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 equaling 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.
In the simple ‘worksheet method’, each balance sheet item has their column. Transactions are included in the rows, with ‘entries’ in the columns of the items that are affected by the transactions. Increases were added, and decreases subtracted. Even though this method would work (even for large volumes of transactions), this is not how accounting systems are organized.
In practice every balance sheet item has their own record, called a T-account. A T-account, as the name suggests, looks like a capital T, the left side is defined as ‘debit’ (or ‘D’) and the right side as ‘credit’ (or ‘C’). On one side additions are written, and on the other side subtractions. Which side is ‘+’ and which side ‘-’ depends on the type of T-account. See the figure below for the debit-and-credit rules for the different T-accounts.
Increases in assets (assets have a normal debit balance), are written on the debit side (and decreases on the credit side). Increases in liabilities and equity, which normally have a credit balance, are written on the credit side (and decreases on the debit side).
A straightforward way to remember the debit and credit rules is that T-accounts increase on same side (debit or credit) as the side on where it is normally presented on the balance sheet. Since assets are presented on the balance sheet’s debit side, it is natural to write an increase on the debit side of an asset’s T-account (and decreases in the credit side). Similarly, liabilities and equity are presented on the credit side of the balance sheet. Hence, increases for these T-accounts are included on the credit side of the T-account (and decreases on the debit side).
The value (balance) of a T-account is computed by balancing out the debit and credit side. For example, a T-account with total debits of 100 and total credits of 80 will have a debit balance of 20. A T-account can technically ‘switch’ from one side to another. For example, a credit of 7 to a T-account with a debit balance of 5 will result in a credit balance of 2. This switching can take place for a bank account when the balance of the bank account switches from positive and negative.
Which T-accounts does the firm need? A company is free to chose the number of T-accounts. Depending on the nature of the business detail may be required in different areas. For example, a consultancy firm may have a single T-account ‘vehicles’ to register the cost of the vehicles they own. A car rental firm probably requires more detail when it comes to accounting for the cars they own. Such a company could have T-accounts for different kind of cars such as sedans, SUV’s and trucks.
How transactions enter T-accounts
The journal is a chronological list of all transactions that have occurred. Each transaction enters the journal in a journal entry. The journal entry lists the T-accounts and the amounts that change as a result of the transaction. The journal entry follows the debit and credit rules discussed above. As a result, a journal entry is always balanced (total amount of debits equals the total of credits).
Jan 1: The firm is incorporated on the 1st of January, 20X0. The owner, Betty, pays 40,000 cash for 10,000 shares.
Following the accounting equation:
The following journal entry corresponds with this transaction:
Cash is an asset, which has a normal debit balance. Increases are written on the debit side of its T-account. Therefore, the 40,000 is written in the debit column of the journal entry.
Paid-in capital is part of equity. For equity T-accounts, increases are written on the credit side. Thus, the 40,000 appears in the credit column for Paid-in capital.
Using Temporary T-AccountsUsing the accounting equation for keeping the books for an actual business has one main drawback, which is that it is cumbersome to infer what caused equity to change, as only the level (the value at a point in time) of equity is available. In other words: revenues and expenses are not separately recorded. Using temporary T-accounts overcomes this drawback. Instead of changing the T-account ‘retained earnings’ as a result of revenues or expenses, additional T-accounts are used (such as ‘sales’, ‘wages expense’, ‘interest expense’, etc.). These T-accounts are called temporary T-accounts, as at the end of the accounting period their balances are booked into retained earnings. This way, the next period’s income statement starts with all zeros, while at the same time getting the balance sheet back into balance (as net income needs to be added to retained earnings). The balance sheet T-accounts are called permanent, because they are not cleared at year’s end.
Permanent T-accounts will show the amount or ‘stock’ at some point in time: Value = Beginning value + increases – decreases = Ending value
Temporary T-accounts will show the change, or ‘flow’, since the beginning balance is set to zero for these T-accounts: Value = 0 + increases – decreases = Change
Jan 15: ABCD Inc receives 3,000 cash for services delivered in January.
From Transactions to Financial Statements
Some readers may prefer to refer to the comprehensive example before studying the various steps involved as described in this section.
There are several steps from the recording of financial transactions to constructing the financial statements (each step is explained in more detail below):
– recording the transaction in a journal entry
– posting the journal entry to a log called ‘the journal’
– updating ‘the ledger’ which holds all T-accounts to reflect the newly posted journal entry
– at year’s end, adjusting entries are made
– at year’s end, temporary T-accounts are used to construct the income statement, which is added to retained earnings, and dividends declared are subtracted from retained earnings; in this step all temporary T-accounts are reset to zero
– at year’s end, the permanent T-accounts (included the updated retained earnings) are used to construct the balance sheet
Recording the transaction in a journal entry
As discussed above, transactions are recorded on T-accounts that are impacted by the transaction. For example, when a firm pays the electricity bill, the T-accounts cash and electricity expenses need to be updated with the amount paid.
Not all transactions are recorded. Usually when parties come to an agreement, but neither party performs their part of the deal, no transaction is recorded. For example, a customer places an order (which is legally binding), but does not pay yet. Also, the firm has not made a delivery. Only if at least one party delivers (either the customer pays, or the firm makes a delivery), a journal entry is made.
For accounting purposes, a transaction can also be the mere passing of time. Consider for example the effect of time on the value of a loan. A loan that is interest bearing will increase when time passes by. Journal entries that are made at year’s end to update the financial statements are called ‘end of year adjusting entries’.
Posting the journal entry to the log called ‘the journal
The ‘journal’ is a list of all journal entries that were made (in chronological order). It is used as a reference so that at a later point in time people can easily see which journal entries were made on a specific date. It is not helpful in constructing the actual values of T-accounts, as you will need to work through the whole journal to collect all entries to some T-account. For this purpose, the ledger is used (discussed next).
Updating ‘the ledger’ which holds all T-accounts to reflect the newly posted journal entry
The ‘ledger’ is a collection of all T-accounts and contains all the changes to these T-accounts. So, if you want to verify whether or not the actual amount of cash equals the amount of cash in the books, it can easily be determined by accessing the T-account cash from the ledger. This T-account will show all transactions involving the receipt or payment of cash and will show the balance.
Tax authorities require firms to keep several years of history of the ledger. With the ledger, the tax authorities can easily verify whether or not the firm has correctly applied fiscal law in the audited years.
At year’s end, adjusting entries are made
At year’s end, it is common that assets and liabilities need to be adjusted. For example, the firm has long term assets that gradually reduce in value. So, at year’s end, the decline in value for the period needs to be accounted for. Also, the liabilities may have changed. For example, over time, interest accrues on interest bearing liabilities.
The adjustments are booked with a journal entry and posted to the journal, just as any other transaction.
At year’s end, temporary T-accounts are used to construct the income statement, which is added to retained earnings, and dividends declared are subtracted from retained earnings; in this step all temporary T-accounts are reset to zero
In the process of making the financial statements, a list of all T-accounts with their balances is constructed, which is called the ‘trial balance’. It is important to realize that the trial balance is not a balance sheet, but rather a list of temporary T-accounts (expenses and revenues and dividends declared) as well as permanent T-accounts (assets, liabilities and equity).
The temporary T-accounts related to expenses and revenues are used to make the income statement, where net income equals total revenues minus total expenses.
As the trial balance is balanced (total debits equal total credits), net income is implicitly included twice in the trial balance. First, it is the balance of the temporary T-accounts. In case of a profit, the net balance of the temporary T-accounts will be a credit balance. Second, net income will be the net balance of the permanent T-accounts. In case of a profit, assets will have a higher balance than liabilities and equity. When temporary T-accounts are used, revenues and expenses were no longer added to retained earnings. In other words, net income needs to be added to retained earnings to have a balanced balance sheet.
When net income is know, the statement of retained earnings can be computed. During the year, all changes in retained earnings are booked on temporary T-accounts. Thus, retained earnings is not used during the year. Hence, the balance of this T-account on the trial balance will be last year’s ending balance. So, at year’s end this T-account needs to be updated. Retained earnings increases with net income of the year, and decreases with dividends declared. This step is performed by making a journal entry which resets all temporary T-accounts to zero, and transferring the balance to retained earnings.
Consider the following trial balance:
the journal entry to ‘close the books’ is the following:
Notice that all temporary T-accounts will have zero balances as a result of this entry. Even though net income is 20 (=100 – 50 – 30), retained earnings will increase by 5, as during the year 15 had been paid out as a dividend.
It is also possible to use an additional temporary T-account ‘Profit summary’. In this case, first all temporary T-accounts are cleared against this T-account (and not retained earnings). As a second step, the profit summary is added to retained earnings. The ending balance of retained earnings is the same for either method.
At year’s end, the permanent T-accounts (included the updated retained earnings) are used to construct the balance sheet
When the statement of retained earnings is made, construction of the balance sheet is straightforward. All permanent T-accounts (and their balances) are taken from the trial balance, while using the updated value for the balance of retained earnings. This will result in a balance sheet where total debits equal total credits.