What is Double Entry Accounting?
Double Entry Accounting is a standardized bookkeeping system wherein each and every transaction results in adjustments to at least two offsetting accounts.
Each financial transaction must have an equal and opposing entry in order for the fundamental accounting equation — i.e. assets = liabilities + shareholders’ equity — to remain true.
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Double Entry Accounting System
The double entry accounting system is a method for companies of all sizes to accurately record the impact of transactions and keep close track of the movement of cash.
The premise of the system is the accounting equation that states that a company’s assets must always be equal to the sum of its liabilities and equity, i.e. the company’s resources must have been funded somehow, with either liabilities or equity.
Just like the accounting equation, the total debits and total credits must balance at all times under double-entry accounting, where each transaction should result in at least two account changes.
Each adjustment to an account is denoted as either a 1) debit or 2) credit.
In short, a “debit” describes an entry on the left side of the accounting ledger, whereas a “credit” is an entry recorded on the right side of the ledger.
- Debit → Entry on Left Side
- Credit → Entry on Right Side
What are Debits and Credits?
Each transaction under double entry accounting results in a debit in one account and a corresponding credit in another, i.e. there must be an offsetting entry for all transactions to track the flow of money within a company.
Conceptually, a debit in one account offsets a credit in another, meaning that the sum of all debits is equal to the sum of all credits.
- Debit → Increases Assets Accounts, Decreases Liabilities and Shareholders’ Equity Accounts
- Credit → Decreases Assets Accounts, Increases Liabilities and Shareholders’ Equity Accounts
The debits and credits are tracked in a general ledger, otherwise referred to as the “T-account”, which reduces the chance of errors when tracking transactions.
Formally, the summarized list of all ledger accounts belonging to a company is called the “chart of accounts”.
When determining the appropriate adjustment to cash, if a company receives cash (”inflow”), the cash account is debited. But if the company pays out cash (”outflow”), the cash account is credited.
- Debit to Asset → If the impact on an asset account’s balance is positive, you would debit the asset account, i.e. the left side of the accounting ledger.
- Credit to Asset → On the other hand, if the effect on the asset account’s balance is a reduction, the account would be credited, i.e. the right side of the accounting ledger.
The debit and credit treatment would be reversed for any liability and equity accounts.
On the general ledger, there must be an offsetting entry for the balance sheet equation (and thus, the accounting ledger) to remain in balance.
Types of Accounts in a Double Entry Accounting
There are seven types of accounts in double entry accounting:
- Asset Account → The assets owned by a company, which either are items that either hold monetary value or represent future economic benefits, e.g. cash and cash equivalents, accounts receivables, inventory, property, plant and equipment (PP&E).
- Liabilities Account → The liabilities that a company owes to a third party (and represents an outstanding obligation), e.g. accounts payable, accrued expenses, notes payable, debt.
- Equity Account → The equity account tracks the capital invested into the company by the owner, investments, and retained earnings.
- Revenue Account → The revenue account tracks all the sales generated by a company from selling its products or services to customers.
- Expenses Account→ The expenses account is all the expenses incurred by a company, such as the direct and indirect costs of operating, i.e. rent, electricity bills, employees, and salaries.
- Gains Account → The gains account is non-core to the operations of a company, but provides a positive effect, e.g. sale of an asset for a net profit.
- Losses Account → The losses account is also non-core to a company’s core operations, yet depicts a negative impact, e.g. sale of an asset for a net loss, write-down, write-off.
Debit and Credit Entries — Impact on Accounts
The chart below summarizes the impact of a debit and credit entry on each type of account.
|Type of Account||Debit||Credit|
Single Entry vs. Double Entry Accounting
Unlike double entry accounting, a single entry accounting system — as suggested by the name — records all transactions in a single ledger.
While simpler, the single entry system does not track any balance sheet items, whereas the double entry system is the standardized method adopted by most accountants across the globe and provides enough information to create the three major financial statements.
- Income Statement
- Cash Flow Statement
- Balance Sheet
The chart below summarizes the differences between single entry and double entry accounting.
Double Entry Accounting — Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Double Entry Accounting Example Calculation
Suppose we’re recording four separate transactions using double entry accounting.
Scenario 1 → $250,000 Cash Purchase of Equipment
In our first scenario, our hypothetical company has purchased $250,000 in equipment using cash as the form of payment.
Since the purchase represents a “use” of cash, the cash account is credited $250,000, with the offsetting entry consisting of a $250,000 debit to the equipment account.
Scenario 2 → $50,000 Credit Purchase of Inventory
In our next scenario, our company purchases $50,000 in inventory — however, the purchase was completed using credit rather than cash.
Because the purchase is not a “use” of cash — i.e. deferred to a future date — the accounts payable account is credited by $50,000 while the inventory account is debited by $50,000.
The accounts payable captures an owed payment to the supplier or vendor that must be fulfilled in the future, but the cash remains in the possession of the company until then.
Scenario 3 → $20,000 Credit Sale to Customer
The next transaction in our example involves a $20,000 credit sale to a customer.
The customer made a purchase using credit instead of cash, so it is the reverse of the prior scenario.
The company’s sales account is debited by $20,000 because it is revenue for products/services already delivered (and thereby “earned”) by the company and all that remains is for the customer to fulfill their cash payment obligation.
Unlike the previous scenario, the cash balance is reduced from the customer opting to pay using credit instead of cash, so the $20,000 in owed payments is recognized in the accounts receivable account, i.e. as an “IOU” from the customer to the company.
Scenario 4 → $1,000,000 Equity Issuance for Cash
In our fourth and final scenario, our company decides to raise capital by issuing equity in exchange for cash.
Our company was able to raise $1 million in cash, reflecting an “inflow” of cash and therefore a positive adjustment.
The cash account is debited by $1 million, whereas the offsetting entry is a $1 million credit to the common stock account.
In all of our scenarios, the sum of the debits and credits are equal, so the core accounting equation (A = L + E) remains in balance.