Luca Pacioli, inventor of double-entry accounting in 1494, probably had no idea how important double-entry bookkeeping would become to modern commerce. Even so, the requirement of equal offsetting debits and credits would become the cornerstone of financial reporting. Understanding the effect of double-entry accounting systems on financial statements can help you see how financial statements are built on a transactional basis.

Income Statement

Double-entry accounting systems help create the income statement by accumulating debits and credits to sales and expense accounts. When your company makes a sale, it's recorded as a credit to the sales account. In a double-entry system, there also has to be an offsetting credit. In this case, you want to record the receipt of cash with a debit to the cash account. While you record half of the transaction on the income statement and half on the balance sheet, the entry, in total, balances. Double-entry accounting systems require that each entry has an equal debit and credit side.

Balance Sheet

The balance sheet provides financial statement users with a snapshot of the financial position of the company at a point in time. This financial statement is created as a product of the fundamental accounting identity. That is, assets must always equal liabilities plus equity. Double-entry systems help preserve this identify. For example, if you debit an asset account to increase an asset balance, you'll need an offsetting credit. By no coincidence, credits to liability and equity accounts increase the balance of these accounts. Therefore a debit to assets and a credit to liabilities or equity keeps the accounting equation correct and the balance sheet remains in balance.

Statement of Owners' Equity

The statement of owners' equity presents financial statement users with information about transactions between the company and ownership. Debits to equity accounts reduce account balances, while credits increase account balances. Double-entry accounting systems allow for investments and withdrawals with owners to be reconciled with the addition and removal of cash and other assets to the business. For example, if you, as the owner, were to write yourself a check for $2,000 to reflect money withdrawn from the business, you would record a debit to reduce owner's equity and a credit to reduce cash. The same process happens in reverse for investment in the company. The company would record a debit to cash and a credit to owner's equity for an investment in the company. To record any activity in a double-entry accounting system, both sides of the journal entry must be recorded.

Statement of Cash Flows

The statement of cash flows provides financial statement users with sources and uses of the company's cash. Accrual accounting principles require that companies make entries in the books when they incur costs and recognize revenues. However, this is often different than when cash changes hands. Therefore, other financial statements do not provide much useful information about changes in cash. Double-entry accounting is the backbone for preparing the statement of cash flows. For most businesses, the actual preparation of the statement of cash flows involves a complex series of steps to reconcile cash and business activity. However, these steps would not be possible without the offsetting of debits and credits throughout the company's business cycle.