ABSTRACT
A basic foundation of modern accounting recognizes that every financial action has two distinct, interrelated, and opposite impacts. This method goes back hundreds of years to Italy (see Lee 1977).
financial situation remains in balance. In double entry bookkeeping, all financial activities are dealt with using this systematic, two-step/two-account approach. Unless a clerical mistake is made, the two sides of the equation will always remain in balance. Happily, modern accounting software prevents simple mathematical mistakes. The key formulation of accounting is typically presented as:
Assets = Liabilities + Equity
In this presentation, “Assets” are everything that is owned by the individual or the organization, “Liabilities” are the total obligations or debts, and “Equity” is whatever is left over (i.e. what the owner possesses “free and clear” after all the debts have been taken into account). When double entry bookkeeping is used, a particular transaction impacts both the Assets and the Liabilities/Equity sides of the equation, keeping them in balance. Although this method of double entry bookkeeping accounting is systematic, in some situations it might inadvertently misrepresent the actual value of an asset. If a factory is acquired and its value is depreciated by 10 percent of the purchase price every year, in ten years, the value of the factory “on the books” would be $0.00. In reality, of course, if the factory has been maintained in a responsible manner, it would continue to have a significant value although naïve double entry bookkeeping would not recognize this worth. Of course, the accounting profession has responded to these possibilities with the development and utilization of more accurate methods of appraisal such as “fair value methods” (see Arya and Reinstein 2010); nonetheless, examples such as this demonstrate the possibility of imprecision. The opposite is also true. An obsolete piece of equipment might have a $100,000 value “on the books” even though the true worth might be $0.00 (or a minimal scrap value). Once again some form of fair valuation can be of service under such circumstances. Nonetheless, accounting systems are not perfect and human judgement is often useful when actual evaluations and decisions are made. In double entry bookkeeping, all financial activities are initially entered in the “Ledger” which is an ongoing diary of financial exchanges that are recorded approximately when they occur. These transactions are eventually reconciled in what is called a “trial balance” in which the entries in the Ledger (that are recorded in the order in which they occurred) are placed into their appropriate categories and reconciled. This systematic and better organized record is used to create a number of important financial documents. Although the theoretic and practitioner underpinning of this method is simple, the actual application can be very complex because in most cases
equation are kept in balance. It is also useful to remember (as we saw above) that financial accounting, even when done correctly and honestly, might not reflect the true value of assets. The information created by double entry bookkeeping is used for various branches of accounting, such as financial and managerial accounting. Each is discussed below.
