So, what is double entry accounting?
Double-entry bookkeeping/accounting is an accounting technique where two entries are made for every transaction.
Who invented double entry accounting?
There is a common misconception that double-entry bookkeeping was first developed by Leonardo Da Vinci’s math teacher, Luca Pacioli, who is widely credited as the father of accounting. However, the first known descriptions of the double entry bookkeeping system were made by a Croatian man named Benedikt Kortuljevic.
More about the double entry accounting system
On the surface, creating two entries for every transaction may seem to complicate the work of a bookkeeper; however, in practice, double entry bookkeeping helps minimize errors, provide a clear money trail and simplify the entire accounting process. In every business transaction, two things occur: there is an outflow of an item and an inflow of another item. These inflows and outflows affect the asset base of the company and are recorded as debits and credits.
In general, any transaction inflow that increases the asset base of the company should create a debit entry, and every transaction outflow that decreases or creates a future decrease in the asset base should be recorded as a credit entry.
That was a very simple explanation and you may still be asking yourself, what is double entry accounting?
The double entry accounting system relies on the features of the different classes of accounts; therefore, to understand how double entry accounting works in practice, it is essential to understand these different classes of accounts. An item such as cash may be used in many different types of transactions, but there will only be one “cash account” where every cash item will be recorded.
Classes of accounts are the different broad categories the individual accounts of a business may fall into, and they are used to keep track of:
- What resources come in and leave the business.
- Which of these resources are owned by the business.
- Which of these resources are owned by the owners of the business.
- Which of these resources are owned by the creditors of the business.
The five classes of accounts
#1: Assets – These are resources that are owned by the business itself and can be converted into cash. Assets are further divided into fixed assets and current assets. As mentioned previously, any transaction item that increases assets should be recorded as a debit entry. For example, a sale of products or services for which cash is paid will result in a debit entry for the value of the amount received, in the company’s cash account (along with a corresponding credit entry in the sales account, as required by the double entry accounting system).
#2: Liabilities – Liabilities are generally thought to be the opposite of assets, but in accounting, liabilities actually share some similarity with assets. This is because liabilities are resources used by a business to make money, with the main difference being that liabilities are not owned by the business, and the business must repay the value of these liabilities to their real owners. An increase in liabilities by default implies a future outflow of assets, so this would be recorded as credit entry.
#3: Revenue – Revenue transactions have to do with the core profit-making activities of a business. When a business sells a product, it loses an asset in the form of stock, and typically gains another asset in the form of cash or accounts receivable. This is one of the clearest examples of how the double entry system works: the outgoing asset is recorded as a credit entry in the sales account, and the incoming asset is recorded as a debit entry in the cash or accounts receivable account.
#4: Expenses – You might think that everything a business spends money on should be recorded as an expense, but that is incorrect. Expenses are items purchased by a business for its immediate use. They are similar to assets, and sometimes an expense item can be considered an asset under certain conditions. The key difference is that assets have future value, whereas expenses have immediate short-term value. As with assets, an increase in expenses should be recorded as a debit entry, and the outgoing item, usually cash, should be recorded as a credit entry, following the double entry accounting system.
#5: Capital – Capital, or stock owner’s equity, refers to the amount of investment the owner(s) of a business have put into it. For a sole proprietorship, there is no real difference between the capital and asset base of a business, since in legal terms a sole proprietorship takes on the legal personality of its owner. However, for companies and partnerships, capital is an important class of accounts since it reflects the value that the business owes to its owner or respective owners. Capital is like liability items, and an increase in the capital base of a company should be recorded as a credit entry in the capital account, with a corresponding debit entry in an asset account.
How it all comes together
These five classes of accounts are an umbrella which covers all the other accounts a business will have and operate. These individual accounts will typically be structured with two columns – a structure referred to as a T account, with the left side containing debit entries, and the right side containing credit entries.
At the end of the month (or any other period), both sides are summed up, and the difference between them is recorded as a positive balance if the debit side is higher, and a negative balance if the credit side is higher. These figures are then entered into a similar structure called a trial balance, where the balances of every account operated by a business are entered. In the trial balance, accounts with debit balances (positive balances) should be entered into the debit column, and accounts with credit balances (negative balances) should be entered into the credit side.
Finally, if everything is done correctly, the sum from the debit column will equal the sum of the credit column amounts. In this manner, the double entry accounting system helps business owners and bookkeepers ensure the accuracy of all transactions