Double-Entry Bookkeeping.—Several systems or methods of keeping business records have at various times been in use. The method which at the present time is used by all businesses, excepting those of the simplest sort, is called “double-entry bookkeeping” and is the method which is being set forth here. It is based on the proprietorship equation expressed in the form: Assets = Liabilities + Proprietorship. It is possible to make a balance sheet if only asset and liability records are kept, because proprietorship is always the difference between them. Such a system of record-keeping would fail completely in giving the information as to the current increases and decreases in proprietorship and the causes of such changes. As was indicated in an earlier chapter, such a system would have the disadvantages which the comparative balance sheet has as a means of managing and controlling a business enterprise. The information which is given by the profit and loss records of the business would be entirely lacking.

Double-entry bookkeeping, accordingly, keeps a record not only of assets and liabilities, but also of proprietorship and its constantly changing value. The advantages of such a system were discussed when the need for the information furnished by the profit and loss statement was pointed out (see page 39). Not only does double-entry bookkeeping give this full and complete information, but it ties this information into a system whose mathematical accuracy and correctness can be proved. It is an invention or device whose purpose is definitely to give the desired information and to demonstrate the mathematical correctness of that information.

As already stated, the system of double-entry bookkeeping is based on the proprietorship equation. An equation is an expressed equality. The ledger kept by double-entry bookkeeping always maintains this equality. The sum total of the entries on the left side of all the accounts must equal the sum total of the entries on the right side of the accounts. The way in which the ledger becomes an expanded or detailed balance sheet was explained fully in the previous chapter. There it was shown that the sum of the net balances of all asset accounts, as carried in the ledger as left-side balances, at all times equals the sum of the net balances of the liability and the proprietorship accounts carried in the ledger as right-side balances.

It is evident that, if in place of the net balances of each group of accounts, the gross left- and right-side totals are substituted, the equation would still be maintained, inasmuch as the net balance in each instance is secured by subtracting the same amount, namely, the lesser total, from both sides of the account.

Under double entry, therefore, the equality of the left side of the ledger, that is, the total of the left-side amounts of all of the accounts, is constantly maintained with the right side of the ledger, that is, the total of the right-side amounts of all the accounts. The vertical division of the ledger separating an account into its left and right sides, may with little stretch of the imagination be considered an equality sign, which thus makes one big equation out of all the accounts in the ledger. Under double-entry bookkeeping, therefore, the principles of entry in the ledger are based on no logic or philosophy other than that which attaches to the fundamental proprietorship equation of the balance sheet. Double entry is an invention, a device, and its use requires adherence to the principles of entry necessary to maintain its equation. What these principles are will now be explained.

The Business Transaction Defined.—Reference has constantly been made to business transactions. It may be well to show the idea at the bottom of such transactions. We may define a business transaction as an exchange of values. It may be between persons, as when a sale is made, or it may be between accounts within the business itself, as when a transfer is made between accounts, i.e., when an item is taken from one account and transferred to another for the sake of more clearly showing its nature. Some authors further analyze transactions as complete when the bargain is fully consummated between the parties, as when delivery is made and the money is paid in cash; or incomplete as where something still remains to be done by either or both parties to the transaction. In this latter case, claims or rights of action at law arise to protect the parties until the transaction is consummated. But, since from the accounting standpoint a claim or right is one kind of property or asset, there is little need of this finer analysis.

Analyzing the Transaction as to Its Accounting Record.—When a transaction occurs in a business, it must first be classified before proper record can be made of it under the account title which groups transactions of a like nature. Its elements must be analyzed, its effect on assets and liabilities, or on expenses and income, must be determined. Has the transaction increased or decreased assets or liabilities, or has it increased or decreased proprietorship, or has it resulted in simply a transfer between accounts—these are the first questions to be determined. The basis of all fundamental classifications is the effect of the transaction upon the balance sheet and profit and loss statements. They are the goal towards which all records look, but the principle which determines the subdivisions in the main classes of accounts and the titles to be given to the accounts which are to be carried in the records, is the amount and kind of information desired by the management throughout the fiscal period. After the transaction has been properly classified, it is merely a matter of recording it according to the standards or forms of good accounting, which is merely a device for abbreviating the work of recording, i.e., the transaction is translated into correct accounting language.

The Use of Debit and Credit.—To show the side of the account affected by a transaction, the words “debit” and “credit” are used, indicating left and right respectively. The use of these words had its origin with transactions between persons and the accounts kept with them. The person owing was charged or debited, while the person to whom the business owed a debt was credited. Through use the terms have come to have the meaning stated first above, though still retaining their original connotation when applied to persons.

Fundamental Principle of Debit and Credit.—As stated in Chapter V, every transaction is recorded from two viewpoints, viz., its effect on the assets and liabilities and its effect on the proprietorship or net worth. Sometimes, however, the transaction may require merely a transfer entry, i.e., a transfer of an amount from one account to another without affecting the fundamental classes, as was shown above when defining the transaction as an exchange of values. If it is remembered that from long-continued custom asset accounts are debit accounts, i.e., normally have debit or left-side balances, and liability accounts are credit accounts; that expense accounts are debit and income accounts are credit, the fundamental principles for determining the debit and credit involved in every transaction become pretty well established in one’s mind.

Starting, therefore, with the original investment, whatever form it may have, the transaction is reducible to the fundamental equation:

Assets = Liabilities + Proprietorship

in which “liabilities” may or may not be a “zero” quantity, depending on the nature of the investment. All transactions thereafter must be viewed according to their effects on the three terms of the equation above. We may summarize the effects produced by the various transactions of the business as:

with this qualification: that some transactions result in transfers only without affecting the totals of any of the three groups above, as when an asset is transferred from one account to another for purposes of more accurate classification.

The Debit and Credit Schedule.—Bearing in mind the customary distinction between debit and credit, and the fact that entry of a transaction is always made from a double viewpoint—that of cause and effect—every transaction may have its debit and credit determined by the following schedule:

Debit and Credit Determination Illustrated.—Examples illustrating the various classes of transactions and the manner of determining their debit and credit will now be given. The student should strive to understand the double point of view necessary in determining debit and credit. It is perhaps well to call attention to the fact that the illustrations are entirely unrelated, i.e., do not constitute a sequence of events in any business. It should also be kept in mind that transactions are recorded always from the standpoint of the business whose records are being kept.

1. The purchase of merchandise for cash. The result is an increase of the asset Merchandise caused by the decrease of the asset Cash. Accordingly, the debit and credit of the entry for the transaction are shown by the above schedule under (1) and (a), i.e., debit Merchandise and credit Cash. The transaction is also an illustration of the transfer entry, in which there is no increase or decrease of total assets, liabilities, or proprietorship.

2. The purchase of merchandise on account. This results in an increase of assets caused by the increase of liabilities. The schedule above shows under (1) and (b) a debit to Merchandise and a credit to the personal account payable, indicated by the name of the creditor.

3. The receipt of cash for services performed, as when a broker receives the amount of his commission in cash. The result here is an increase of the asset Cash, caused by the increase of proprietorship, as the performance of services is the chief source of the broker’s income. The schedule shows under (1) and (c) a debit to Cash and a credit to some temporary proprietorship account by name, as Commissions Earned.

4. The payment of a note payable in cash. This results in a decrease of the liability, Notes Payable, caused by the decrease of the asset Cash. Accordingly, debit Notes Payable and credit Cash, (2) and (a).

5. The settlement of a personal account payable by giving a note payable. The effect here is simply a cancellation of one kind of liability with another kind; it is a transfer entry. Debit the personal account payable; credit Notes Payable, (2) and (b).

6. The rendering of a business service to a creditor, thereby canceling an indebtedness to him; as when a physician renders medical aid to his creditor from whom he has purchased supplies. The effect is a decrease in liabilities and an increase in proprietorship. Debit the personal account payable, by name, and credit some temporary proprietorship account, by name, as Fees or Services, (2) and (c).

7. A workman is paid his wages in cash. The result is a decrease in proprietorship and a decrease in the asset Cash. Wages are a cost of doing business and therefore decrease Proprietorship. They are a service rendered to the business instead of by it—an expense as distinguished from an income. Debit the temporary proprietorship account, Wages, and credit Cash, (3) and (a).

8. The account of a lawyer is credited for the amount of his fee. A decrease of proprietorship, for the service rendered the business, and an increase in liabilities. Debit Legal Expense and credit the personal account payable, (3) and (b).

9. Transfer the net gain shown by the Profit and Loss account to the Surplus account. The result is a simple transfer, causing a decrease in proprietorship as shown in the Profit and Loss account and an increase in proprietorship as shown in the Surplus account. Debit Profit and Loss and credit Surplus, (3) and (c).

In a similar manner, all transactions may be analyzed and their entry in the accounts determined.

Necessary Equilibrium of Debits and Credits.—Before passing to more detailed rules for debit and credit, the necessary equality of debits and credits should again be pointed out. Starting with the proprietorship equation expressed in this form:

Assets = Liabilities + Proprietorship,

of which the left side is represented in the accounts by debits and the right side by credits, the equality of the debit balances and the credit balances of the accounts in the ledger is readily seen. If, now, for all succeeding transactions an entry is made having an equal debit and credit, evidently the equilibrium of the total debits and credits in the accounts is maintained and the two sides of the ledger are in agreement. The making of an equal debit and credit for every entry is fundamental and must be strictly observed.