Double Entry Accounting for Engineers

Accounting is the estimation and tracking of value in a company. Double entry accounting is the method that accountants use to track the movement of that value in, out, and within a business. Cash that you have earned, is of course everyone's favorite thing to track.

This tracking is based on a simple equation, and algebra says we can change an equation as long the changes are the same on both sides of the equation. Simple algebra is no problem for an engineer.

The problem that someone with a math background runs into is that accountants have created their own language to describe changes to that equation. This language is unheard of in standard algebra, uses words you've heard before in a different way, and most accounting texts gloss over this issue. This document is a basic guide to help bridge that divide.

The accounting equation

The accounting equation is the simplest possible view of a company.

Assets = Liability + Owner's Equity

Simple and elegant, you can represent changes in your company by changing this equation using algebra. The rule is, the changes on each side of the equation, and therefore the equation itself, always have to balance

Basic algebra on the accounting equation

Let's look at how you can change the variables in this equation. Let's say you get a check for $100 because you designed a part for a client. Your assets go up $100, and your owner's equity goes up as well. Owner's equity is what you get to keep if you close down the business today.

Let's say you buy a set of socket wrenches at the store for $50. You use a credit card. Your assets increase $50 and your liabilities increase to match. You owe that $50 to the credit card company.

Let's say you take some of your cash and mail it to the credit card company. You decrease assets by $50 and decrease liability by $50.

Note that every time you make a change you are changing two things. Everything must balance. You can't change only one part of an equation and have it still balance. This is the nature of double entry accounting.

Did I say double entry? I meant multiple entry.

Of course you can change more than two things in an equation, as long as the changes balance. Accountants still call it double entry though.

Let's say you buy a milling machine for $2000. The terms are $300 down and you have 30 days to pay off the other $1700. You decrease assets by $300 (the cash you paid), increase assets by $2000 (the machine was delivered) and increase liabilities by $1700 (they will come after you if you don't pay up in 30 days). 2000 - 300 = 1700.

That's right. Assets can be cash, tangible items, or even intangible items. We can safely call it "stuff". When you trade cash for "stuff" you are only modifying the left hand side of the equation. As long as that equation still balances we are okay.

Accountants have to track changes to the accounting equation. Alot of changes. In some cases millions of changes. They invented words to help describe these changes. The two main words are debit and credit. The confusion comes from the fact that you've head these words before. One sounds bad and one sounds good. These definitions from your life are useless here. Throw them out the window.

Debit - A debit is a increase on the left hand side of the equation, OR a decrease on the right hand side of the equation.

Credit - A credit is an increase on the right hand side of the equation OR a decrease on the left hand side of the equation.

What the heck? They both have two meanings?

Yes. This sounds crazy until you realize that when you define the terms this way, you ALWAYS have a debit and credit. Buy a $30 software program and you debit assets (you have your software program in hand) for $30 and you credit assets (you spent cash) for $30. If you had used a credit card you would debit assets for $30 (you have your software program in hand) and credit liabilities for $30 (you owe money). Always at least one debit and at least one credit (described in that order), and they always balance the accounting equation.

When accountants talk about balancing the books, they are checking to see that debits and credits balance.

Tracking value with accounts...

Clearly, if you want to keep track of your stuff, you can't use just one tally. Therefore you break each part of the accounting equation into different sub-divisions. We call these sub-divisions accounts. When you are talking about a specific accounts you need to know the name of the account and what type of account it is. You can then rewrite the accounting equation in a way that makes sense to you.

Assets = Liability + Owner's Equity

becomes...

(bank account + piggy bank + power tools) = (bank loan + loan from favorite uncle) + (my equity + my partner's equity)

How accountants burn money...

That's all fine and good, but what about when you spend money and you don't end up with anything? What if you buy 100 lbs of ice and it melts? You had an asset, cash, and now a few hours later you have nothing to show for it. Poof!

To account for temporary changes you use expense and income accounts. You re-write the accounting equation in an expanded form like this...

Assets + Expenses = Liability + Owner's Equity + Income.

So when you buy that $25 worth of ice you debit "picnic expenses" for $25 and credit cash for $25. When you get get $100 for designing a widget you debit cash for $100 and you credit "design income" for $100. Debiting cash sounds like a bad thing, but when you do it with money you have earned it is a good thing.

At the end of the accounting period, you cancel out the expense and income accounts using the owner's equity. If incomes were larger than expenses you made money and increased owner's equity. The opposite and you lost money.

The difference between expenses and assets...

When you pay rent, it doesn't do you any good the day after that month is finished, it is an expense.

An asset is something that you have and could resell. For instance, if you buy a computer, you could sell it to someone, albeit for less than you probably paid for it. It is an asset. Things you buy in order to resell them are inventory assets. Equipment you buy that is used in business but you don't sell are fixed assets. The problem is that things do lose value, break down, and get thrown out.

What happens when your car breaks down?

Accounting is the estimation and tracking of value in a company. The keyword is estimation. You know when you buy a car exactly how much it is worth. You know when you drive it off the lot it's worth alot less. Exactly how much? Do you decide the car will last ten years and write off 1/10th of the value every year? What mathematical equation best represents reality?

Moving value from assets to expenses to is called depreciation.

This is where the mathematicians leave the building and the lawyers and politicians walk in. If you can say you have less than you do, you pay less taxes. You say your car has lost $3000 in value, you might end up paying $1000 less in taxes. Because of this issue, the IRS closely regulates what assets you can depreciate and when. Because no approximation can come close to reality in every situation, you and your accountant look at which approximation allowed by the IRS works out best to lower your taxes.

How to make money by selling widgets... moving from inventory to income.

If you buy some raw material, say 10 pounds of stainless steel, there is no expense or income, just a change in assets. If you start making something with that material, you move the asset from raw materials to the work-in-progress account. When that item is finished, you move it to inventory. Even though you've spent time working on it and you could sell it for more than you bought the raw material, you don't recognize the change in value. You have to sell it and generate income to increase the owner's equity. Let's say you sell something that cost you $3 to make for $10. You debit cash for $10, credit income for $10, debit cost of goods sold for $3 and credit inventory for $3.

The key issue here is the fact that cost of goods sold (COGS) is deductible on your taxes, while inventory is not. If you trade $1000 in cash for $1000 worth of goods, the IRS doesn't care. If you sell half of those goods for $3000, you now have $500 in COGS, which you can subtract from the $3000 you made, meaning you only get taxed on $2500.

Approaching reality constrained by convenience and the IRS

For more information, see the Wikipedia entry for Double Entry Bookkeeping.

Copyright © 2005 - 2007 by Jeff Albro. All rights reserved.