double-entry bookkeeping.md

Double-Entry Bookkeeping

Double-entry bookkeeping is an accounting system where every financial transaction is recorded in at least two different accounts. For each transaction, there must be:

• A debit entry in one account
• A credit entry in another account
• The total debits must equal the total credits

For example, when a business purchases equipment for $5,000 in cash:

• Equipment account is debited $5,000 (asset increase)
• Cash account is credited $5,000 (asset decrease)

Why It's Needed

1. Error Detection: Because debits must equal credits, mathematical errors become immediately apparent when accounts don't balance.

2. Complete Financial Picture: It captures both where money came from and where it went, providing a comprehensive view of financial standing.

3. Foundation for Financial Statements: It enables the creation of accurate balance sheets and income statements that properly reflect a company's financial position.

4. Audit Trail: It creates a clear record that can be followed and verified, which is essential for auditing and compliance.

5. Asset and Liability Tracking: It properly tracks what a company owns (assets) and what it owes (liabilities).

Without double-entry bookkeeping, businesses would struggle to maintain accurate financial records, detect errors, or generate reliable financial statements that investors, regulators, and managers need for decision-making.​​​​​​​​​​​​​​​​

Common Business Accounts for Double-Entry Bookkeeping

Account Type	Examples	Description
Assets	Cash	Money in bank accounts and on hand
	Accounts Receivable	Money owed to the business by customers
	Inventory	Goods available for sale
	Prepaid Expenses	Payments made for future expenses (insurance, rent)
	Equipment	Machinery, computers, vehicles, etc.
	Buildings/Real Estate	Property owned by the business
Liabilities	Accounts Payable	Money the business owes to suppliers
	Notes Payable	Formal debt obligations (loans)
	Accrued Expenses	Expenses incurred but not yet paid
	Unearned Revenue	Payments received for services not yet provided
	Payroll Liabilities	Taxes and wages owed to employees
Equity	Owner's Capital	Owner's investment in the business
	Retained Earnings	Accumulated profits kept in the business
	Common Stock	Shares issued to stockholders
	Dividends	Distributions to shareholders
Revenue	Sales Revenue	Income from selling goods or services
	Service Revenue	Income from providing services
	Interest Income	Income from investments or loans
	Rental Income	Income from renting property
Expenses	Cost of Goods Sold	Direct costs of items sold
	Wages/Salaries	Employee compensation
	Rent Expense	Payment for use of property
	Utilities	Electricity, water, internet, etc.
	Advertising	Marketing and promotion costs
	Depreciation	Allocation of asset costs over useful life
	Insurance	Coverage for various business risks
	Interest Expense	Cost of borrowing money

These accounts work together in the double-entry system to ensure that every transaction maintains the fundamental accounting equation: Assets = Liabilities + Equity.​​​​​​​​​​​​​​​​

I'll walk through a complete example of double-entry bookkeeping for a small coffee shop from startup through closure.​​​​​​​​​​​​​​​​

I've created a comprehensive example showing the complete lifecycle of a coffee shop business through double-entry bookkeeping. Here are some highlights from the example:

Key Phases Covered

Startup Phase

• Initial owner investment
• Taking out a business loan
• Purchasing assets (building, equipment, inventory)
• Prepaying expenses (insurance)

Operations Phase

• Daily sales transactions (cash and credit)
• Inventory usage and cost of goods sold
• Employee wages and utility payments
• Loan payments (principal and interest)
• Depreciation of assets
• Month-end closing entries

Closure Phase

• Selling remaining inventory and assets
• Recognizing gains/losses on sales
• Paying off remaining liabilities
• Final distribution to owner

Financial Reports

• Trial Balance (showing all accounts balance)
• Income Statement (showing profitability)
• Balance Sheet (showing financial position)
• Statement of Cash Flows (showing cash movement)

The example demonstrates the core principle of double-entry bookkeeping: for every transaction, debits always equal credits, maintaining the accounting equation (Assets = Liabilities + Equity).

Would you like me to explain any particular transaction or concept in more detail?​​​​​​​​​​​​​​​​

Double-Entry Bookkeeping: Complete Business Lifecycle Example

Morning Brew Coffee Shop

STARTUP PHASE

January 1, 2025: Owner invests $50,000 cash to start business

Account	Debit	Credit
Cash	$50,000
Owner's Capital		$50,000
Effect: Increases assets (Cash) and increases equity (Owner's Capital)

January 5: Secure business loan of $30,000

Account	Debit	Credit
Cash	$30,000
Notes Payable		$30,000
Effect: Increases assets (Cash) and increases liabilities (Notes Payable)

January 10: Purchase building for $60,000

Account	Debit	Credit
Building	$60,000
Cash		$60,000
Effect: Increases one asset (Building) and decreases another asset (Cash)

January 15: Purchase equipment for $15,000

Account	Debit	Credit
Equipment	$15,000
Cash		$15,000
Effect: Increases one asset (Equipment) and decreases another asset (Cash)

January 20: Purchase inventory (coffee beans, cups, etc.) for $5,000

Account	Debit	Credit
Inventory	$5,000
Cash		$5,000
Effect: Increases one asset (Inventory) and decreases another asset (Cash)

January 25: Pay for insurance, 1-year policy at $2,400

Account	Debit	Credit
Prepaid Insurance	$2,400
Cash		$2,400
Effect: Increases one asset (Prepaid Insurance) and decreases another asset (Cash)

OPERATIONS PHASE

February 1: Sales of coffee and pastries for day, $1,200 (70% cash, 30% credit card with 3% fee)

Account	Debit	Credit
Cash	$840
Accounts Receivable	$348.60
Credit Card Fees Expense	$10.80
Sales Revenue		$1,200
Effect: Increases assets (Cash, Accounts Receivable), increases expense (Credit Card Fees), increases revenue (Sales)

February 2: Receive credit card settlement from February 1 sales

Account	Debit	Credit
Cash	$348.60
Accounts Receivable		$348.60
Effect: Increases one asset (Cash) and decreases another asset (Accounts Receivable)

February 3: Use $500 of inventory for production

Account	Debit	Credit
Cost of Goods Sold	$500
Inventory		$500
Effect: Increases expense (COGS) and decreases asset (Inventory)

February 5: Pay employee wages, $800

Account	Debit	Credit
Wages Expense	$800
Cash		$800
Effect: Increases expense (Wages) and decreases asset (Cash)

February 10: Pay utility bill, $350

Account	Debit	Credit
Utilities Expense	$350
Cash		$350
Effect: Increases expense (Utilities) and decreases asset (Cash)

February 15: Monthly loan payment $1,100 ($900 principal, $200 interest)

Account	Debit	Credit
Notes Payable	$900
Interest Expense	$200
Cash		$1,100
Effect: Decreases liability (Notes Payable), increases expense (Interest), decreases asset (Cash)

February 28: Record monthly depreciation

Account	Debit	Credit
Depreciation Expense - Building	$100
Depreciation Expense - Equipment	$125
Accumulated Depreciation - Building		$100
Accumulated Depreciation - Equipment		$125
Effect: Increases expenses (Depreciation) and increases contra-assets (Accumulated Depreciation)

February 28: Record monthly insurance expense

Account	Debit	Credit
Insurance Expense	$200
Prepaid Insurance		$200
Effect: Increases expense (Insurance) and decreases asset (Prepaid Insurance)

Month-End Entries

February 28: Closing Revenue accounts

Account	Debit	Credit
Sales Revenue	$30,000
Income Summary		$30,000
Effect: Zeroes out revenue accounts, transfers balance to Income Summary

February 28: Closing Expense accounts

Account	Debit	Credit
Income Summary	$20,000
Cost of Goods Sold		$12,000
Wages Expense		$3,500
Utilities Expense		$1,200
Credit Card Fees Expense		$900
Interest Expense		$200
Depreciation Expense - Building		$100
Depreciation Expense - Equipment		$125
Insurance Expense		$200
Rent Expense		$1,775
Effect: Zeroes out expense accounts, transfers balance to Income Summary

February 28: Closing Income Summary to Retained Earnings

Account	Debit	Credit
Income Summary	$10,000
Retained Earnings		$10,000
Effect: Zeroes out Income Summary, increases Retained Earnings by the net income amount

BUSINESS CLOSURE (After 1 Year)

December 31: Sell remaining inventory for $3,000 (cost basis $4,000)

Account	Debit	Credit
Cash	$3,000
Loss on Inventory Sale	$1,000
Inventory		$4,000
Effect: Increases asset (Cash), records loss, decreases asset (Inventory)

December 31: Sell equipment for $8,000 (book value $10,500)

Account	Debit	Credit
Cash	$8,000
Accumulated Depreciation - Equipment	$4,500
Loss on Equipment Sale	$2,500
Equipment		$15,000
Effect: Increases asset (Cash), eliminates accumulated depreciation, records loss, eliminates asset (Equipment)

December 31: Sell building for $65,000 (book value $58,800)

Account	Debit	Credit
Cash	$65,000
Accumulated Depreciation - Building	$1,200
Building		$60,000
Gain on Building Sale		$6,200
Effect: Increases asset (Cash), eliminates accumulated depreciation, eliminates asset (Building), records gain

December 31: Pay off remaining loan balance of $20,000

Account	Debit	Credit
Notes Payable	$20,000
Cash		$20,000
Effect: Eliminates liability (Notes Payable), decreases asset (Cash)

December 31: Final distribution to owner of $77,000

Account	Debit	Credit
Owner's Capital	$50,000
Retained Earnings	$27,000
Cash		$77,000
Effect: Eliminates equity accounts, decreases asset (Cash)

Final Balance Sheet (After All Closure Entries)

All accounts should have zero balances, confirming that the books balance.

Key Financial Reports Throughout the Business

Trial Balance (Sample - End of February)

Account	Debit	Credit
Cash	$23,538.60
Inventory	$4,500
Prepaid Insurance	$2,200
Building	$60,000
Accumulated Depreciation - Building		$100
Equipment	$15,000
Accumulated Depreciation - Equipment		$125
Notes Payable		$29,100
Owner's Capital		$50,000
Retained Earnings		$10,000
Sales Revenue		$30,000
Cost of Goods Sold	$12,000
Wages Expense	$3,500
Utilities Expense	$1,200
Credit Card Fees Expense	$900
Interest Expense	$200
Depreciation Expense - Building	$100
Depreciation Expense - Equipment	$125
Insurance Expense	$200
Rent Expense	$1,775
TOTAL	$125,238.60	$125,238.60
Note: Debits = Credits, confirming the books balance

Income Statement (February)

Item	Amount
Revenue
Sales Revenue	$30,000
Total Revenue	$30,000
Expenses
Cost of Goods Sold	$12,000
Wages Expense	$3,500
Rent Expense	$1,775
Utilities Expense	$1,200
Credit Card Fees Expense	$900
Interest Expense	$200
Insurance Expense	$200
Depreciation Expense	$225
Total Expenses	$20,000
Net Income	$10,000

Balance Sheet (End of February)

ASSETS			LIABILITIES & EQUITY
Current Assets			Liabilities
Cash	$23,538.60		Notes Payable	$29,100
Inventory	$4,500		Total Liabilities	$29,100
Prepaid Insurance	$2,200
Total Current Assets	$30,238.60		Equity
			Owner's Capital	$50,000
Non-Current Assets			Retained Earnings	$10,000
Building	$60,000		Total Equity	$60,000
Less: Accumulated Depreciation	($100)
Equipment	$15,000
Less: Accumulated Depreciation	($125)
Total Non-Current Assets	$74,775
TOTAL ASSETS	$105,013.60		TOTAL LIABILITIES & EQUITY	$89,100

Statement of Cash Flows (February)

Item	Amount
Operating Activities
Net Income	$10,000
Adjustments for non-cash items:
Depreciation	$225
Changes in working capital:
Decrease in Inventory	$500
Decrease in Prepaid Insurance	$200
Net Cash from Operating Activities	$10,925
Investing Activities
No investing activities in February	$0
Net Cash from Investing Activities	$0
Financing Activities
Loan Principal Payment	($900)
Net Cash from Financing Activities	($900)
Net Increase in Cash	$10,025
Beginning Cash Balance	$13,513.60
Ending Cash Balance	$23,538.60

For example, when a business purchases equipment for $5,000 in cash:

Equipment account is debited $5,000 (asset increase)
Cash account is credited $5,000 (asset decrease)

Why is it not the opposite; cash account is debited and Equipment account is credit?

Great question! This gets to the heart of how debits and credits work in accounting.

In accounting, "debit" and "credit" don't inherently mean increase or decrease. Instead, whether a debit or credit increases or decreases an account depends on the account type.

Here's how it works:

Account Type	Debit Effect	Credit Effect
Assets	Increase	Decrease
Liabilities	Decrease	Increase
Equity	Decrease	Increase
Revenue	Decrease	Increase
Expenses	Increase	Decrease

So in your example:

• Equipment is an asset account. Assets increase with debits, so we debit Equipment $5,000.
• Cash is also an asset account. Assets decrease with credits, so we credit Cash $5,000.

This might seem counterintuitive at first, but the system is designed to maintain the accounting equation: Assets = Liabilities + Equity.

Think of it as two sides of a balance scale:

• Asset accounts normally have debit balances (left side of the equation)
• Liability and equity accounts normally have credit balances (right side of the equation)

When you record a transaction, you're keeping that scale balanced by making equal entries on both sides.​​​​​​​​​​​​​​​​

Assets = Liabilities + Equity.​​​​​​​​​​​​​​​​ But we also have expenses and revenue accounts. What are not they included in the formula?

Excellent question! Revenue and expense accounts are actually part of equity, but they're kept separate during the accounting period for better tracking and reporting.

Here's the expanded view:

Complete Accounting Equation:

Assets = Liabilities + (Owner's Capital + Retained Earnings + Revenue - Expenses)

The parenthesized part represents total equity. Revenue and expenses are technically temporary equity accounts that affect the Retained Earnings component.

What happens with Revenue and Expenses:

1. During the accounting period:

   • Revenue increases equity (credited)
   • Expenses decrease equity (debited)
   • They're kept separate to track performance

2. At period end (closing process):

   • Revenue and expense accounts are zeroed out
   • Their net impact (Net Income = Revenue - Expenses) is transferred to Retained Earnings
   • This process is called "closing the books"

So while the basic equation Assets = Liabilities + Equity is always true, revenue and expenses are tracked separately throughout the period to measure performance, then absorbed into equity (via Retained Earnings) at period end.

This is why income statements show a specific time period's performance, while balance sheets represent the cumulative position at a specific point in time.​​​​​​​​​​​​​​​​

Top 10 Beginner Double-Entry Bookkeeping FAQs

1. Why do debits have to equal credits?

Answer: Debits equaling credits maintains the accounting equation (Assets = Liabilities + Equity). This balance ensures that all resources are properly accounted for and the financial position is accurately represented. It's the foundation of the double-entry system that prevents mathematical errors.

2. How do I know which account to debit and which to credit?

Answer: Follow these rules:

• Assets increase with debits, decrease with credits
• Liabilities increase with credits, decrease with debits
• Equity increases with credits, decreases with debits
• Revenue increases with credits, decreases with debits
• Expenses increase with debits, decrease with credits
  When in doubt, analyze how the transaction affects the accounting equation.

3. What's the difference between accrual and cash accounting?

Answer: Cash accounting records transactions only when cash changes hands. Accrual accounting records transactions when they occur economically, regardless of when cash moves. Accrual better reflects business performance by matching revenues with related expenses in the same period.

4. What is a journal entry?

Answer: A journal entry is the initial recording of a transaction, showing all accounts affected with their respective debits and credits. It includes the date, accounts involved, amounts, and often a brief description explaining the transaction's purpose.

5. What is a trial balance?

Answer: A trial balance is a worksheet listing all accounts with their debit or credit balances to verify that total debits equal total credits. It's typically prepared at the end of an accounting period to check for mathematical accuracy before creating financial statements.

6. How do adjusting entries work?

Answer: Adjusting entries update accounts at period-end to ensure revenues and expenses are recognized in the correct period. Common adjustments include:

• Recording depreciation
• Recognizing prepaid expenses used
• Accruing unpaid expenses
• Recording unearned revenue that's been earned

7. What happens when I make an accounting error?

Answer: For errors that don't affect the trial balance (like recording to wrong accounts), make a correcting entry. For errors that do affect the trial balance, find and fix the specific mistake. Never erase or delete entries; always correct with proper documentation.

8. What's the difference between the general journal and general ledger?

Answer: The general journal chronologically records all transactions with debits, credits, and explanations. The general ledger organizes these entries by account, showing running balances. Entries are first recorded in the journal, then posted (transferred) to the ledger.

9. How do closing entries work?

Answer: Closing entries transfer balances from temporary accounts (revenue, expense, dividend) to permanent accounts (retained earnings) at period-end. This process:

1. Zeros out all revenue/expense accounts
2. Updates retained earnings with net income/loss
3. Prepares temporary accounts for the next period

10. What's the difference between a balance sheet and income statement?

Answer: The balance sheet shows the company's financial position (assets, liabilities, equity) at a specific point in time. The income statement shows performance (revenues, expenses, profit/loss) over a period of time. The balance sheet is cumulative, while the income statement covers only the specified period.​​​​​​​​​​​​​​​​