The first principle of accounting we need to understand is called double-entry bookkeeping. Each transaction made in the accounting system is entered twice. No, this does not mean we are keeping two sets of books. We enter every transaction twice, to show where the money comes from and where it is going.

An Italian monk, Luca Pacioli, gets the credit for developing double entry in 1494, although it first appeared some 50 years earlier. Next time you think you’re getting confused by double entry, remember this. It’s been around for more than 500 years. Most of the people who used it didn’t know how to program VCRs. You are way ahead at the start.

Accounting is concerned with three basic concepts:
• assets
• liabilities
• equity

Let’s use a series of T accounts to trace a small job all the way through a business. Let’s say you do some work for a customer and you take along a contractor as an assistant. You invoice the client; the client pays. Also, the contractor bills you. How does this look in double- entry bookkeeping, illustrated with T accounts? Let’s walk through it one step at a time. Your customer calls you and asks you to do the work. You plan the job, put it on the schedule, and arrange for the contractor to come with you. All of this is important business, but none of it shows up in accounting. No transaction has happened yet; if the appointment falls through, you will not get paid anything.

You go and do the work and the contractor comes with you. The customer tells you he is happy with the work and looks forward to receiving your invoice, which he’ll pay promptly. The contractor says she’ll send you a bill and you promise to pay within one month. Still, no transaction has occurred. If no invoices are sent, and no one gets paid, then it’s as if you’d
worked for free.

The next day, you write up an invoice for $1,000 and mail it to the customer. The invoice has gone out; now a transaction has occurred. In a pair of T accounts, it looks like this.

What do these two diagrams mean?

The first one says that on June 2 the company received $1,000 in income. How is this possible, if you haven’t gotten a check yet? Because in accounting, we count the money as coming in when we bill it. Why? Because the money we are owed is an asset and we want to keep track of it. It is of value to our company. We could go to a bank and borrow against the money our customers are due to pay us. So, the value of the company has increased, from an accountant’s perspective. The company is worth $1,000 more than the day before, because income has come in. So we have a credit to income—money coming in.

The balancing T account is a debit to assets. But if our assets have increased, why do we debit them? This is one odd aspect of accounting. Asset accounts are debit accounts. So a debit to an asset is an increase of money in the company. Later on, we’ll see how this keeps the books in balance.

But, in double-entry bookkeeping, all transactions are entered twice, so that all accounts are balanced. That is a fundamental rule of accounting. If the income account goes up (is credited) by $1,000, then a debit for $1,000 must show up somewhere else. It shows up in Assets—Accounts Receivable, as we see in the second T account diagram.

Accounts receivable is a single account that shows all of the money that you are owed by everyone. Accounts receivable is an asset account. That is, it is one of the accounts that show how much money is in the company.

The next day, you receive a bill in the mail from your subcontractor. This is another transaction. You enter the bill in your accounting ledger or system to show that you owe her the money. The T accounts look like this:

Together, these two T accounts say that your company has a $200 expense and owes a subcontractor $200. Even though you haven’t paid her bill yet, your company owes the money, so the value of the company is $200 less than it was.

At the end of the week, you receive a $1,000 check from your customer and deposit it into the corporate checking account. Again, two T accounts record this in your accounting system. These two diagrams may seem backwards. But remember: all asset accounts are debit accounts, so an entry in the debit column is an increase to the account and an entry to
the credit column is a decrease.

Now you feel like your business is up and running. You feel so good that you want to pay your subcontractor’s bill. Only you can’t—the check from the customer hasn’t had time to clear the bank. While you’re waiting for the check to clear, you ask those three basic questions all managers want to know:
• How much money came in?
• Where did the money go?
• How much money is left?

Since you’ve entered every transaction, your accounting system should be able to answer those questions. The questions are answered in reports called financial statements. The two most important financial statements are the income and expense statement and the balance sheet.

If you’re using a computerized accounting package, you simply go to the reports menu, select the report you want, select the start and end dates, and print it out. But, rather than relying on the magic of a computer program, let’s walk through the process of building our financial statements, so that you can see how accounting moves from the recording of each transaction to the presentation of useful reports.

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