One of the key cultural advancements that made modern economies possible was the invention of double-entry accounting in the fifteenth century. The very concept of “owner equity” being reduced to a mathematical equation was a major advance that brought about the corporation, the idea of a shareholder and the relationship between owner’s equity and a company’s assets.
As important as this mathematical advancement was, it is a subject that few people outside the accounting profession understand. Given the centrality of money, business and ownership in a society and economy dominated by private enterprise and the public markets, the language of business expressed in double entry accounting is not only necessary, it is crucial.
Double entry accounting boils down to one equation and one rule. The equation is assets = liabilities + owner’s equity. The rule is both sides of the equation must balance at all times. This is accomplished through a system of debits and credits.
A Ledger Entry
The process is called “double entry” because every transaction must be “entered” in at least two accounts. One is a debit and the other is a credit. By combining these two entries, the central equation is balanced along with the ledger itself. When the equation is in balance, it means all the funds transacted have been accounted for. It is not possible to hide entries or tamper with the ledger, as it would cause the central equation to be out of balance, meaning the books would not be in order.
The locations in which entries are made are called “accounts,” like assets, cash, expenses and so on. When a transaction takes place, an entry of either a debit or credit is made in at least two accounts to make certain the equation is balanced. For example, collecting $1.00 in sales revenue would debit the “cash” account for $1.00 and credit the “revenue” account for the same amount.
Accounting is a lot like any skill. It requires basic knowledge and considerable practice to understand well. There are a lot of details involved in keeping the books for even a modest enterprise, which is why the accounting profession is unlikely to fade away any time soon. Everyone should take at least a basic class in accounting, as it is a skill that can be used on an almost daily basis.