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Businesses and nonprofit entities use double-entry accounting. But we’ve never met an individual who used double-entry accounting in personal bookkeeping. Instead, individuals use single-entry accounting. For example, when you write a check, process an electronic payment, or make a payment on your credit card balance, you undoubtedly make an entry in your checkbook to decrease your bank balance. And that’s it. You make just one entry — to decrease your checking account balance. It wouldn’t occur to you to make a second, companion entry to decrease your credit card liability balance. Why? Because you don’t keep a liability account for what you owe on your credit card. You depend on the credit card company to make an entry to decrease your balance.

Businesses and nonprofit entities have to keep track of their liabilities as well as their assets. And they have to keep track of all sources of their assets. (Some part of their total assets comes from money invested by their owners, for example.) When a business writes a check or processes an ACH payment to pay one of its liabilities, it makes a two-sided (or double) entry — one to decrease its cash balance in the bank and the second to decrease the liability. This is double-entry accounting in action. Double-entry does not mean a transaction is recorded twice; it means both sides of the transaction are recorded at the same time.

The two-sided nature of business accounting is summarized in the accounting equation, which puts assets on one side (almost always on the left) and the sources of assets on the opposite side, as follows:

$Assets = $Liabilities + $Capital + $Retained Earnings

The equal sign means that for every dollar of assets, there’s a dollar from one of the sources of assets on the right side of the accounting equation. Assets do not materialize out of nothing. Assets come from somewhere. There are three fundamental sources of assets: liabilities, capital invested in the business by its owners, and retained earnings (accumulated profit that has been earned but not distributed to its owners by the entity). Combining a business’s capital and retained earnings gives you its owners’ equity, or the net worth of the business.

The accounting equation is a condensed version of the balance sheet. The balance sheet is the financial statement that summarizes a business’s assets on the one side and its liabilities plus its owners’ equity on the other side. As we just mentioned, liabilities and owners’ equity are the sources of the business’s assets. Each source has different types of claims on the assets, which we explain in Chapter 7.

One main function of the bookkeeping/accounting system is to record all transactions of a business — every single last one. If you look at transactions through the lens of the accounting equation, there’s a beautiful symmetry in transactions (well, beautiful to accountants at least). All transactions have a natural balance. The sum of financial effects on one side of a transaction equals the sum of financial effects on the other side. Thus, the name of the balance sheet — because in theory, the balance sheet should always be, well, in balance.

Suppose a business buys a new delivery truck for $65,000 and pays by check (how old-fashioned is that?). The truck asset account increases by the $65,000 cost of the truck, and cash in the bank decreases $65,000. Here’s another example: A company borrows $2 million from its bank. Its cash in the bank increases by $2 million, and the liability for its note payable to the bank increases by the same amount.

Just one more example: Suppose a business suffers a loss from a tornado because some of its assets were not insured (dumb!). The assets destroyed by the tornado are written off (decreased to zero balances), and the amount of the loss decreases the owners’ equity by the same amount. The loss works its way through the income statement but ends up as a decrease in retained earnings.

Virtually all business recordkeeping systems use debits and credits for making sure that both sides of transactions are recorded and for keeping the two sides of the accounting equation in balance. A change in an account is recorded as either a debit or a credit according to the rules in Table 3-1.

TABLE 3-1 Bookkeeping Rules for Debits and Credits

Account Type	Increase	Decrease
Asset accounts	Debit	Credit
Liability accounts	Credit	Debit
Owners’ equity accounts	Credit	Debit

An increase in an asset is tagged as a debit; an increase in a liability or owners’ equity account is tagged as a credit. Decreases are just the reverse. Following this scheme, the total of debits must equal the total of credits in recording every transaction. In brief: Debits have to equal credits. Isn’t that clever? Well, the main point is that the method works. Debits and credits have been used for centuries. (A book published in 1494 describes how business traders and merchants of the day used debits and credits in their bookkeeping.)

Note: Sales revenue and expense accounts also follow debit and credit rules. Revenue increases owners’ equity (and thus is a credit), and an expense decreases owners’ equity (and thus is a debit).

Following the rules of debits and credits, asset accounts have debit balances, and liabilities and owners’ equity accounts have credit balances. (Yes, a balance sheet account can have a wrong-way balance in unusual situations, such as cash having a credit balance because the business has written more checks than it has money for in its checking account.) The total of accounts with debit balances should equal the total of accounts with credit balances. When the total of debit balance accounts equals the total of credit balance accounts, the books are in balance.

Even when the books are in balance, errors are still possible. The bookkeeper may have recorded debits or credits in the wrong accounts, or may have entered wrong amounts, or may have missed recording some transactions altogether. Having balanced books simply means that the total of accounts with debit balances equals the total of accounts with credit balances. The important thing is whether the books (the accounts) have correct balances, which depends on whether all transactions and other developments have been recorded correctly.