The Accounting Model of Double-Entry Accounting - dummies

The Accounting Model of Double-Entry Accounting

By Stephen L. Nelson

Here’s the first thing to understand and internalize in order to use double-entry bookkeeping with QuickBooks 2012: Modern accounting uses an accounting model that says assets equal liabilities plus owner’s equity. The following formula expresses this in a more conventional, algebraic form:

assets = liabilities + owner’s equity

This formula summarizes the organization of a business’s balance sheet. Conceptually, the formula says that a business owns stuff and that the money or the funds for that stuff come either from creditors (such as the bank or some vendor) or the owners (either in the form of original contributed capital or perhaps in reinvested profits).

If you understand the balance sheet shown, you understand the first core principle of double-entry bookkeeping. This isn’t that tough so far, is it?

A Simple Balance Sheet for the Hot Dog Stand
Cash $1,000
Inventory 3,000
Total assets $4,000
Accounts payable $2,000
Loan payable 1,000
Owner’s equity
S. Nelson, capital 1,000
Total liabilities and owner’s equity $4,000

Here’s the second thing to understand about the basic accounting model: Revenues increase owner’s equity and expenses decrease owner’s equity. Think about that for a minute. That makes intuitive sense. If you receive $1,000 in cash from a customer, you have $1,000 more in the business. If you write a $1,000 check to pay a bill, you have $1,000 less in the business.

Another way to say the same thing is that profits clearly add to the owner’s equity. Profits get reinvested in the business and boost owner’s equity. Profits are calculated as the difference between revenues and expenses. If revenues exceed expenses, profits exist.

The basic model says that assets equal liabilities plus owner’s equity. In other words, the total assets of a firm equal the total of its liabilities and owner’s equity. Furthermore, revenue increases the owner’s equity and expenses decrease the owner’s equity.

At this point, you don’t have to intuitively understand the logic of the accounting model and the way that revenues and expenses plug in to the owner’s equity of the model. If you do “get it,” that’s great, but not necessary. However, you do need to memorize or remember (for at least the next few paragraphs) the manner in which the basic model works.

Every transaction and every economic event that occurs in the life of a firm produces two effects: an increase in some account shown on the balance sheet or on the income statement and a decrease in some account shown on the balance sheet or income statement. When something happens, economically speaking, that something affects at least two types of information shown in the financial statement.

Suppose that in your business, you sell $1,000 of an item for $1,000 in cash. In the case of this transaction or economic event, two things occur from the perspective of your financial statements:

  • Your cash increases by $1,000.

  • Your sales revenue increases by $1,000.

Another way to say this same thing is that your $1,000 cash sale affects both your balance sheet (because cash increases) and your income statement (because sales revenue is earned).

See the duality?

Here’s another common example: Suppose that you buy $1,000 of inventory for cash. In this case, you decrease your cash balance by $1,000, but you increase your inventory balance by $1,000. Note that in this case, both effects of the transaction appear in sort of the same area of your financial statement — the list of assets. Nevertheless, this transaction also affects two accounts.