Accountants refer to it as “Double-Entry Principle,” but I call it the “Law of Double-Entry.” It is the law upon which modern accounting derives its validity and credibility; it is the same law that controls the monetary policies of all nations.
The Law of Double-Entry states that, for every transaction, the sum of all the debit entries must be equal to the sum of all the credit entries, and vice versa:
Total Debit(s) = Total Credit(s) ………………………….. (1)
This implies that every accounting transaction must result in at least two entries: the debit(s) part and the credit(s) part—and the sum of all the debit entries must be equal to the sum of all the credit entries.
This is an important accounting law, which provides both the heuristics and mathematical foundation for accounting. Ensuring that both the sources and destinations of all financial transactions are accounted for provides the basis for accountability. This, to me, should be the first rule of accountability—a transparently self-accounting system where both the sources and the destinations of money are clearly specified or accounted for. This will eliminate every black hole and expose all the sinks.
If we regard the first equation as an expression of the basic law of accounting, then the corollary to this law is the one that states that the sum of all Assets must be equal to the sum of all the Liabilities plus Equity:
Total Assets = Total Liabilities + Total Equity ………… (2)
The first equation applies to individual transactions, while the second equation applies to the entire book (all the accounts combined). It is a Balance Sheet equation that tells us that everything is in order as far as our postings are concerned. It is a corollary because if the first equation is satisfied for all the transactions, then the second one will follow, invariably.
When all the accounting entries comply with these two laws the balance resulting from subtracting all the credits from all the debits will be zero; the balance resulting from subtracting the total of all liabilities from the total of all assets will be the equity. If any of these fail, then there is a problem, and the accountant will have to find the problem and fix it before he or she can sleep well. Have you ever heard the statement “account is not balanced?” It is a very bad news that means the account has not satisfied the law of Double-Entry. It could connote one of the following: either there is an error or fraud in the system.
Now let us rewrite equation (2) by changing the subject of the formula:
Total Equity = Total Assets – Total Liabilities ………….. (3)
If we define liabilities as claims against assets, what this equation tells us is that if we want to become wealthy we have to increase our equity (or net worth), by making sure that our assets are higher than our liabilities. This may be common sense, anyway.
But let us recast equation (4) in a different form:
Total Assets – Total Liabilities – Total Equity = 0 …….. (4)
We can see from equation (4) that we are operating in a self-sustaining ecosystem where nothing is created or destroyed but can only be transformed from one form to another. You will disrupt this system if you introduce anything that violates the law of Double-Entry—something that will make equation (4) to yield a non-zero value. Unwholesome government interventions in monetary policies can easily disrupt this balance, thereby leading to either a positive or negative value for equation (4). A positive value will result in inflation, while a negative value will result in deflation. That is why inflation results when a government decides to print more money to fund its budget. That is a clear violation of the Law of Double-Entry.
Similarity with Natural Laws of Physics…
Double-entry is not just an accounting principle; it is a natural law that conforms to all empirical observations and measurements in our physical and economic ecosystems. Apart from providing a universal way of measuring and managing wealth, it is also an ethical formulation that provides a basis for accountability at the corporate, national and private levels.
We can also see a clear similarity between this accounting law and some of the known laws of Physics: Newton’s Third Law of Motion, which states that “Action and Reaction are equal and opposite;” the First Law of Thermodynamics, which also states that “Matter can neither be created nor destroyed, but can only be transformed from one form to another….” This is why I regard Double-Entry as not just a principle, but a law which provides the basis for accountability and economic stability at both the micro and macro levels.
You can find practical examples on double-entry transactions in my book IFRS ACCOUNTING MANUAL FOR SMALL BUSINESSES, available in Amazon Kindle Store.