Double Entry accounting

Understanding the Accounting Equation

  • The accounting equation is fundamental to financial accounting.

Lemonade Stand Example

  • A scenario using a lemonade stand is utilized to explain the concepts.

  • Initial setup involved:

    • Opening a business checking account with $100,000 of personal investment.

    • Borrowing $50,000 from the bank at a 10% annual interest rate.

  • On the first day (01/01/2014), the assets equated to $150,000 in cash.

    • Assets: $150,000

    • Liabilities: $50,000 (debt)

    • Equity: $100,000

  • The balance sheet is structured as follows:

    • Left side: Assets = $150,000 cash

    • Right side: Liabilities = $50,000, Equity = $100,000

  • The crucial observation: Assets equal liabilities plus equity.

Movement of Assets and Liabilities

  • Companies possess various assets beyond cash.

  • When purchases are made (e.g. inventory, fixed assets),

    • Cash may decrease while other assets increase.

  • Changes in the balance sheet must always remain balanced; for every transaction, a corresponding adjustment must occur.

Transaction Analysis

  • Each transaction has two aspects:

    • Source of funds: Where the money originated.

    • Use of funds: How the funds were utilized.

Examples of Transactions

  • Buying a plant

    • Source of funds: Cash

    • Use of funds: Built the plant

  • Purchasing inventories on credit

    • Source of funds: Accounts payable (new liability)

    • Funds used to buy inventory

  • Issuing stock

    • Source of funds: Additional investor equity

    • Use of funds: Increase in cash for the company

Fundamental Principle

  • Assets = Liabilities + Equity represents a fundamental accounting principle.

Double Entry Accounting Framework

  • Double entry accounting records each economic event's two sides:

    • Funding source

    • Use of funds

Debits and Credits

a. Debits:

  • Represent the use of funds.

  • Increase in assets

  • Can also decrease liabilities and equity

  • Recorded on the left side of a T-account.
    b. Credits:

  • Represent the source of funds.

  • Increase in liabilities and equity or decrease in assets

  • Recorded on the right side of a T-account.

Application of T-Accounts

  • T-accounts illustrate the relationship between debits and credits visually.

  • For the loan of $50,000:

    • Credit: Increase in liabilities

    • Debit: Increase in cash

  • For equity investment of $100,000:

    • Credit: Increase in equity

    • Debit: Increase in cash

Transaction Tracking with T-Accounts

  • Post-loan and investment:

    • Cash increased to $150,000

    • Three T-accounts for tracking:

    • Debt increase (credit)

    • Equity increase (credit)

    • Cash increase (debit)

Expansion of the Lemonade Stand Transactions

  • After securing funds, the following purchases were made:

    • $20,000 worth of lemonade, lemons, and paper cups.

    • $15,000 for a lemon squeezer.

    • $15,000 for a lemonade stand.

    • $2,000 for a cash register.

T-Account Analysis of Purchases

  • For each purchase:

    • Cash used corresponds to an increase in inventory or fixed asset (debit).

  • Example:

    • Buying lemonade stand for $15,000:

    • Decrease in cash (credit)

    • Increase in Property, Plant, and Equipment (PPE) (debit).

  • In summary:

    • All transactions involve movements in assets without affecting liabilities.

Consolidated Transaction Tracking

  • Instead of multiple T-Accounts, transactions are better represented in an aggregated table listing debits and credits.

  • Total debits amount to $52,000 aligning with corresponding cash credits.

Importance of Double Entry Accounting

  • Reinforces the relationship between resources and funding.

    • The balance sheet, income statement, and statement of cash flows interconnected.

  • Debits and credits serve as fundamental concepts but are not commonly discussed in practice among finance professionals.