The accounting equation and double entry
Everything in financial accounting rests on one equation: assets equal liabilities plus equity. Assets are what the business owns, liabilities are what it owes and equity is the owner's claim on what is left. Every transaction changes at least two accounts so that the equation always stays in balance. That is what double entry means.
To record a transaction, you ask three questions. Which accounts are affected? Is each one increasing or decreasing? And therefore does each get a debit or a credit? A debit is simply the left side of an account and a credit is the right side. They are not good or bad, and they do not mean increase or decrease on their own. Whether a debit increases or decreases an account depends on the type of account.
The debit and credit rules
| Account type | Normal balance | Debit | Credit | Examples |
|---|---|---|---|---|
| Asset | Debit | Increases | Decreases | Cash, accounts receivable, supplies, equipment |
| Liability | Credit | Decreases | Increases | Accounts payable, wages payable, loans |
| Owner's equity (capital) | Credit | Decreases | Increases | Owner's capital |
| Drawings or dividends | Debit | Increases | Decreases | Owner's drawings |
| Revenue | Credit | Decreases | Increases | Service revenue, sales |
| Expense | Debit | Increases | Decreases | Wages expense, rent expense, supplies expense |
A simple way to remember it: assets and expenses increase with debits, and everything else increases with credits. Equity, drawings, revenue and expenses all sit inside the equation, which is why the signs work out. Total debits must always equal total credits.
The accounting cycle step by step
The accounting cycle is the repeating routine that takes raw transactions to financial statements. Most textbooks list the steps like this.
| Step | What happens | Output |
|---|---|---|
| 1. Analyze transactions | Decide which documents and events must be recorded and what they affect | Source documents analyzed |
| 2. Journalize | Record each transaction in the general journal in date order | Journal entries |
| 3. Post to the ledger | Copy the debits and credits into individual accounts | General ledger balances |
| 4. Prepare an unadjusted trial balance | List every account balance and check debits equal credits | Unadjusted trial balance |
| 5. Make adjusting entries | Bring revenue and expenses into the right period | Adjusting entries |
| 6. Prepare an adjusted trial balance | Recheck that the books balance after adjustments | Adjusted trial balance |
| 7. Prepare financial statements | Income statement, statement of equity, balance sheet and cash flows | Financial statements |
| 8. Close the books | Transfer revenue, expense and drawings balances to equity | Closing entries |
| 9. Prepare a post-closing trial balance | Confirm only permanent accounts remain, with balanced totals | Post-closing trial balance |
A worked month: Bright Lawn Services
Bright Lawn Services is a hypothetical lawn-care business that starts in June. Here are its transactions and the journal entry for each.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Jun 1 | Cash | 10,000 | |
| Owner's Capital | 10,000 | ||
| Jun 2 | Equipment | 4,800 | |
| Cash | 4,800 | ||
| Jun 3 | Supplies | 600 | |
| Accounts Payable | 600 | ||
| Jun 10 | Cash | 2,500 | |
| Service Revenue | 2,500 | ||
| Jun 15 | Accounts Receivable | 1,800 | |
| Service Revenue | 1,800 | ||
| Jun 20 | Wages Expense | 1,200 | |
| Cash | 1,200 | ||
| Jun 25 | Cash | 1,000 | |
| Accounts Receivable | 1,000 | ||
| Jun 28 | Accounts Payable | 300 | |
| Cash | 300 | ||
| Jun 30 | Owner's Drawings | 500 | |
| Cash | 500 |
The entries in plain words: the owner invests $10,000 cash; buys $4,800 of equipment for cash; buys $600 of supplies on credit; earns $2,500 cash from services; earns $1,800 on account; pays $1,200 of wages; collects $1,000 from a customer; pays $300 to the supplier; and withdraws $500.
After posting, the balances give this unadjusted trial balance. Cash is 10,000 minus 4,800 plus 2,500 minus 1,200 plus 1,000 minus 300 minus 500, which is 6,700. Accounts receivable is 1,800 minus 1,000, which is 800. Accounts payable is 600 minus 300, which is 300.
| Account | Debit | Credit |
|---|---|---|
| Cash | 6,700 | |
| Accounts Receivable | 800 | |
| Supplies | 600 | |
| Equipment | 4,800 | |
| Accounts Payable | 300 | |
| Owner's Capital | 10,000 | |
| Owner's Drawings | 500 | |
| Service Revenue | 4,300 | |
| Wages Expense | 1,200 | |
| Totals | 14,600 | 14,600 |
Debits and credits both total 14,600, so the books balance. A trial balance that balances does not prove every entry is right, because an entry posted to the wrong account still balances. But one that does not balance proves there is an error.
Adjusting entries
Transactions are recorded when cash moves or an invoice is raised, but profit must be measured when revenue is earned and expenses are incurred. Adjusting entries fix the timing at the end of the period. There are four standard types.
| Type | What it handles | Typical entry |
|---|---|---|
| Accrued expense | An expense incurred but not yet paid or recorded | Debit expense, credit payable (for example wages) |
| Accrued revenue | Revenue earned but not yet billed or received | Debit receivable, credit revenue |
| Deferred (prepaid) expense | Cash paid in advance, used up over time | Debit expense, credit prepaid asset (for example supplies used) |
| Deferred (unearned) revenue | Cash received in advance, earned over time | Debit unearned revenue, credit revenue |
| Depreciation | Spreading the cost of equipment over its useful life | Debit depreciation expense, credit accumulated depreciation |
For Bright Lawn at June 30, three adjustments are needed.
| Adjustment | Debit | Credit | Amount | Working |
|---|---|---|---|---|
| Supplies used | Supplies Expense | Supplies | 250 | Supplies on hand count shows 350 left of the 600 bought |
| Depreciation | Depreciation Expense | Accumulated Depreciation | 80 | 4,800 over a five-year (60 month) life, no residual value, is 80 a month |
| Accrued wages | Wages Expense | Wages Payable | 200 | Workers earned 200 that will be paid in July |
After the adjustments, wages expense is 1,400 (1,200 plus 200), supplies expense is 250 and depreciation expense is 80. Total expenses are 1,730. With revenue of 4,300, net income is 2,570.
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Get an instant quoteClosing entries
Revenue, expense and drawings accounts are temporary. They measure one period and then start again at zero. Closing entries move their balances into owner's equity.
| Entry | Debit | Credit | Amount |
|---|---|---|---|
| Close revenue | Service Revenue | Income Summary | 4,300 |
| Close expenses | Income Summary | Wages Expense 1,400; Supplies Expense 250; Depreciation Expense 80 | 1,730 |
| Close Income Summary | Income Summary | Owner's Capital | 2,570 |
| Close drawings | Owner's Capital | Owner's Drawings | 500 |
Owner's capital now stands at 10,000 plus 2,570 minus 500, which is 12,070. The balance sheet confirms the books are right: assets are cash 6,700, receivables 800, supplies 350, equipment 4,800 less accumulated depreciation 80, which is 12,570. Liabilities are 500 (payables 300 plus wages payable 200) and equity is 12,070. Liabilities plus equity are 12,570, which equals the assets. Our guide on preparing financial statements uses these same numbers.
Practice problems with solutions
Try each one on paper first, then check against the solution.
Problem 1: prepaid insurance
On April 1 a business pays $2,400 for a 12-month insurance policy. Record the payment, then the adjusting entry needed at December 31.
Solution. Payment: debit Prepaid Insurance 2,400, credit Cash 2,400. Insurance costs 2,400 / 12 = $200 a month. From April 1 to December 31 is 9 months, so 1,800 has been used up. Adjusting entry: debit Insurance Expense 1,800, credit Prepaid Insurance 1,800. The remaining Prepaid Insurance of 600 is an asset covering the next three months.
Problem 2: unearned revenue
On November 1 a customer pays $3,000 in advance for six months of service. Record the receipt and the adjusting entry at December 31.
Solution. Receipt: debit Cash 3,000, credit Unearned Revenue 3,000, because the service has not been performed yet and the business owes it. Two months (November and December) have been earned, which is 3,000 / 6 x 2 = $1,000. Adjusting entry: debit Unearned Revenue 1,000, credit Service Revenue 1,000. A liability of 2,000 remains.
Problem 3: accrued wages
Weekly payroll of $4,000 covers Monday to Friday and is paid on Friday. December 31 falls on a Wednesday. Record the adjusting entry.
Solution. Three of the five working days (Monday, Tuesday, Wednesday) have been worked but not paid, so the accrual is 4,000 x 3 / 5 = $2,400. Adjusting entry: debit Wages Expense 2,400, credit Wages Payable 2,400. When the next payday arrives, debit Wages Payable 2,400 and Wages Expense 1,600 and credit Cash 4,000, which avoids counting the 2,400 twice.
Common errors and how to find them
| Symptom | Likely cause | What to check |
|---|---|---|
| Trial balance is out by an exact multiple of 9 | Transposed digits, such as 540 recorded as 450 | Compare each posted amount with the journal |
| Out by exactly half the difference | A debit posted as a credit, or the reverse | Look for an amount equal to half the gap |
| Out by a round number | A missing amount or a one-sided posting | Check that each entry has both sides posted |
| Balanced but statements look wrong | Wrong account used, or missing adjustments | Review account choices and adjusting entries |
| Equity does not reconcile | Drawings or net income treated incorrectly | Roll forward equity: opening plus net income minus drawings |
Format matters in an assignment
Show the date, the account titles with the debit first and the credit indented, the amounts in separate columns and a short explanation if requested. Marks are often lost for correct numbers in an unreadable layout.
Checklist before you submit
- Does every entry have equal debits and credits?
- Have you used the right account for each item, and the right side for its type?
- Does the trial balance balance, before and after adjustments?
- Have you made all the adjustments: accruals, deferrals and depreciation?
- Do the closing entries leave only balance sheet accounts open?
- Does the final balance sheet satisfy assets equals liabilities plus equity?
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