Double Entry Accounting
Double-entry accounting is a method of recording financial transactions that is used by most businesses and organizations. Each transaction is recorded in at least two accounts: one account is debited, and another account is credited. The total amount debited and the total amount credited should always be equal, maintaining the accounting equation:
Assets = Liabilities + Owner’s Equity
The concept of double-entry accounting is based on the principle that every financial transaction has two effects. For example, if a business takes out a loan, its assets (cash) increase, and its liabilities (loan payable) also increase.
Every transaction involves both a debit entry and a credit entry. In the most simple terms:
- Debits increase asset and expense accounts, and decrease liability, equity, and revenue accounts.
- Credits increase liability, equity, and revenue accounts, and decrease asset and expense accounts.
Here’s an example: If a company borrows $5,000 from a bank, it would debit its Cash account (an asset) by $5,000 and credit its Loans Payable account (a liability) by $5,000.
This system helps maintain accuracy in the financial records, as the two entries should offset each other. If they don’t, it’s an indication that there may be an error in the accounting records.
The use of double-entry accounting allows for the preparation of financial statements, including the balance sheet, income statement, and statement of cash flows.
Example of Double Entry Accounting
Let’s use a few examples to illustrate double-entry accounting.
Example 1:
Suppose a company receives $20,000 from an investor. In this case, the company would:
- Debit (increase) the “Cash” account (an Asset) by $20,000 because the company has more cash now.
- Credit (increase) the “Common Stock” account (Owner’s Equity) by $20,000 because the equity of the company has increased.
Example 2:
Now suppose the company spends $5,000 on inventory. In this case, the company would:
- Debit (increase) the “Inventory” account (an Asset) by $5,000 because the company now has more inventory.
- Credit (decrease) the “Cash” account (an Asset) by $5,000 because the company has less cash.
Example 3:
Lastly, imagine the company makes a sale of $1,000 on account (meaning the customer will pay later). In this case, the company would:
- Debit (increase) the “Accounts Receivable” account (an Asset) by $1,000 because the company is owed money from the customer.
- Credit (increase) the “Sales Revenue” account (Revenue) by $1,000 because the company has earned revenue from the sale.
In each case, the total debits equal the total credits, maintaining the balance in the accounting equation: Assets = Liabilities + Owner’s Equity.
These examples are simplified for illustrative purposes. In reality, a company would often need to make more complex entries that involve multiple debits or credits for a single transaction. However, the basic principle always applies: for every transaction, debits must equal credits.
