In our continuing exploration of Luca Pacioli’s documentation of bookkeeping in 1494, this weeks’ video highlights the purpose of Debits and Credits.
Bookkeeping has a flow to it. Like raw materials through a production line, amounts in various accounts rarely are static. The balances increase, and decrease, and move from one account to another.
Debits and Credits simply make that movement happen.
In a recent dinner conversation, a large international bank Group Controller expressed great admiration for the simple accounting equation. She majored at university in Physics, and suggested that perhaps Newtons Laws of Physics were influenced in some way by the simply accounting equation. We discussed, as noted in Balancing Act (p. 22), my financial systems textbook, Debits and Credits make up “a journal entry….Why two rows? Because bookkeeping, the process of accounting, is based upon the accounting equation.
“The basis of the Balance Sheet is:
“Assets = Liabilities + Owner’s Equity.
“The Income Statement uses this equation:
“Net Income = Revenue – Expenses
“These equations and recording two rows for everything keeps the system ‘in balance’. It allows bookkeeping to check for errors in recording the information. If we remove time periods from the equation, or in other words assume that we only produce one Income Statement covering one’s entire life, then Owner’s Equity = Net Income. Then we can combine the balance sheet and income statement equations:
“Assets = Liabilities + (Revenue – Expenses)
“…We can use basic algebra to manipulate the accounting equation to be:
“Assets – Liabilities – Revenues + Expenses = 0
“You’ll remember again from basic algebra that you can do anything you like to an equality, such as the accounting equations listed above, as long as you (1) do the same thing to both sides of the equation, or (2) the net result of what you do to one side equals zero. All journal entries have a minimum of two entries to hold to that rule. The effect of the two entries equals zero…,” always keeping the accounting equation in balance.
Pacioli documented this simple by amazingly useful equation in his book over 500 years ago. This is Episode 118 of Conversations with Kip, the best financial system vlog there is.