Double Entry system of accounting
Double Entry Accounting is the system of accounting in which each transaction has equal debit and credit effects, thus ensuring that the accounting equation remains in balance.
History of Double Entry System of Accounting
The double entry system of accounting was first introduced by an Italian mathematician “Fra Luca Pacioli” who wrote the first book on double entry system of accounting entitled “De-Computis-et-Scripturis”. It was first published in Venice in 1544. Vinice had trade relations with different parts of the world through trade channels and the double-entry system was introduced in Great Britain and other parts of the world.
What is a Double Entry System of Accounting? – Definition
Every business transaction has two effects or changes and the system under which both the changes in a transaction (one change is debited, while the other change is credited) are recorded together with an equal amount, is known as “Double Entry System“.
The concept of the double entry system
The double entry system is much superior to a single entry system of accounting and all significant businesses keep their accounting records in this way. At the heart of the double-entry system of accounting is the concept that every transaction involves both the giving of a benefit and the receiving of a benefit. Consequently, every transaction is written into the book twice, once as a debit and once as credit. It follows that the bookkeeping system must always balance, which is a big advantage. Some types of mistakes will cause the system to be out of balance, and as a result, the bookkeeper will be alerted to a problem.
Double-entry should not be taken to imply that two transactions are entered. it means that an inherent feature of a single transaction is that it is entered into two different accounts, in one as a debit and in one as a credit.
Consider as an example a cheque for $5,000 to insure the company cars. $5,000 is entered in the insurance account as a debit. this account will eventually be a charge in the profit and loss account. At the same time, $5,000 will be credited to the Bank Account. This reduces the balance of money in the bank or increases the overdraft. The balance of the bank account will eventually appear in the balance sheet.
This system is named the double-entry system because every transaction has two aspects and both are recorded under this system. Every transaction involves two aspects one aspect involves the receiving of benefit and other of giving benefit. This can also be termed as two-fold aspects. The account which receives the benefit is debited and the account which gives benefit is credited. It should be noted that debit and credit accounts must be equal.
Under the double entry system of accounting, each business transaction affects at least two accounts. One of these accounts must be debited and the other credited, both with equal amounts. The total of all debit entries therefore always equal to the total of all credit entries. This is a very important fact and is called the golden rule of accounting – debits must always equal credits.
Since every transaction affects at least two accounts, we must make two entries for each transaction to fully record its impact in books of account. One of the entries is a debit entry and the other a credit entry, both of equal amounts. This is what we call the double-entry system of accounting.
Very simply, a double-entry system states that at least two entries must be made for each business transaction, one a debit entry and another a credit entry, both of equal amounts. Nowadays, the double-entry system of accounting is used all over the world as it is the only reliable system of recording business transactions.
Three basic rules of double entry system of accounting
The founding father of the double entry system was a Franciscan monk called Luca Pacioli. He did not invent it, but in 1493 he wrote down the principles of the system being used by himself and others.
Given his calling, he must have been a man of considerable education and wide-ranging interests. His work has stood the test of time because the fundamental principles are timeless. if he was able to visit a modern accounts office, once computers had been explained to him he would recognize that his principles were still being applied.
The bookkeeping system (the ledger) will contain a number of accounts, perhaps just a few or perhaps many thousands. The above section of this article gave an example of a cheque for $5,000 paying an insurance premium. this resulted in postings to the Insurance Account and the Bank Account. Each account has a separate page in the ledger, though in practice the records are likely to be computerized. In a manual system, the layout of each account will be the same. The following show the two entries resulting from the payment of the insurance premium.
As you look at these accounts please keep in mind:
- They might seem rather cramped, but in reality, the paper would almost certainly be considerably wider than this book.
- Debit is often abbreviated to ‘Dr’ and credit is often abbreviated to ‘Cr’.
- The entry may incorporate a folio reference. This is not shown but it enables each entry to be cross-referenced to the correct input document.
It is time now to list and explain three fundamental rules that apply today and which Luca Pacioli would undoubtedly recognize.
1. Debit on the left, credit on the right
Why this way round? It does not matter so long as everyone does it the same way. It is rather like driving – it does not matter which side of the road we drive so long as everyone follows the same law or convention. a long time ago most people did it this way, so that’s the way we all do it.
On my first morning as a trainee accountant, I was told that debit was nearest the window and that it was best not to talk to the boss until he had had a cup of tea. I found both pieces of advice invaluable, but I always sat with my left shoulder next to the glass.
2. Debit receives the benefit, credit gives the benefit
Again, why this way round? Again, because it was decided a long time ago and that’s the way it is. The rule may be hard to grasp and it is probably the opposite of what you would instinctively expect. after all your bank statement is credited when money is paid into your bank account. but look at it from the bank’s point of view, and it is the bank that issues the statement. The bank’s records are a mirror image of your records, so credit for the bank is a debit for you, and vice versa.
It may help you to remember the rules if you keep in mind that assets in the balance sheet and costs in the profit and loss account are both debits. So if you buy a new factory or if you buy some postage stamps, the appropriate accounts will be debited. Liabilities in the balance sheet and income in the profit and loss account are both credits. So, if you buy something on credit, the amount is credited to the supplier’s account. this is because it is a liability. Similarly, if you make a sale, the amount is credited to the sales account and it will eventually contribute to revenue in the profit and loss account.
3. For every debit, there must be a credit
This is a fundamental and implicit consequence of the double-entry system of accounting, and there are no exceptions. One account gives the benefit and one account receives the benefit. Scientists sometimes help themselves remember the rule by thinking of the law of physics: ‘for every action, there is an equal and opposite reaction’.
We have already seen how this works in relation to the insurance premium payment of $5,000, but it is not always so straightforward. In fact, it may be exceedingly complicated. A batch of postings may include a large number of debits and credits, but the total of the debits must always equal the total of credits. If they do not, a mistake has been made. As an example, consider the entries resulting from an approved expense claim. The amounts are large, so perhaps the expenses were incurred by a senior manager or just possibly a journalist.
Five individual accounts would be debited with a total of $6,499. One account would be credited with $6,499.
So, please remember the first fundamental rule of the double-entry system of accounting: ‘for every debit, there must be a credit’. There are no exceptions and it ranks alongside ‘The sun always rises in the east’, ‘water does not flow uphill’ and ‘A government initiative to cut bureaucracy always creates extra work’.
Three Examples of the double entry system of accounting postings
The $3,000 cash is received from Mr. Sam who is a debtor of the business.
Double effect of the transaction:
A receipt of $3,000 from Mr. Sam, a debtor, will be recorded on the debit side of cash in hand account (as this asset is increasing) and on the credit side of Mr. Sam account (as the amount due from him is decreasing). Entries in both these asset accounts will be of $3,000 each.
The furniture costing $2,500 is purchased on credit from Fine Furniture Co.
Double effect of the transaction:
The purchase of furniture on credit for $2,500 from Fine Furniture Co. will be recorded on the debit side of a furniture account because the furniture is an asset and is increasing. Also, entry of $2,500 will be made on the credit side of the Fine Furniture Co. account because the liability to this creditor is increasing.
The owner of the business takes $500 in cash from the business cash box for personal use
Double effect of the transaction:
An entry of $500 will be made on the debit side of the capital account because the owner’s capital in the business has reduced. Also, an entry of an equal amount will be made on the credit side of the cash in hand account because the cash is an asset and is decreasing.