Double-entry accounting means at least two entries for every accounting transaction. The practice leads to the balancing act of debits and credits. The double-entry system follows the principle of the basic accounting equation. It leads to the accuracy accounting function where all debits and credits must equal at any given time.
There are several types of double-entry accounting systems. It offers several advantages to the users. However, it requires accounting knowledge and skills to pursue that some individuals and small businesses may not be available. Let us discuss the key concepts of double-entry accounting with the help of some simple examples.
What is Double entry Accounting?
A double-entry is an accounting system that requires at least two entries for every transaction. It means there will be at least one debit and one credit entry for each transaction recorded. There is no limit to the maximum number of accounts under double-entry accounting. However, each transaction must have at least entries in two accounts.
In simple words, the double-entry concept means for every entry into one account, there must be an equal and corresponding entry into another. It means for one or more debit entries there should be one or more credit entries.
How Does Double-entry Accounting Work?
The modern accounting system relies on double-entry bookkeeping practices. Each transaction here is recorded in terms of debits and credits.
For recording purposes, the debit is recorded on the left side, and the credit is recorded on the right side. These accounts depict the financial accuracy of an entity at any given time.
The Accounting Equation
The double-entry accounting system follows the principle of the accounting equation.
Assets = Liabilities + Equity
The basic equation follows that the accounting balance of all debits must equal the balance of all credit at all times.
The accounting records through journal entries form the basis of financial statements. The balance sheet follows the same accounting equation.
Debits and Credits
Debits and credits are essential components of an accounting system. The accounting equation means debits and credits should always remain in balance.
In accounting, a debit has the following features:
- The portion of a transaction that increases an asset or an expense account.
- It decreases the liability or an income account.
- Recorded on the left side of the journal.
Similarly, credit has the following features:
- The portion of a transaction that increases a liability or an income account.
- It decreases the asset or expense account.
- It is recorded on the right side of the journal.
Features of Double-entry Accounting
The double-entry accounting system has the following features:
- There are two sides to each transaction, a debit, and a credit. It means there are always at least two parties involved in every accounting transaction, a giver and a receiver.
- Each transaction must follow the basic accounting equation meaning that it must have an equal debit and credit effect.
- Each transaction must have at least one debit and one credit.
- The accounting system should be maintained as a separate entity from its owners or users.
Types of Account in Double-entry Accounting
Broadly, a double-entry accounting system can have three types of accounts.
Real accounts mean assets owned by a business such as a machinery, equipment, land, property, and so on.
Nominal accounts include all accounts relevant to profit, loss, expense, and income.
Personal accounts refer to the accounting entries related to individuals such as owners, creditors, and lenders.
An accounting system can have as many account types as it requires. The most common types of accounts in the double-entry accounting system are as follows:
- Assets such as cash, property, equipment.
- Liabilities such as bank loans, payables, taxes.
- Owners’ Equity including stocks and retained earnings.
- Income such as sales, interest earned, etc.
- Expenses such as inventory purchases, selling, admin, etc.
- Gain including the sale of assets, trading, etc.
- Loss including losses on the sale of assets, trading, investments, etc.
Let us consider a few examples of different double accounting entry transactions for a company ABC.
Inventory Purchased: ABC purchased inventory worth $ 10,000. Paid in cash amount $ 5,000 and on credit terms $ 5,000.
|Accounts Payable||$ 5,000|
ABC purchases machinery worth $ 25,000 on cash terms.
|Current Assets – Machinery||$ 25,000|
ABC pays monthly salaries through a bank transfer for a total amount of $ 50,000.
|Bank Account||$ 50,000|
|Salaries Payable||$ 50,000|
A Short-Term Loan:
Suppose ABC takes a short-term loan with a maturity period of 3 months for a total amount of $ 50,000.
|Bank Account||$ 50,000|
|Notes Payable||$ 50,000|
Suppose ABC company sells its shares worth $ 100,000 to raise capital.
|Equity- Common Stocks||$ 100,000|
Difference Between Single-Entry and Double-entry Accounting
Individuals, sole proprietors, and small businesses follow the single-entry accounting system. It does not require a balancing act for each transaction.
It means the single accounting system may not portray a balanced financial position of the user. Also, it is difficult to follow and reconcile accounts under the single-entry accounting system.
The biggest advantage of the single-entry system is its simplicity. However, it is only suitable for users with limited accounting requirements.
General Ledger and Double-entry Accounting
The general ledger is the books of accounts for an accounting system. It follows and represents the same accounting principles as double-entry bookkeeping does.
The general ledger of an entity forms the basis of the accounting function. It keeps a record of each account used by an entity separately. Each journal account is then reconciled and taken forward to the trial balance records.
The figures from the trial balances are then used to create the business’s financial statements. Thus, the accuracy of the general ledger through double-entry accounting leads to the accuracy of the financial statements.
It means an accurate and consistent double-entry accounting function will lead to a consistent ledger and eventually accurate financial statements of a business.
Advantages of Double-entry Accounting
Double-entry accounting is the basis of modern accounting and bookkeeping functions. It comes with several advantages.
- It follows the widely used and followed accounting principles around the world.
- It records two sides of a transaction; thus, it is a comprehensive accounting system.
- It helps management keep accurate accounting records with fewer errors and omissions.
- It helps management in key decision-making processes.
- Record-keeping, reconciliation, and visualization of accounting records are easier in this system.
Disadvantages of Double-entry Accounting
Despite a comprehensive approach and several benefits, the double-entry system also comes with some disadvantages.
- It is not suitable for small businesses as it may require comprehensive accounting skills and time.
- It gets complex and difficult to maintain as the business grows.
- Automation of the system means higher costs for small businesses.
- The system also requires skilled human resources with accounting skills and knowledge.
The double-entry accounting system is the most widely used system around the world. It presents comprehensive and accurate accounting records of an entity. It offers several advantages such as accuracy of records, a modern system, and a strong foundation for financial statements.