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Accounting Part 4: Double-Sided Accounting
In this section I will discuss what is known as double-sided accounting. This is the fundamental way to populate your accounting records with transaction activity. From there you will be able to publish financial statements (as discussed in earlier sections) and perform any type of analysis that you deem necessary.
I'm going to start with an example in order to provide my way of recording entries using the double-sided method. Let's say you start your own business and open a checking account by depositing $1,000 which you borrowed from the bank. How do you code this on your books? Well you should ask yourself two questions: "What do I have and how did I get it?" The answer is you have cash so that means you have an asset because it has value. How did you get it? You borrowed it and since you know you have to pay it back then it means there is a claim on that asset meaning you have a liability. So on your books you would enter $1,000 for cash and $1,000 for a liability. In this way a person reviewing your books would see that while you have $1,000 in the bank you also owe this entire amount to a lender. This is how double-sided accounting works. It identifies not only the type of asset, it also identifies the source of the asset which helps identify how it should be classified.
Now let's say you provided consulting services to someone and charged them $1,000 which they pay to your company by check. Again we ask, "What do I have and how did I get it?" The answer is you have cash so you have an asset. How did you get it? You made a sale by providing consulting services so you book this cash as sales revenue which hits your income statement account.
Now there may be some real accountants reading this and they are thinking, "What about the pluses and minuses?" In other words, do you book the transactions as positive numbers or negative numbers or what? Well, I'll get to that in the next section because for now I just want to discuss the technique of correctly classifying your transactions.
How about another example? But this time it will be from the payment side of the ledger. Say you want to pay yourself a salary and you've decided you want that $1,000 you have from your consulting services sale; how should you book it? Well since the records are for your company you have to look at it like this: the company writes you a check for $1,000. So "what do I have and how did I get it" turns into "what did I do and why did I do it?" In this instance you paid $1,000 to an employee (Yourself!) so you would subtract from your cash balance of $2,000 leaving you with $1,000. Now you ask yourself "why did I do that" and you know you paid a salary to your employee so this becomes salary expense which goes on your income statement because salaries are a deductible expense.
There are probably a million questions in your mind (like how do I figure out what is a balance sheet account or an income statement account) but the point here is to think like an accountant which is to say you have to identify the characteristics of any transaction.
Another way to look at money you have received is to ask if you have to pay it back or not. If so, then you have cash and a liability. If you don't have to pay it back then you have cash and a sale (unless it's a refund of some sort but there are many examples of cash receipts and I'm trying to keep it simple). So... do you get to keep it or do you have to pay it back? That's the question.
It's the same with a payment. Do they get to keep it or do they have to pay you back? If they have to pay you back then you have lowered your cash by the amount you paid but you book a receivable for the same amount which is an asset because it has value to your company. If they don't have to pay you back (such as an employee being paid a salary) then you lower cash and book an expense to the income statement.
Hopefully this made some sense and if you read it several times and think about simple, common transactions you will see how asking these questions will help determine how to book your entries. I will cover this further in the next installment where I will talk about debits and credits (the pluses and minuses).
Accounting Part 3: Account Classification