- About BCI
December 9th, 2014
Businesses today use different accounting methods such as cash-basis or accrual accounting, but most of them rely on a system called double-entry bookkeeping to record their transactions. This practice, according to Cornell University’s School of Law, is defined as:
“A fundamental accounting concept where every transaction or event affects at least two different accounts. In modern day accounting and bookkeeping, the double-entry accounting system is expressed as (Assets = Liabilities + Equity).” This fundamental accounting equation is known as the basic accounting equation or the balance sheet equation.
When it comes to using double-entry bookkeeping, transactions are documented using debits and credits, which must always balance according to the basic accounting equation. In other words, if assets don’t equal liabilities plus equity, for instance, then there’s an error in your books. Let’s take a look at some examples, but first here are some reasons why businesses use double-entry bookkeeping.
Suppose you purchase a new computer for your office that costs $1,000, which you pay in-full using cash. When you add the transaction to your books, you must adjust two accounts: cash and real property (or office equipment). The logic behind double-entry bookkeeping says you’re spending an asset (i.e. cash) to purchase another asset (i.e. a computer), so you have to change both accounts for this transaction.
In the books, here’s how you would record the purchase of a new computer:
Of course, at the bottom of the entry you can include a short description that explains the details of the transaction. For instance, “Purchased new computer for reception desk.”
It’s important to note that this transaction only affects the left side of the basic accounting equation (assets). The debit increases the office equipment account for $1,000 while the credit decreases the cash account for $1,000, yielding no change to the basic accounting equation and, thus, your books stay balanced.
But what happens when you make a purchase on credit?
Let’s say you purchased $8,000 of ceramic bisque figurines for your pottery store, but instead of using cash you pay with credit. Using double-entry bookkeeping, this transaction affects both sides of the basic accounting equation. The new figurines are considered an increase to your inventory assets (left side), and because you purchased on credit (i.e. a liability that is paid in the future) you must also increase your accounts payable (right side).
To record the purchase of new inventory on credit, you need to make the following adjustments:
Notice your books stay in balance because both sides of the equation increase by $8,000 (no change is recorded to equity).
These simple examples only scratch the surface of double-entry bookkeeping, and transactions can get complicated when multiple accounts need adjustments. For more information on the double-entry system, you can enroll in our Financial Accounting Fundamentals (FAF) program.