Introductory accounting books often gloss-over or completely ignore bookkeeping principles and teach by example rather than by presenting a consistent framework. While examples are necessary, this practice-based approach leaves office administrators and software developers, who have very little exposure to the workings of accounting. This paper attempts to bridge this fundamental gap.
There are four fundamental types of bookkeeping accounts, which are best represented in a four-square:
Revenue and Expense accounts are used to track the flow of value into and out of a business entity. Revenue accounts represent activities which produce value, expenses represent activities which consume value. For example, labor and interest earned are revenue accounts. Revenue accounts also record, as a negative amount, the cost of goods sold or kept as short-term inventory. Payment of rent, utility, and interest on loan are expense accounts. Expenses also include the purchase of consumable goods or other items which are consumed during normal business activities.
Asset and liability accounts are used to track the entity's economic condition. Asset accounts represent what is owned by or owed to the business entity, liabilities represent what is owed by the business entity. In this model, investment by an owner is treated as a special case of liability since it reflects an obligation to the investor.
There are two primary financial reports produced by a bookkeeping system, the Revenue Statement and the Balance Sheet.
|Balance Sheet||Net Value = Assets - Liabilities||gives book value of an organization at a particular point in time|
|Income Statement||Net Income = Revenue - Expenses||gives change in value of an organization over a time period|
The balance sheet lists all asset and liability accounts, showing the total value of the organization at a particular point in time. The income statement, by contrast, shows the change in the organization's value over a specific time period. The important distinction between these two statements reflects the kind of accounts they summarize: Asset and Liability accounts reflect the organization's holdings and obligations. Revenue and Expense reflect changes in the organization's value.
The essence of bookkeeping is that every transaction must satisfy an invariant:
That is, if you affect any account from a given type, a balancing change to the other accounts is required. For example, if revenue is received from work, and the corresponding revenue account increases, then the value of that work must go somewhere. According to Pacioli's law, one of the following must also be recorded: (a) an increase to an asset account, such as cash, (b) an increase to an expenditure account, such as paying one's taxes, (c) a decrease to a liability account, such as a debt owed to the employer, (d) any combination of the above items, such as cash less taxes.
Credits and Debits are a mechanism to implement Pacioli's Law. By ensuring that credits always equal debits for a given transaction, the invariant above is maintained. The table below shows how a credit or debit affects a given account type.
Let's use three examples to explain how this works. In each example, one quadrent from the credit is used, and one from the debit. A combination of one credit and one debit is called a bookkeeping rule, which is subject to Pacioli's law.
|Cash from Work||
Consulting or labor revenue produces $100 of value. The revenue to the business is $100, and this is reflected with a corresponding increase in assets. Note that both the credit and the debit are positive.
|Loan for Cash||
Company takes out a loan for $100 cash. Both the liability and the assets increase by $100.
|Expense for Cash||
This example represents paying rent or purchasing a consumable good with cash or some other asset. In this case, the credit results in a decrease to the asset account.
Overall, there are 13 such rules, including the Identity.