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Basics of double entry accounting system

Basics of Double Entry Accounting System

Let me clarify one thing guys, double-entry accounting is not doubling of accounting. There is no risk that a transaction will be recorded twice or that you have to do double work. So don’t worry about the concerns which may arise on listening the term first time. It is a beautiful system which properly takes care of accounting entries, read below.

Background

If you are new to learn accounting then this would probably be the first article you should read after knowing definitions of assets, liabilities, income, expenses and capital here. This article shall lay foundation of your accounting concepts regarding double entry accounting system.

If you are a professional then this article would help in revising basic concepts of double entry and would erase your doubts, if there is any. If you are an accounting teacher or a mentor, then feel free to utilize explanations and definitions given in this article and share the link of this article with your students for their better understanding.

Before we talk about the double entry book keeping system, I would like to mention that a company’s accountant will have to open ‘accounts’ for each of the items of assets, liabilities, income and expenses etc. Every item for which a transaction needs to be recorded, an account of that particular head has to be opened, so that debit and credit transactions can be recorded there. For example, an account for ‘cash in hand’ has to be opened. If you are not aware of basic definitions of ‘assets’, ‘liabilities’, ‘books of accounts’ or ‘account’ etc. I would strongly recommend you to first read our article on definition of accounting terms.

What is Debit and what is Credit

Now what is a debit and what is a credit. We’ll not go on their literal English meanings. We’ll just treat these as two sides of the book where we are recording our transactions. Left-hand side is the debit side and right hand side is the credit side. Both debit and credit are opposite to each other and they negate each other. For example, if there are debit entries of $100 in one account and there are credit entries of $80 in the same account, then the net balance of that particular account shall be $20 ($100 minus $80).

We cannot say that a debit is a good thing or a bad thing. Similarly, a credit is a good thing or a bad thing. We also cannot say that a debit is an increase or a decrease. Similarly, we also cannot say that a credit is an increase or a decrease. IT ALL DEPENDS. So have to see differential scenarios. In some cases, debit indicates an increase and in some cases debit indicates a decrease. In some cases, debits are good while in some cases debits may not be liked by the management.

If you see “Dr.” in any accounting document, please note that it is not ‘doctor’. In accounting, “Dr.” normally refers to Debit and “Cr.” Refers to Credit.

Principles of debits and credits

There are 5 main classes of types of accounts in accounting. All of the accounting entries are booked under any of these classes. These 5 main classes are i) Assets, ii) Liabilities, iii) Income, iv) Expenses and v) Capital.

Below, we have provided a brief detail of the rule of debit and credit for each type of the account. When you have debit an account and when you have to credit an account. Ready these rules below first carefully and absorb them as much as possible. Then refer to the detailed examples given in the next section to enhance your understanding.

Assets: Whenever company’s purchases a new asset (i.e, increase in assets) then in the asset account a debit entry should be recorded. Whenever there is a decrease in assets (i.e., any asset is sold) a credit entry should be passed in an asset’s account. Please remember that this is just 1 side of the double entry. (Refer example 1 below)

Liabilities: When a company borrow’s money (or incurs any other liability), it should record a credit entry in that liability’s account. The principle is that liabilities are recorded as credit entries once they increase. Similarly, liabilities are recorded as debit entries once they decrease. (Refer example 5 below)

Income: Sales shall be recorded on the credit side of the sales account. A sales return/return (i.e., decrease in sales) shall be booked as debit entry in the sales account. (Refer example 2 below)

Expenses: Whenever a company shall incur an expense, that expense shall be recorded in the debit side of the expense account. So increase is expenses is always debited. Similarly, if there is any decrease in expense it will be recorded on the credit side of the account. However, decrease in expense is a rare scenario. (Refer example 3 below)

Capital: When capital increases, it is recorded on the ‘credit’ side of the capital account. When the capital decreases, it is booked as a debit entry in the books of accounts of the company. (Refer example 4 below)

Below tables shall be a key basic tool for you to understand debit and credit principles. Same principle has been explained in two different tables using different presentation style. Read both tables separately or together, they refer to same accounting principle.

Principles of debits and credits

Principles of double entry bookkeeping

Double entry book keeping system is based on the premise that every financial transaction has two aspects. One is referred to as ‘debit’ and the other is referred to as ‘credit’. These two terms (debit and credit) are very important to understand if you really want to have clear concept of double entry book keeping system. This will be base of your whole accounting knowledge.

The key concept here is “Every financial transaction has two aspects. One being debit and other being credit”.

This means that whatever financial transaction is performed, it will result in production of one debit entry and one credit entry, in the books of accounts of the company. That transaction may be sale of goods to customers, purchase of inventory from suppliers, paying of rental bills or consumption of electricity in the company’s office. Every financial transaction shall be recorded in two lines, one will be a debit line and other will be a credit line.

Examples of double entry

Now, we’ll look at detailed examples and utilize the above principles of double entry. Let’s try to create double entry for these transactions.

  1. Purchase of furniture worth $500 against paying cash.

Now, there are two sides of this transaction. First is the increase in company’s assets (i.e., by purchase of furniture) and second is the decrease cash (as cash is paid to the furniture seller). This example contains the cases where an asset (furniture) has increase while the other asset (cash) has decreased. It will be recorded as follows:

Account title

Debit

Credit

Furniture account

$500

Cash account

$500

  1. Sale of $100 to a customer for cash.

Now, apparently, this seems 1 transaction i.e., goods sold for $100 and collected cash. But from an accounting perspective, it has two implications (remember? Every transaction will have 2 entries i.e., 1 will be debit and 1 will be credit), the first implication is the increase in sales by $100 and second implication is increase in cash by same amount.

If we refer to above tables, increase in sales shall be entered as credit entry and increase in cash (asset) will be recorded as debit entry. So the double entry for the above transaction shall be recorded as follows:

Account title

Debit

Credit

Cash account

$100

Sales account

$100

  1. Let’s say that a cleaner was hired to clean the new office and he charged $30 to do the work.

This transaction has two aspects (one debit and one credit ). The debit aspect is that an expense has been incurred by the company (i.e, cleaning expense). This will be referred to as ‘increase in expenses’ and will be booked as a debit entry. The credit aspect of this transaction is that cash has been paid to the cleaner thus resulting in decrease of cash (decrease of asset). This decrease of asset shall be recorded as a credit entry.

Account title

Debit

Credit

Cleaning expense account

$30

Cash account

$30

  1. Capital entry of the businessman’s contribution to start the business.

Let’s say that Mr. Yamazaki commenced a business with an amount of $100,000. He deposited this money in the bank account of his enterprise. This will be an introduction of capital by the owner. This transaction has two aspects in the books of accounts of the business. Firstly, assets of the business has increased by a bank balance of $100,000. Secondly, owner’s capital has also increased by the same amount.

This increase in the bank balance shall be booked as a debit entry in ‘cash at bank account’ because this is an increase in the assets of the enterprise. Secondly, a credit entry shall be booked as increase in capital in the capital account of the owner.

Account title

Debit

Credit

Cash at bank account

$100,000

Capital account

$100,000

  1. If a company borrows money from a bank. This would result in increase in liabilities of the company because now it has an obligation to repay this loan to the entity. Therefore, this increase in liabilities shall be booked as a credit amount. Similarly, company’s own cash at bank will be increased because bank will transfer money in the company’s bank account. This second aspect of the transaction shall be booked as a debit.

Account title

Debit

Credit

Cash at bank account

$xxxxx

Loan from bank account

$xxxxx

In some cases, more than two accounts are also affected but total of all debits and credits should always be equal. Let’s take example of Mr. Sampochi. He purchased items worth of $3,000 but paid cash only $1,000 and promised to pay the rest of the amount after 2 months. Now, the accounting entry by the business will be as follows:

Account title

Debit

Credit

Cash in hand account

$1,000

Receivables from Mr. Sampochi

$2,000

Sales account

$3,000

Total of all debits and all credits in any double-entry should always be same.

Characteristics of double-entry

Double entry book keeping system has been in place for more than 600 years in the accounting history. This was a great invention and is still in place. There doesn’t seem to be any alternative of this in the near future as well. Below are some key properties of double entry accounting system:

  1. It ensures that every transaction is recorded with its both aspects i.e., debit and credit.
  2. This leads to ensuring that a balance trial balance is generated so that a balanced statement of financial position can be prepared easily.
  3. This helps in identifying missing transactions in case the accounting records are lost or burnt etc.
  4. In an entry where multiple accounts are involved, any shortage in debit or credit shall be alerted by system and would lead to instant identification of missing amounts while posting the entry. Thus, it helps in reduction of errors.

Single-entry accounting

Double entry can be contrasted with single-entry accounting system. Single-entry accounting system is very limited and in no way can compete with the double-entry accounting system. Therefore, single entry system is used in a very limited manner. Please refer to our detailed article on single-entry accounting for more information.

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