Double-entry book-keeping

Double-entry book-keeping is the standard accounting practice for recording financial transactions. It was "invented" by the merchant venturers of Venice and codified for the first time by Luca Pacioli, a close friend of Leonardo da Vinci, in a 1494 footnote to a scientific paper.

The system is based on the concept that a business can be described by a number of different variables or accounts, each describing an aspect of the business in monetary terms. Every transaction has a 'dual effect'—increasing one aspect and decreasing another, in such a way that all of the different variables always sum to zero. This is illustrated below.

Examples

Buying an asset:

  1. The amount of fixed assets in the business increases.
  2. The amount of cash is reduced.

Selling merchandise on credit:

  1. The amount of trade receivables for the business increases.
  2. The level of merchandise inventory is reduced.

Paying a trade creditor:

  1. The amount of trade payables for the business is reduced.
  2. The amount of cash in the business is reduced.

Debits and credits

Double-entry book-keeping is governed by the accounting equation. At any point in time, the following equation must be true:

assets = liabilities + equity

For a particular time period, the equation becomes:

assets = liabilities + equity + (revenue − expenses)

Finally, this equation may be rearranged algebraically as follows:

assets + expenses = liabilities + equity + revenue

This equation must be true, for any time period. If it is, then the accounts are said to be in balance. If the accounts are not in balance, an error has occurred.

For the accounts to remain in balance, a change in one account must be matched with a change in another account. These changes are known as debits and credits. Note that the usage of these terms in accounting is not identical to their everyday usage. Whether one uses a debit or credit to increase or decrease an account depends on the normal balance of the account. Asset and expense accounts (on the left side of the equation) have a normal balance of debit; liability, equity, and revenue accounts (on the right side of the equation) have a normal balance of credit. On a general ledger, debits are recorded on the left side and credits on the right side for each account. Since the accounts must always balance, for each transaction there will be a debit and a matching credit, and the sum of all debits for all accounts must equal the sum of all credits.

Credits and debits are then defined as follows:

  • debit: an increase in one of the accounts with a normal balance of debit or a decrease in one of the accounts with a normal balance of credit.
  • credit: an increase in one of the accounts with a normal balance of credit or a decrease in one of the accounts with a normal balance of debit.

The following accounts have a normal balance of debit:

  • Assets
  • Accounts receivable: debts promised by other entities but not yet paid
  • Drawings by the owners on equity
  • Expenses
  • Losses (that is, when expenses exceed revenue)

The following accounts have a normal balance of credit:

  • Liabilities
  • Accounts payable and taxes, notes or loans payable: debts promised to outsiders but not yet paid
  • Revenue (note that since it is a credit, revenue is recorded as a negative number)
  • Profit (that is, when revenue exceeds expenses)

Credit and debit items are summarised at the end of a recording period in a trial balance which is a list of all the debit and credit balances. The trial balance acts as a self checking mechanism for the correctness of entries in the individual accounts and also as a starting point for the preparation of the balance sheet and a profit and loss account.

The following table summarizes the basic accounts. A "+" indicates an increase; a "−" indicates a decrease.

General Ledger (in 000s)

>

Debit/credit
Account Debit Credit
Assets + −
Liabilities − +
Shareholder Equity − +
Revenue (−) +
Expenses +

Ledger example

XYZ Company is closing its books for the end of the month. Each of the daily journals has been summarized and the amounts are ready to be transferred to the general ledger. The amounts to be transferred are:

To close the books for the month, we will adjust expenses and revenue to be zero by appropriately crediting and debiting the income summary and then closing the income summary to retained earnings (part of equity).

These items are entered in the ledger below; each matching credit and debit have been numbered to make finding them in the ledger easier.

>

Transaction

Debit

Credit

Balance

Expenses

Balance forward

     

1 Raw materials

$ 500

 

$ 500

2 Labor

$ 1500

 

$ 2000

3 Sales costs

$ 1000

 

$ 3000

5 Income summary

 

($ 3000)

-0-

Total

$ 3000

$ 3000

 

Revenue

Balance forward

     

4 Revenue from sales

 

$ 3500

$ 3500

6 Income summary

($ 3500)

 

-0-

Total

$ 3500

$ 3500

 

Cash

Balance forward

   

$11000

2 Labor

 

$ 1500

$ 9500

3 Sales costs

 

$ 1000

$ 8500

4 Revenue from sales

$ 3500

 

$12000

Total

$ 3500

$ 2500

 

Accounts Payable

Balance forward

   

$ 1000

1 Raw materials

 

$ 500

$ 1500

Total

-0-

$ 500

 

Income summary

Balance forward

   

-0-

5 Expense

$ 3000

 

−$ 3000

6 Revenue

 

$ 3500

$ 500

7 Retained earnings

$ 500

 

-0-

Total

$ 3500

$ 3500

 

Retained earnings

Balance forward

   

$10000

7 Income summary

 

$ 500

$10500

Total

-0-

$ 500

 

Total all accounts:

$13500

$13500

 

The amount in equity (in the form of retained earnings) has changed with a net credit of $500,000. Since equity has a normal balance of credit, this means there is now $500,000 more in equity than at the beginning of the month.

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