Do you really understand the principle underlying double-entry book-keeping? Perhaps you think it is too difficult to understand and you leave everything to your bookkeeper and accountant to sort out.
What is the basic principle underlying double-entry book- keeping? Is double-entry merely a collection of well-recognised conventions for recording business transactions, without any theoretical foundation? The answer is No. Double-entry book-keeping is essentially an equation. The equation is Liabilities of the Business = Assets of the Business. Or, put in another way, "owners" or financiers of the business = assets of the business. The proprietor of the business is, of course, a financier of the business but one with very special rights. The business is regarded as a separate entity from the proprietor. Accordingly, the business owes the proprietor the funds that he has invested in the business. Let us look at a typical Balance Sheet of a professional person.
|Capital of John Smith, proprietor||12,000|
|Commissioner of Taxation||6,000|
|TOTAL LIABILITIES $||33,000|
|Furntiure and equipment||15,000|
|Balance at bank||2,000|
|TOTAL ASSETS $||33,000|
As you can see, total assets of $33000 equal total liabilities of $33000. The Balance Sheet is in equilibrium.
The object of all our double-entry book-keeping from this point on is to keep our Balance Sheet in equilibrium. Obviously, to do so, if we add to one asset, we must either add to a liability or subtract from another asset. The same applies to a liability. If we add to one liability, we must either add the same amount to a corresponding asset or deduct the same amount from another liability. Obviously, the converse rules will apply if we deduct an amount from an asset or a liability.
Examples will make matters clearer. John Smith pays an outstanding account of $600. Decrease an asset (bank balance) and decrease a liability (creditors) by $600 each. John Smith buys a desk for $500. Decrease one asset (bank balance) by $500 and increase another asset by $500 (furniture and equipment). A debtor pays his account of $1000. Increase one asset (bank balance) by $1000 and decrease another asset (debtors) by $1000. John Smith hands over his vehicle worth $10000 in satisfaction of his long-term loan of $10000. Decrease an asset (vehicle) and a liability (long-term loan) by $10000 each.
So far, so good. But, you may ask, what happens when I pay an expense, say rent of $500? Obviously, I will decrease an asset (bank balance) by $500 but what asset do I increase or what liability do I decrease? The answer is that all expenses are really short-term assets. When you pay the rent of $500, you will gain a lease for a term of, say, a week. When you pay for electricity, you get actual electric current. As a rule-of-thumb, if an asset lasts for less than a year, it is regarded as an expense. If it has a life of over a year, it is regarded as an asset. At the end of each financial year, all expired assets , i.e. with a lifetime of less than a year, are amalgamated as expenses. They are then offset against the owner's capital account, representing a loss of capital. The double-entry, therefore, at year end is decrease expense- assets by $x and decrease liability (owner's equity) by $x.
What happens when the owner carries out professional services and thereby increases his bank balance and also increases his capital account? The answer is you increase an asset (bank balance) by $x and increase a liability (owner's equity) by $x.
Suppose for example that the owner carried out the following professional work during the year and incurred the following expenses.
|NET PROFIT FOR YEAR $||40,000|
The double-entry records for the above are as follows. First, increase asset (bank balance) and increase liability (Owner's equity) by $100000. Next, decrease assets (decrease all expense assets to zero) and decrease liability (owner's equity) by $60000. The net result of these entries is of course to increase the owner's capital account by the amount of the net profit for the year i.e. $40000.
So that is all there is to double-entry book-keeping.
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