Debits and credits

OneThe accounting equation

Everything a business controls was funded by somebody. Either an outsider lent it, or the owners provided it and left the profits in. That gives the identity on which the whole system rests:

Assets = Liabilities + Equity

This is not a rule imposed on the accounts. It is a description of what the accounts are. Because each transaction is recorded twice, once as a debit and once as a credit, the equation cannot fall out of balance unless somebody makes a mistake.

Notice the symmetry. The two categories that increase by debit, assets and expenses, are both uses of resources. The three that increase by credit, liabilities, equity, and income, are all sources of them. Debits record where value went; credits record where it came from.

TwoPosting the ledger

Below are ten transactions from the company's first period. For each, choose the account to debit and the account to credit. Entries are posted to the ledger as you go, and the trial balance beneath assembles itself from what you have recorded.

Work out the two effects before you answer. Ask what the company received, and what it gave up or owes as a result.

ThreeWhat a balanced trial balance does not prove

A trial balance that agrees tells you the debits equal the credits. It does not tell you the entries were right. Six classes of error leave the totals in perfect agreement, which is why agreement is a weak form of assurance rather than a strong one.

This matters well beyond the classroom. If the arithmetic can agree while the substance is wrong, then the reliability of published accounts depends on judgement, incentive, and audit rather than on the mechanics of the system. Much of what interests me as a historian sits in that gap.

FourWhere the technique becomes historical

The final transaction above moved £1,500 from retained earnings to a renewals reserve. Mechanically it is trivial: a debit and a credit, both inside equity, leaving total equity unchanged and total assets untouched. Nothing enters or leaves the company.

Its consequences were not trivial at all. Profits carried to a named reserve were, in the ordinary course, no longer available for distribution. A board that wished to resist pressure for a larger dividend, or to make the company appear less profitable to a government contemplating a tax or a renegotiated concession, could achieve a great deal through that one entry.

For a British firm operating under a foreign jurisdiction, this was a serious instrument. Reserves could be layered so that capital remained portable across a hostile border. Profits could be sheltered from a fiscal authority with a claim on them. The accounts reported, but they also concealed, and the same entry did both jobs at once.

That question runs through my research on accounting choice under political risk, and it is the reason double entry is worth learning properly rather than merely passing.

FiveCheck yourself

Eight questions on the material above. Answers and reasoning appear as you go.