2. What is Double-Entry Bookkeeping?

The meaning of the Accounting Equation must begin with a brief review of the foundation of all financial information – double-entry bookkeeping. Double-entry bookkeeping is the relating of each financial transaction to its source and destination (a financial transaction being a single event that results in the allocation of resources from one place to another).

The relating of the transaction to both its source and destination comprises the “double” in the term “double-entry.” Historically, each transaction has been related to each side of the exchange by having the bookkeeper make two recordings (“entries”) of the transaction, one in an account representing the source side of the transaction and a second one in an account representing the destination side.

The recording on the source side is known as a “credit” entry and is effectively a record of a withdrawal from an account representing that side. The recording on the destination side, in turn, is known as a “debit” entry and is effectively a record of a deposit into an account representing the destination side.

For example, when the business pays a utility bill, the payment transaction is recorded as a withdrawal (“credit”) from the cash account and a deposit (“debit”) to an account that represents utility expenses. The deposit increases the “debit” balance of the utility expense account while the withdrawal decreases the cash accounts “debit” balance. The amount reported as deposited in one account is exactly the same as the amount reported as withdrawn from another account.

Although a single transaction changes the balances in various individual accounts, it has a net effect of zero on the total balance of all of the accounts. Just as the utility expense account increased its debit balance in the previous example, the cash account’s balance was decreased by the same amount, causing absolutely no change to the combined balance of the two accounts together as well as the combined balance of the accounting system in general.

Each deposit is exactly balanced by its corresponding withdrawal, leaving the balance of the whole system (referred to as the “General Ledger”) at its point of origin – zero. The system begins with a zero balance and continues to have exactly a zero balance throughout its lifetime. Regardless of how many transactions we enter, each transaction’s recorded deposit is offset by its recorded withdrawal, leaving the balance of General Ledger just as it was before the first transaction was recorded – zero.

General Ledger = 0

And, if we partition the accounts of the General Ledger into two sets, set “A” and set “B”, we do not change its balance and therefore we have:

A + B = 0

In fact, regardless of how we partition the accounts of the General Ledger, their combined balance will be the balance of the General Ledger. If we partition the General Ledger into three sets representing the company’s assets, liabilities, and owner’s equity (after closing the temporary accounts), we have the following expression:

Assets + Liabilities + Owner’s Equity = 0

This formula is the correct way to express the Accounting Equation. It has a very different meaning from the standard way of expressing the equation:

Assets = Liabilities + Owner’s Equity

In following posts to this blog, the contradiction between these two expressions of the Accounting Equation and the significance of that contradiction to the financial world will be explored.