Accounting is a vital cog in any business. Accounting helps track incomes and expenditures in a business. It helps in ensuring compliance with statutory norms. It also lays the foundation for financial analysis on which stakeholders like management and investors can take crucial business decisions.
There are primarily 2 documented accounting systems, which are
- Single-entry system
- Double-entry system
The double-entry system is the most widely adopted system in the accounting world due to the many advantages over the single-entry system. We shall cover all the relevant details of the Double-entry system in the sections below.
It is important to note that Accounting is a much larger topic covering analysis and interpretation of financial transactions. Understanding the golden rules of accounting is equally important in this context. The double-entry system is just a type of bookkeeping that obviously does not involve financial analysis and inferences.
What is the double entry system of accounting?
The Double entry system of bookkeeping is undoubtedly the fundamental and most prevalent bookkeeping system in the accounting world. The Double-entry system is a system of bookkeeping where every financial transaction is recorded in at least 2 different accounts, with equal and opposite effects on the respective accounts. In a double-entry system, the entries are made in the system to satisfy the equation:
Assets = Liabilities Equity
Every credit is offset by debits, either in the general ledger or a T-account in this system. In other words, every transaction has an equal credit entry and debit entry in different accounts.
Note: T-accounts is an informal term used for a set of financial records used for double-entry bookkeeping. In this form of account, a large T is drawn on the page after which the account is entered above the T’s horizontal line. The debits are recorded on the left side of the T whereas the credits are recorded on the right.
A quick example would be the purchase of office furniture using cash. So, you credit the office account and debit the cash account. We shall take up more detailed examples in further sections. But we haven’t defined a credit and a debit yet. Let’s pen down short explanations of each.
Debit entries are entries recorded for payments made or dues owed. In general, Debit signifies
- Decrease in liability
- Decrease in income
- Decrease in equity
- Increase in assets
- Increase in expense
Credit entries which are the exact opposite of debit entries, are entries recorded for payments received. In general, Credit signifies
- Decrease in expense
- Decrease in assets
- Increase in income
- Increase in equity
- Increase in liability
Every transaction in a Double-entry system is recorded as a credit as well as debit. The credit entry is used for recording those transactions that bring in revenue into the account. On the other hand, the debit entry is used to record every payment transaction from the account. The idea is to have both these entries balance out the accounts.
Difference between Single Entry & Double Entry System
If there is a Double-entry system, what happened to the Single-entry system? This bookkeeping system deserves mention in this section before we understand what the Double entry system brought to the table.
The Single entry system records financial transactions in a single ledger. Transactions are shown to affect only a single account. In such a system, only one account’s value will increase or decrease. The most significant disadvantage that this system suffers from is the inability to generate proper financial reports or statements.
Let’s look at some important differences other than the number of entries.
- Single-entry bookkeeping does not show the current state of wealth
- With the single-entry bookkeeping system, generating financial statements, cash-flow statements, and balance sheets wasn't easy.
Advantages of Double Entry system
There are several benefits that the double-entry system of accounting brings to the table. Most of them are listed below.
- The double-entry system allow s for trial balance, ensuring accuracy in accounting.
Trial balance is usually prepared periodically or at the end of the financial year, assuring arithmetic accuracy by ensuring that there is an equal and corresponding credit for every debit.
- The double-entry system allows for recording details so that the overall profit and loss scenario is clear.
The Trading and Profit & Loss A/c gives a clear picture of overall profit or loss for any given financial year.
- Financial facts are much clearer for taking crucial financial decisions.
Whether for expansion or a round of investment, keeping a clean book with up-to-date transactional facts is necessary. The Double entry system of bookkeeping keeps the system transparent and clean, thus keeping investor confidence high.
- The Double entry system allows easy identification of dues owed.
The double-entry system makes it easy for the business to identify dues owed to lenders, suppliers, and service providers.
- The Double entry system facilitates easy tax liability identification.
It becomes easier for businesses and tax authorities to calculate comprehensive income and levy appropriate and accurate taxes.
- Frauds can be detected quite easily with the double entry system.
With the double-entry system improving the transparency of the accounting system, frauds are also picked up early.
- It makes it easy for a year-on-year analysis of financial performance.
With trial balances and profit & loss statements becoming easy wit h a double entry system, deeper analysis lik e year-on-year financial performance analysis is readily available.
How to implement Double Entry System
Keep this simple rule in mind when using the double-entry bookkeeping system.
Debits and credits should offset each other completely.
While recording transactions in the general ledger using the double-entry system, the
- Debit entries are recorded on the left
- Credit entries are recorded on the right
- Debits fall under the liabilities column.
- Credits fall under the assets column.
- The assets and liabilities should tally at the end.
Example of Double Entry System
Let’s take a simple example of the purchase of office furniture that we mentioned earlier.
The purchase of office furniture shall be recorded in a double-entry system as follows.
Office Furniture Account
As you can see, a single transaction has affected 2 different accounts with corresponding debit and credit entries.
Let’s take another example for more clarity.
This time let's take the example of salary
Here, you increase your salary expenses with a debit entry and offset it with a corresponding credit entry against the cash account.
This can be generalized and summarized using a couple of statements.
Debits always increase assets or expenses and decrease liabilities or income.
Credits always decrease assets or expenses and increase liabilities or income.
The One Quirk
Well, it is not actually a quirk, but it sure goes against our general understanding of financial transactions in our daily lives.
Generally, we tend to associate a financial debit with withdrawal and a credit with a deposit. This is not the case with the double entry system.
In this system, debit indicates an entry made in the left column in a two-column system, and credit indicates an entry on the right side.
In the case of assets and expenses, a debit indicates an increase in account balance. For revenue, equities and liabilities, a credit indicates an increase in account balance.
This has necessitated the understanding of various types of accounts that are pertinent to the double-entry system.
Types of Accounts in the double entry system
There are various types of accounts that the double-entry system is based on. Let’s briefly go through them.
Asset accounts list the values of assets the business owns, including business capital. It is a general ledger account that is used to record the transactions involving company resources.
Asset account balances generally increase with a debit entry and decrease with a credit entry. Resources like cash, inventory, real estate, equipment, vehicles and investment capital are examples of Asset accounts.
Liability accounts list the values of liabilities that the business owes to external entities. Generally, a debit to a liability account would mean a reduction in liability of the business and a credit to a liability account would increase the present liability of the business. Examples of liability accounts include Accounts payable, salaries and wages, income tax, among others.
Equity Accounts are a representation of ownership of a business in terms of its value. Common stocks, preferred stocks and shares are examples of equity accounts.
Income or gains accounts record the earnings of the business. Income accounts are further classified into Gains and revenue accounts. This account represents the inflow of cash into the business. A good example of an income account is sales. Other examples include income from interest and services revenue.
Expense accounts show day to day spending on running the business. This account represents the outflow of cash from the business. Examples of expense accounts include salaries, utility payments, rent, insurance.
Popular Accounting Software for Double Entry System
While most of the software available today is based primarily on double-entry systems, they do allow single entry systems. Cashbook is one such application software which is made for keeping track of business income and expenses. It’s also very easy to use.
Before you start using a double entry system at your business, you need to be charting out all your accounts within the accounting software.
While working with double entry accounting software, the general guideline is
- Chart out all the accounts within your business within the accounting software
- Record all transactions with their debits and credits or vice versa
- Check to ensure that financial statements satisfy the accounting equation.
The choice of software actually depends on how intuitive it is to use and the number of features it offers. The total cost of ownership is also a big factor. However, many open-source applications today are as good as proprietary software, if not better.
Khatabook is an example of a basic bookkeeping software. However, If you are looking for a comprehensive package that scales up to the enterprise level, some of the options you have are:
- Oracle Netsuite
- SAP Business One
- Sage Intacct
Double entry bookkeeping is fundamental to present-day accounting practices, enabling transparency and deep financial analysis. Although the many bookkeeping packages in the market today will help manage accounts easily, a good understanding of accounting based on the double-entry system will ensure you understand the finer nuances of the trade. A solid understanding of the debit entry accounting system will also help you select the right accounting software for your business.