Introduction
One of the most crucial responsibilities in accounting is to accurately record business transactions. All transactions, sales and purchases, payments and receipts have a financial impact on a business and need to be recorded correctly to maintain proper financial reporting. Knowing how to record business transactions using double-entry bookkeeping is essential. Double entry bookkeeping is the system of accounting that the businesses throughout the world use to achieve this accuracy. In this system, each financial transaction will have at least two accounts involved and the accounting equation will be always balanced. As each transaction has two sides, the risk of errors, omissions and inconsistencies are greatly minimized helping organizations to keep accurate financial records and prepare accurate financial statements.
The journal, ledger and trial balance process can be confusing for the beginning student. The entire accounting cycle starts to be easier to understand and apply, once the relationship between debits and credits is clear, in the context of the relationship. Double entry bookkeeping is the core of bookkeeping practice and it is essential that students learn these concepts, as well as bookkeepers and other finance professionals, and business owners. These principles empower people to accurately record transactions, detect errors and generate accurate reports for effective decision making.
Understanding the Principles of Double Entry Bookkeeping.
Double-entry bookkeeping principle: Any transaction has at least two accounts, each increased by the same dollar amount, but in opposite directions. The debit or credit entry is made on one account and the credit or debit entry is made on the other account. This way the accounting equation will always be balanced:
Assets = Liabilities + Owner’s Equity
For every asset added to a business, another asset has to be deducted, a liability added, or owner equity increased as well. Likewise, as liabilities go down, assets or equity must go down as well. This balance is essential in ensuring that double-entry bookkeeping is reliable and effective in financial reporting. Double entry bookkeeping is more efficient than a single entry bookkeeping because it gives a full picture of financial activities, and makes it easier to spot errors or fraudulent transactions.
An example of a business transaction in which the accounts of a business are affected is when the business buys office furniture for cash, $2000.00. In this case, the accounts of the business are changed by increasing the furniture account by $2000.00 and decreasing the cash account by $2000.00. The debit to Furniture is an increase in the furniture and the credit to Cash is a decrease in the cash. The transaction involves two accounts and as long as the increase in one asset is equal to the decrease in another asset the accounting equation will be balanced.
The Accounting Equation and its Significance
The accounting equation is the foundation of bookkeeping system. Each transaction that is entered into the accounting records should preserve the balance of the accounting equation (assets = liabilities + owner’s equity). Assets are what the business owns, liabilities are what the business owes and owner’s equity is what the owner has in the business after the business’s liabilities have been subtracted from its assets.
If a business owner puts in $20,000 into a new business, what is the total investment in the company? If a business owner invests $20,000 in a newly formed company, how much is the total investment in the company? The business is receiving cash (increase) of $20,000. Concurrently, the owners’ funds increase by the same amount, since the owner has laid out funds in the business. This gives the accounting equation as:
Assets ($20,000 Cash) = Liabilities ($0) + Owner’s Equity ($20,000 Capital)
Assuming that the business also borrows $10,000 from a bank at a later time, the assets increase due to the addition of cash, and the liabilities also increase because the money is also owed to the bank. Again, there is a balance of the accounting equation. This relationship enables a beginning accountant to understand why there is a debit and credit side to every accounting transaction.
Understanding Debit and Credit Rules
Beginners get the most confused about the application of rules for debit and credit. Many think that debits are increases and credits are decreases in every circumstance. In fact, it depends on the type of the account whether debit or credit increases the account.
The basic guidelines are:
- Debits lead to increases in assets; credits lead to decreases in assets.
- Debits increase expenses, credits decrease expenses.
- A credit will add to liabilities; a debit will take away from liabilities.
- The Owner’s equity section is increased by credits and decreased by debits.
- Credits will add to revenue and debits will reduce it.
A good trick to remember this rule is that the normal balance of the accounts for Assets and Expenses are debit, whereas the normal balance for the accounts for Liabilities, Equity and Revenues are credit. It is important to understand these rules because they are all fundamental to applying them correctly in each journal entry. The account classifications will become more familiar to learners and will make it easy for them to record the transactions instead of the confusing exercise it is.
The Function of the Journal Entries in Accounting
The first formal way of recording business transactions is through journal entries. It is called the book of original entry since all transactions are first entered into this book before they are posted to the ledger accounts. A journal entry will include the date of the transaction, involved accounts, the debit amount, the credit amount, and a brief description of what the transaction is.
An example of this would be if a company orders items valued at $5,000 on credit, it would be recorded on the books as follows:
Debit: Inventory Account — $5,000
Credit: Accounts Payable — $5,000
The inventory account is debited since asset accounts are increased by debits, and the accounts payable is credited since liability accounts are increased by credits. The debits are equal to the total credits, which is the requirement of the double-entry book keeping system. Journal entries create a history of transactions or transactions record and make it easy to audit money by following the trail of money movement.
Practical Examples of Journal Entries
Accounting concepts with practical examples are easier to understand and real business situations. Suppose these are the transactions that were made in a small retail shop in its first month of business.
1. The owner puts $30,000 cash into the business:
Debit: Cash — $30,000
Credit: Owner’s Capital — $30,000
2. The business buys $8,000 worth of equipment in cash:
Debit: Equipment — $8,000
Credit: Cash — $8,000
3. A business buys some stock on credit for $6,000:
Debit: Inventory — $6,000
Credit: Accounts Payable — $6,000
4. The business makes sales of $10,000 in cash:
Debit: Cash — $10,000
Credit: Sales Revenue — $10,000
5. The business’s rent amount is $1,500:
Debit: Rent Expense — $1,500
Credit: Cash — $1,500
Each of the following examples shows an accounting of at least two accounts such that the amounts debited equal the amounts credited in the transaction. Journal entry practice helps novice bookkeepers build confidence and accuracy in bookkeeping tasks.
Posting Transactions to the Ledger
Once the transactions are properly entered in the journal, the next step is to post the transactions in the ledger. Each account is kept in its own individual account on the ledger and all its transactions are grouped in that account. Journal is a record of transactions chronologically while Ledgers are transactions sorted by accounts and account balances can be known at any point in time.
For instance, when owner investment, sales receipts, equipment purchase and rental payment is entered into the cash account, all these entries are also transferred to the Cash ledger account. The accountant can see what cash is available in the ledger, without having to go through each and every journal entry. Ledger posting thus converts the raw transaction data into structured financial information that can be utilized for analysis and reporting.
The ledger is also useful in assisting management to be aware of the trends in business activities. For example, if accounts payables fluctuate often, that can be a sign of greater reliance on suppliers’ credit, while a decrease in cash balances can be a red flag that means there are liquidity issues that need to be addressed.
Preparing a Trial Balance
A trial balance is made after all the transactions have been entered into the ledger accounts. It is mainly used to ensure that there are equal debits and credits and that the bookkeeping is mathematically accurate. A trial balance is a list of all the ledger accounts and their ending debit or credit.
The following is an example trial balance that can contain the following balances:
- Cash — Debit $30,500
- Inventory — Debit $6,000
- Equipment — Debit $8,000
- Rent Expense — Debit $1,500
- Accounts Payable — Credit $6,000
- Owner’s Capital — Credit $30,000
- Sales Revenue — Credit $10,000
The total of all debits is equal to the total of all credits and the records are balanced. If the totals don’t match, the accountant knows that there is some error somewhere in the recording and/or posting, and will need to dig deeper before preparing the financial statements.
A balanced trial balance does not verify that each transaction has been recorded properly, but does offer an important check in the accounting cycle, and is helpful in the detection of mathematical errors before the report is prepared.
The Common Errors in Double Entry Bookkeeping
With double entry bookkeeping systems, errors can happen when entries are made and posted. Typical mistakes are entry of an incorrect amount, posting to the wrong account, not entering a transaction, and reversing the debit and credit entries. There may be errors that occur that will not impact either the debit or credit side of the equation, which will make it harder to identify.
For instance, if a payment is made to Utilities for rent expense it is not a debits and credits issue, but it will skew the information on the financial statements. Likewise, if you enter $540, instead of $450, you will get an error message, and it may be necessary to delve into this in great detail to discover. Businesses can reduce these errors and ensure they have accurate records by conducting regular reconciliations, scrutinizing source documents, and conducting periodic audits.
Modern accounting software has decreased many manual mistakes by adding double entries to the system for transactions entered. However, an understanding of the principles is important as software users need to select the appropriate accounts and also correctly interpret financial information.
Double Entry Bookkeeping Offers Several Advantages
Double entry bookkeeping has some merits which are why it’s considered the most preferred accounting method around the world. It enhances the accuracy as all transactions are balanced and errors can be easily detected. It helps in preparing income statement and balance sheet as all the accounts are kept in a systematic manner. It also increases transparency and accountability, providing an unbroken flow of transactions and adding transparency for investors, lenders, and regulators.
Double entry bookkeeping allows businesses to gain a greater insight into profitability, cash flow, liability management, and decision making. The system also facilitates adherence with accounting standards and tax laws, helping to eliminate legal and financial issues. Having access to comprehensive financial data can help growing businesses secure financing, investment, and planning for growth.
Conclusion
One of the most significant accounting systems ever developed is double entry book keeping as it provides an accounting framework that allows for accurate and reliable financial records to be maintained. This guarantees that any transaction involves a minimum of two accounts, and the amount of debits is always equal to the amount of credits, maintaining financial accuracy and aiding decision-making.
Students who are new to the debit and credit principles, journal entries, ledger posting and trial balance concepts; will build a solid foundation for further accounting study and practice. While there are many bookkeeping tasks now automated by accounting software, there are fundamental concepts that still apply and are the basis for financial reporting everywhere. Understanding these principles can help enhance your bookkeeping accuracy and provide you with valuable skills that can contribute to the success of your business and career in accounting and finance.
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