What is the Double Entry Accounting System?
If you have spent any time preparing or learning how to prepare financial statements you have likely heard the term double entry, but exactly what is the double entry accounting system?
To help better understand the double entry accounting system we first need to ask, how do you know if a business is making profit? You find this by simply accounting for all the income and expenses of business operations. Without accounting, there is no proof of profit or loss and the entrepreneur will not know if they are achieving the primary objective of conducting business.
Accounting has been around in various forms for thousands of years. Counting of stock, keeping journals and tax collection reports etc. are some of the examples which formed the early accounting practices. This was all recorded in linear statements or ‘single entry system’ format until the introduction of ‘double entry accounting system’ in the year 1494 by Luca Pacioli, an Italian known as ‘The Father of Accounting’.
The double entry accounting system was game changing for recording financial transactions and revolutionized the way accounting books were kept. This method uses two separate accounts for recording a single transaction using ‘debit’ and ‘credit’. According to this method, debits in recording a financial transaction should always equal credits. Two or more accounts used in recording every transaction can be of the same class or different classes e.g. change in two different asset accounts or change in one asset and one liability account.
So, for example if a company transfers $100 cash into its bank account, the resulting transaction will include changes in two different asset accounts i.e.
Bank Account debit by $100
Cash Account Credit by $100
In another instance, if the company buys goods on credit for $250, the transaction recording will include two different classes of account i.e. asset and liability
Purchases Asset Account Debit by $250
Payables Liability Account Credit by $250.
The double entry system ensures the balancing of the accounting equation.
Accounting Equation: Capital = Assets – Liabilities
In our first example of transaction recording, one asset increased by $100 and another decreased by $100, resulting in the asset value remaining the same. In the second example, assets and liabilities both increased by the same amount and hence the capital value in the accounting equation would again remain the same.
There are many benefits of double entry accounting system as compared to single entry accounting system. E.g.
The double entry system lets us prepare financial statements which are used for many purposes including business analysis, providing operating information to investors, securing loans by presenting the financial results, making financial analysis and budgets etc.
Different Account heads:
The double entry system enables us to categorize each transaction into a distinct class of accounts e.g. current and long term assets, short and long term liabilities, revenue and expense etc. This helps in better understanding of the financial results and financial position of a business.
Control Mechanism and Uniformity:
The double entry system also provides a control mechanism with its requirement of debits equalling credits. Errors can be identified easily and then rectified. It also enables the standardization of the preparation and presentation of financial reports. GAAPS and IFRS that are applicable on financial statements rely on the double entry system for preparing financial statements in a standard format. Furthermore, the application of accounting principles e.g. matching, going concern etc. also requires that the double entry accounting system to be used.
The double entry accounting system holds paramount importance in today’s financial recording methods across the globe.