit means that you have money to receive.
For example, in the accounting world, when cash is debited, it means the cash on your bank account increased. Therefore, you received cash. I know it may sound counterintuitive, but this system was created five hundred years ago and it is the system today’s accountants use to record each single transactions.
T-Accounts: The Foundation
The most effective way that accountants use to record each single transaction in the ledger is the T-Account. Although, most of the accounting Software today do it automatically, it is helpful to know how it works.
This visual aid helps the accountant to record a single transaction. Each account, in fact, has two sides, debit and credit.
Therefore, for a transaction to satisfy the accounting requirements has to be recorded on both sides. We will see that in the next paragraph.
Eventually, all the transactions collected for a certain period flow in the General Ledger.
Journal Entry: The Double Faced Entry
Assuming you own a bakery that just sold $100 worth of biscuits. In the real world, it appears as a single transaction. Therefore you may think the same applies in the accounting world.
Instead, it is more complex since each single transaction implies two concurrent movements.
When you sold $100 of biscuits, your customer paid in cash. It means, on one hand, the $100 is debited to the cash account, while on the other hand, the $100 is credited to the income account. It will look like the following:
Accounts And Chart of Accounts (COA)
By defining Accounting as the language, we can define the accounts as the letters of the alphabet. Indeed, the accounts allow to categorize the bunch of transactions happened in a certain period, under the same umbrella.
The account is a record where all the debit and credit transactions are recorded. In the previous paragraph you saw already two of the main accounts, Assets and Revenue.
These accounts get organized under a Chart of Account (COA) or a list of items identified by an organization that will flow in the General Ledger (GL).
This will help the company to build reports such as: Balance Sheet (BS), Income Statement (P&L) and Cash Flow Statement.
Setting up a clear and consistent COA is crucial for the accounting department internal organization. Indeed, a disorganized COA can lead to many accounting mistakes and inaccuracies.
Below an example of best practice:
As you can see, it is suggested to use four figures. In the specific example, each account has its own range. Indeed, the assets are shown under 1xxx, liability 2xxx, equity 3xxx and so on.
It is advisable, when setting up the accounts on the chart is advisable to leave some space between the sub accounts. For example, under assets we have the sub heading “current-assets”.
Within the Current Assets, we have items such as: Cash Account, Accounts Receivable, inventory“>Inventories and Prepaid Expenses. Therefore, we will have: Current Assets, 1100 code; Cash Account, 1110 code; Accounts receivable 1200 code; Inventory 1300; Pre-paid Expenses 1500, code.
Give space between the sub-accounts, this allows you to set up new sub accounts when needed. For example, if two new cash accounts are opened, you can use the coding from 1111-1199.
Therefore, you have plenty of space to organize your COA. Setting up an organized COA and making sure everyone follows it rigorously in the organization is crucial.
Indeed, according to the coded generated, all the internal reports will be built. Such as historical AR, AP, P&L, BS, GL, CFS. If the coding is wrong or disorganized so your reports will be.
Glance at the main accounts
- Assets: Resources owned by an organization. They will produce future benefits for the company. For example, you own a bakery that has to produce biscuits. In order for you to produce them, you have to buy a machine. The machine will be an asset for your organization.
- Liabilities: Obligations (Debt) contracted by an organization. Your bakery bought $100 of raw material from the supplier and you will pay in 60 days. Until the payment will be made the $100 will show as liability (future debt) on your balance sheet.
- Owner’s Equity: Amount of money or resources you endowed to your organization. The accounting definition is: Owner’s Equity = Assets – Liabilities.
- Revenue or Income: The $ amount of sales occurred in a certain period. According to the accrual principle, income is recognized independently from cash receipt.
- Expenses: The $ amount of costs occurred in a certain period. According to the accrual principle, expenses are recognized independently from cash disbursement.
- Accounting Equation
- Financial Statements In A Nutshell
- Cash Flow Statement In A Nutshell
- How To Read A Balance Sheet Like An Expert
- Income Statement In A Nutshell
- What is a Moat?
- Gross Margin In A Nutshell
- Profit Margin In A Nutshell
- What is a Financial Ratio