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: