Balance is key

A clip from the History Channel Documentary “The men who built America” shows a young J.P Morgan (who would grow to become one of America’s greatest financiers) being mentored by his father. In the clip, his father, Junius Morgan, hands him a stack of money to hold and weigh. Then he asks “Do you know what that is? That’s what it feels like to hold a million dollars in your hands. Now, you must learn how to earn it”. He ends the conversation with a stern order, “See to it that these books balance before I return”.
“…. See to it that these books balance….” What does this statement mean? Why is it so important for the books to be balanced? Perhaps, most importantly, what books are we referring to? By books, Junius Morgan was referring to the accounting records of his business. Financial transactions are recorded in accounting under a principle known as the double entry principle. This principle states that for every debit transaction, there is an equal and opposite credit transaction. In simple terms, for every time that value is gained in account A, an equal amount of value has been lost in account X. An example could be seen with a manufacturing company purchasing supplies to be used for production. As its bank account loses cash (credit transaction) which is used to purchase the supplies, its inventory account gains supplies amounting to the monetary value (cost) of the supplies purchased (debit transaction). In a sense, value is not lost but transferred from one form to another, each form captured by an account.
In the periodic reporting of a business’s financial activities, this ‘balance’ is usually indicated in the statement of financial position, otherwise known as the balance sheet. The statement of financial position captures the assets (resources that bring benefits to the company) of the business against its liabilities (financial obligations of the business) and its owners equity. It is captured using the equation below:
Assets = Liabilities + Owner’s equity
The equation above indicates that in every statement of financial position, the assets of the business must always be equal to the sum of its liabilities and owner’s equity. This ‘balance’ ensures that resources are accurately accounted for and that the flow of value across a business can be traced, thus preventing the loss of resources and fraudulent practices. While single entry records, which capture transactions as either a debit or credit in a single account, can be conveniently used by small businesses which typically have lesser volumes of transactions, double entry accounting shows a more complete picture of the financial activities of a business and is typically used by large businesses.
The statement of financial position is usually described as a snapshot statement. This is because while other financial statements are presented to cover a reporting period, the balance sheet shows the financial position of the business at a particular point in time. Double entry accounting ensures accuracy in the balance sheet and can be verified in the trial balance, which ensures that the sum of debit entries equals the sum of credit entries for an entity. Young J.P Morgan certainly had his hands full. We sure hope he made daddy proud!