Double entry bookkeeping is the foundation of modern accounting practices, and most likely what your accounting software is doing for you behind the scenes. This method follows the principle that every transaction has two equal and opposite effects on the accounting equation.
The accounting equation, also known as the balance sheet equation, states that assets equal liabilities plus equity. This fundamental concept underpins all financial transactions and helps maintain the balance in financial statements - most notably the Trial Balance.
In short, the Trial Balance is a list of all accounts in a company's chart of accounts and their balances at a certain date in time. In a chart of accounts, there are five main types of accounts: assets, liabilities, equity, revenue, and expenses. Each account type serves a specific and necessary purpose in tracking the financial activities of a business, and each account is affected differently by debits and credits.
Debits and credits are essential components of double entry bookkeeping. Debits increase asset and expense accounts but decrease liability and equity accounts. On the other hand, credits increase liability and equity accounts but decrease asset and expense accounts.
At the end of an accounting period, a Trial Balance is prepared to ensure that debits equal credits. This step helps identify any errors or discrepancies in the accounting records before generating financial statements.
Understanding these core concepts of double entry bookkeeping is crucial for maintaining accurate financial records and making informed business decisions based on reliable data. Read on for a quick breakdown of each topic in double entry bookkeeping.
The Accounting Equation
Understanding the accounting equation is fundamental to grasping the core principles of bookkeeping and financial accounting. The equation, Assets = Liabilities + Equity, forms the basis of double-entry bookkeeping, where every transaction affects at least two accounts.
The 5 Main Types of Accounts
Firstly, you must understand that there are five types of accounts in double entry bookkeeping. They are:
Assets (bank accounts, vehicles, computers, furniture, etc.)
Expenses (payroll expenses, office supplies, meals and entertainment, etc.)
Liabilities (accounts payable, loans, sales tax, etc.)
Revenue (sales, government earnings, etc.)
Equity (owner capital, retained earnings, shares, etc.)
Each one of these account types will be used in preparing your financial statements:
Assets = Liabilities + Equity is the calculation used on the Balance Sheet.
Revenue - Expenses = Net Profit/Loss is the calculation used on the Income Statement (or Profit and Loss).
As you can see, each account type serves a specific and necessary purpose in tracking the financial activities of a business, and each account is affected differently by debits and credits.
Debits & Credits
Debits and credits are essential components in recording transactions to these accounts. Debits increase assets and expenses while decreasing liabilities, revenues, and equity. On the other hand, credits increase liabilities, revenues, and equity while decreasing assets and expenses.
Debits INCREASE/Credits DECREASE:
Assets
Expenses
Credits INCREASE/Debits DECREASE:
Liabilities
Revenues
Equity
Every time you post a transaction, there is a debit and a credit being entered behind the scenes of your accounting software. A minimum of two accounts will be pulled from the list above and must have a debit and a credit happening.
Purchasing a computer on account for your company? The Asset account gets Debited, Accounts Payable Liability will be Credited.
Paying Sales Tax? Sales Tax Liability is Debited, your Bank Account Asset is Credited.
Understanding the increases and decreases, debits and credits, and types of accounts (i.e. assets vs. liabilities) will help you figure out how to make proper journal entries, and correct mistakes in your previous entries.
The Trial Balance
When all is said and done, your Trial Balance report, in QuickBooks Online, should have equal Assets to Liabilities + Equity, because you cannot post an entry in QuickBooks Online without having a debit and a credit to balance out.
However we’ve seen that without experience, mistakes indeed do happen - so running your Trial Balance is a vital preliminary step in preparing financial statements that will help identify any errors or discrepancies that need correction.
Conclusion
By understanding how the accounting equation relates to debits, credits, and the trial balance, businesses can maintain accurate financial records and therefore make better decisions based on their financial position.