What is Double Entry?
Double entry refers to a system of bookkeeping that, while quite simple to understand, is one of the most important foundational concepts in accounting. Basically, double-entry bookkeeping means that for every entry into an account, there needs to be a corresponding and opposite entry into a different account. It will result in a debit entry in one or more accounts and a corresponding credit entry in one or more accounts.
- Double entry refers to a system of bookkeeping that is one of the most important foundational concepts in accounting.
- Double-entry bookkeeping ensures that for every entry into an account, there needs to be a corresponding and opposite entry into a different account. It will result in a debit entry in one or more accounts and a corresponding credit entry in one or more accounts.
- The main purpose of a double-entry bookkeeping system is to ensure that a company’s accounts remain balanced and can be used to depict an accurate picture of the company’s current financial position.
Brief History of Double-Entry Bookkeeping
Double-entry bookkeeping has been in use for at least hundreds, if not thousands, of years. Accounting has played a fundamental role in business, and thus in society, for centuries due to the necessity of recording transactions between parties.
The early beginnings and development of accounting can be traced back to the ancient civilizations in Mesopotamia and is closely related to the development of writing, counting, and money. The concept of double-entry bookkeeping can date back to the Romans and early Medieval Middle Eastern civilizations, where simplified versions of the method can be found.
The modern double-entry bookkeeping system can be attributed to the 13th and 14th centuries when it started to become widely used by Italian merchants. The first known documentation of the double-entry system was first recorded in 1494 by Luca Pacioli, who is widely known today as the “Father of Accounting” because of the book he published that year detailing the concepts of the double-entry bookkeeping method.
How Does Double-Entry Bookkeeping Work?
The main purpose of a double-entry bookkeeping system is to ensure that a company’s accounts remain balanced and can be used to depict an accurate picture of the company’s current financial position to both the management and external stakeholders such as potential investors, current shareholders, suppliers, or the government. As such, double-entry bookkeeping relies heavily on the use of the foundational accounting equation, Assets = Liabilities + Shareholders’ Equity.
In order to achieve the balance mentioned previously, accountants use the concept of debits and credits to record transactions for each account on the company’s balance sheet. Double-entry bookkeeping means that a debit entry in one account must be equal to a credit entry in another account to keep the equation balanced.
Debits are typically located on the left side of a ledger, while credits are located on the right side. This is commonly illustrated using T-accounts, especially when teaching the concept in foundational-level accounting classes. However, T- accounts are also used by more experienced professionals as well, as it gives a visual depiction of the movement of figures from one account to another.
Example of a Double-Entry Bookkeeping System
To understand how double-entry bookkeeping works, let’s go over a simple example to solidify our understanding. Assume that Alpha Company buys $5,000 worth of furniture for its office and pays immediately in cash. In such a case, one of Alpha’s asset accounts needs to be increased by $5,000 – most likely Furniture or Equipment – while Cash would need to be decreased by $5,000.
Here, the asset account – Furniture or Equipment – would be debited, while the Cash account would be credited. It is important to note that after the transaction, the debit amount is exactly equal to the credit amount, $5,000.
An important point to remember is that a debit or credit does not mean increase and decrease, respectively. However, a simple method to use is to remember a debit entry is required to increase an asset account, while a credit entry is required to increase a credit entry.
The DEAD rule is a simple mnemonic that helps us easily remember that we should always Debit Expenses, Assets, and Dividend accounts, respectively. The normal balance in such cases would be a debit, and debits would increase the accounts, while credits would decrease them. Once one understands the DEAD rule, it is easy to know that any other accounts would be treated in the exact opposite manner from the accounts subject to the DEAD rule.
Different Types of Accounts
There are several different types of accounts that are used widely in accounting – the most common ones being asset, liability, capital, expense, and income accounts.
- Asset accounts relate to goods, equipment, or cash that a business owns.
- Liability accounts refer to what a company owes to other suppliers or businesses, such as equipment or goods bought on credit, a building mortgage, or credit card balances that will be paid at a later date.
- Capital accounts include accounts related to shareholders’ equity, such as common stock, preferred stock, and retained earnings.
- Expense accounts detail numbers related to money spent on advertising, payroll costs, administrative expenses, or rent.
- Income accounts represent the various types of monies received from different sources, such as interest or investment income or revenue gained from the sale of goods or services.
Preventing Errors Through Double-Entry Bookkeeping
The likelihood of administrative errors increases when a company expands, and its business transactions become increasingly complex. While double-entry bookkeeping does not eliminate all errors, it is effective in limiting errors on balance sheets and other financial statements because it requires debits and credits to balance.
It, of course, adheres to the formula Assets = Liabilities + Shareholders’ Equity. The balancing requirement ensures that any errors will be found easily, and the incorrect entry can be easily traced before it leads to subsequent complex errors.
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