Double-Entry Bookkeeping System
Double-entry bookkeeping, also known as double-entry accounting, is a method of bookkeeping under which every financial transaction is recorded through equal and opposite entries known as debit and credit. Every transaction has two aspects, and both aspects are recorded in the books of accounts. This equal recording of debit and credit helps in balancing the books of accounts.
The main purpose of double-entry bookkeeping is to maintain accuracy in financial records and assist in detecting errors or fraud. Since every transaction affects at least two accounts and total debit entries should equal total credit entries, the system provides a mechanism for checking the mathematical balance of accounting records.
Accounting Equation and Double-Entry System
The basic foundation of double-entry bookkeeping is the accounting equation:
Assets = Liabilities + Equity
Every financial transaction must be recorded in such a manner that this accounting equation remains balanced. A transaction may increase or decrease one or more components of the accounting equation, but the total effect must maintain equality between assets and the combined amount of liabilities and equity.
For example, suppose a company purchases a new piece of equipment. The purchase increases an asset because equipment is an asset of the business. If the company pays cash for the equipment, cash, which is another asset, decreases. Therefore, one asset increases while another asset decreases.
Alternatively, if the company purchases the equipment by taking a loan, the equipment asset increases and the company’s liability also increases. In both situations, the accounting equation remains balanced.
The position of an account within the accounting equation determines its normal balance. For example, a debit increases an asset account, whereas a credit increases a liability account.
Importance of Double-Entry Bookkeeping
Double-entry bookkeeping is a standard method used for tracking business transactions. It improves the ability of users of financial information to read, process, and understand the financial position and financial activities of a company.
As the number and complexity of business transactions increase, manual tracking of individual transactions becomes difficult. Therefore, companies use ledgers and accounting information systems to automate the recording and tracking of transactions.
The information recorded through the double-entry system is also used to prepare financial statements. Thus, double-entry bookkeeping provides a systematic foundation for maintaining accounting records and producing financial information.
History of Double-Entry Bookkeeping
The earliest surviving accounting records in Europe that follow the modern double-entry system are associated with Amatino Manucci, a Florentine merchant who lived at the end of the 13th century.
Manucci worked for the Farolfi firm, and the firm’s ledger for 1299–1300 provides evidence of a complete double-entry bookkeeping system. Giovannino Farolfi & Company was a firm of Florentine merchants headquartered in Nîmes. The firm also operated as a moneylender to the Archbishop of Arles, who was its most important customer.
Some sources have suggested that Giovanni di Bicci de’ Medici introduced double-entry bookkeeping for the Medici Bank during the 14th century. However, sufficient evidence supporting this claim is lacking.
Development in Italian Merchant Cities
The double-entry bookkeeping system began to spread among Italian merchant cities during the 14th century. Before the development of the formal double-entry system, accounting records may have been maintained in several books. However, these earlier systems did not necessarily possess the formal and systematic structure required to effectively control business economic activities.
During the 16th century, Venice became an important centre for the theoretical development of accounting science. Important contributions were made through the writings of Luca Pacioli, Domenico Manzoni, Bartolomeo Fontana, accountant Alvise Casanova, and Giovanni Antonio Tagliente.
Benedetto Cotrugli and Double-Entry Bookkeeping
Benedetto Cotrugli, also known as Benedikt Kotruljević, was a Ragusan merchant and ambassador to Naples. He described double-entry bookkeeping in his treatise Della mercatura e del mercante perfetto.
The work was originally written in 1458. However, no surviving manuscript older than 1475 is known, and the treatise was not printed until 1573.
The printer shortened and modified Cotrugli’s discussion of double-entry bookkeeping. These changes made the historical development of the subject less clear.
Luca Pacioli and Codification of Double-Entry Bookkeeping
Luca Pacioli, a Franciscan friar and collaborator of Leonardo da Vinci, played an important role in the development of double-entry bookkeeping.
Pacioli formally codified the double-entry bookkeeping system in his mathematics textbook Summa de arithmetica, geometria, proportioni et proportionalità, which was published in Venice in 1494.
Luca Pacioli is commonly called the “Father of Accounting” because he was the first person to publish a detailed description of the double-entry bookkeeping system. The publication of this description enabled other people to study, understand, and apply the system.
In early modern Europe, double-entry bookkeeping also had theological and cosmological associations. Its balancing nature was compared with the scales of justice and the symmetry of God’s world.
Approaches to Double-Entry Bookkeeping
The double-entry bookkeeping system can be applied through two main approaches: the Traditional Approach, also known as the British Approach, and the Accounting Equation Approach, also known as the American Approach.
Regardless of the approach used, every financial transaction has two aspects: debit and credit. The final effect on the books of accounts remains the same under both approaches.
Traditional Approach or British Approach
Under the Traditional Approach, accounts are divided into three main categories: Real Accounts, Personal Accounts, and Nominal Accounts.
Real Accounts
Real accounts are accounts relating to assets of the business. These assets may be tangible or intangible in nature.
Tangible assets have a physical existence, while intangible assets do not have a physical form. Under the traditional approach, accounts relating to such assets are classified as real accounts.
The golden rule for real accounts is:
Debit what comes in and credit what goes out.
When an asset comes into the business, the relevant real account is debited. When an asset goes out of the business, the relevant real account is credited.
Personal Accounts
Personal accounts relate to persons or organisations with whom the business carries out transactions. These accounts mainly include the accounts of debtors and creditors.
The golden rule for personal accounts is:
Debit the receiver and credit the giver.
The person or organisation receiving value is debited, while the person or organisation giving value is credited.
Nominal Accounts
Nominal accounts relate to revenues, expenses, gains, and losses of the business.
The golden rule for nominal accounts is:
Debit all expenses and losses and credit all incomes and gains.
Therefore, expenses and losses are normally debited, whereas income and gains are normally credited.
Golden Rules of Accounting
| Type of Account | Golden Rule |
|---|---|
| Real Account | Debit what comes in, credit what goes out |
| Personal Account | Debit the receiver, credit the giver |
| Nominal Account | Debit expenses and losses, credit incomes and gains |
These golden rules provide the basis for identifying the debit and credit aspects of transactions under the traditional approach.
Importance of Primary Journals and Original Vouchers
Primary journals are important because accounting records should make it possible to trace every individual business transaction back to its original voucher without significant difficulty.
Such traceability should remain available during the applicable record retention period, including for transactions that occurred in the past. Bank statements may also be used as primary journals.
To simplify the tracking of transactions in the general ledger, the account assignment should be recorded on the original document. Alternatively, an accounting system should provide corresponding digital traceability.
Thus, the accounting records should provide a clear connection between the original document and the transaction recorded in the ledger.
Accounting Equation Approach or American Approach
The Accounting Equation Approach, also known as the American Approach, records transactions on the basis of the accounting equation:
Assets = Liabilities + Equity
The accounting equation represents equality between the debit and credit effects of accounting transactions. The rules of debit and credit depend on the nature of the account involved in the transaction.
Under the accounting equation approach, accounts are classified into five main categories: Assets, Capital, Liabilities, Revenues or Incomes, and Expenses or Losses.
When an increase or decrease occurs in one set of accounts, there must be a corresponding equal decrease or increase in another set of accounts. This ensures that the accounting equation remains balanced.
Books of Accounts under Double-Entry Bookkeeping
Under double-entry bookkeeping, every financial transaction is entered into at least two nominal ledger accounts. This ensures that the total amount of debit entries equals the total amount of credit entries and maintains the balance of the general ledger.
The equality of total debits and total credits provides a partial check that transactions have been correctly recorded. However, equality alone does not necessarily prove that every transaction is completely free from error.
Each transaction is recorded as a debit entry, represented by Dr, in one account and a credit entry, represented by Cr, in another account.
By accounting convention, debits are recorded on the left-hand side of a ledger account and credits are recorded on the right-hand side.
If the total debit entries in an account exceed the total credit entries in the same nominal account, the account is said to have a debit balance.
Nominal Ledgers and Daybooks
Double-entry accounting is applied within nominal ledgers. Daybooks or journals generally serve as preliminary records of transactions and are not normally treated as part of the nominal ledger itself.
Information recorded in the daybooks is subsequently transferred to the nominal ledger. The nominal ledger helps maintain the integrity of financial information produced from the daybooks, provided that the original information recorded in the daybooks is correct.
One reason for using daybooks is to reduce the number of individual entries made in the nominal ledger. Transactions recorded in a daybook can be totalled before the total amount is entered into the nominal ledger.
However, where a business has only a small number of transactions, it may be simpler to treat daybooks as an integral part of the nominal ledger and the double-entry system.
Even when daybooks are used, it is necessary to check that the postings from each daybook are balanced.
Trial Balance
Nominal ledger accounts provide the basis for preparing a trial balance. A trial balance is a statement that lists the debit and credit balances of nominal ledger accounts to check whether total debit balances equal total credit balances.
The trial balance contains all nominal ledger account balances. These balances are divided into two columns. Debit balances are shown in the left-hand column, while credit balances are shown in the right-hand column.
Another column normally contains the name of the nominal ledger account, which identifies the nature of each balance.
The total of the debit column must be equal to the total of the credit column. This equality is an important mathematical check under the double-entry bookkeeping system.
Debits and Credits
A debit entry represents a transfer of value to an account, while a credit entry represents a transfer of value from an account.
Since both sides of a double-entry transaction must remain balanced, every type of account has a normal balance. The normal balance depends on whether a debit or credit normally increases the particular type of account.
The normal debit and credit rules are as follows:
| Account Type | Debit Effect | Credit Effect |
|---|---|---|
| Asset | Increase | Decrease |
| Liability | Decrease | Increase |
| Capital | Decrease | Increase |
| Revenue | Decrease | Increase |
| Expense | Increase | Decrease |
Thus, assets and expenses normally increase with debit entries, while liabilities, capital, and revenue normally increase with credit entries.
Historically, because of the format of ledger accounts, debits are recorded on the left side and credits on the right side. This arrangement can also be graphically represented through a T-account.
Transaction Example under Double-Entry Bookkeeping
Suppose a business performs three transactions. First, it purchases $10,000 of inventory from a vendor on credit. Second, it sells the inventory to a customer for $15,000 in cash. Finally, it pays $10,000 cash to the vendor for the inventory originally purchased on credit.
When inventory worth $10,000 is purchased on credit, the inventory asset increases by $10,000. At the same time, the liability payable to the vendor also increases by $10,000. Therefore, both sides of the transaction are equal.
When the inventory is sold to a customer for $15,000 cash, cash increases by $15,000. The business also records the effect of the sale. The inventory costing $10,000 is removed from the business records.
Finally, when the business pays $10,000 to the vendor, cash decreases by $10,000 and the liability towards the vendor also decreases by $10,000.
After recording all the transactions, the business has a net increase in cash of $5,000 and an increase in equity of $5,000.
This result is logical because the company purchased inventory for $10,000 and sold it for $15,000. The difference of $5,000 represents profit earned by the business.
As a result, the owner’s equity in the business increases by $5,000. This example demonstrates that both aspects of every transaction remain equal and the accounting equation remains balanced.
Exam Focus
Double-entry bookkeeping records every financial transaction through equal and opposite debit and credit entries. Its main purpose is to maintain accounting accuracy and assist in detecting errors or fraud.
The basic accounting equation is Assets = Liabilities + Equity, and every transaction must maintain the balance of this equation.
The two approaches to double-entry bookkeeping are the Traditional or British Approach and the Accounting Equation or American Approach. Under the traditional approach, accounts are classified as Real, Personal, and Nominal Accounts.
Remember the three golden rules: Debit what comes in and credit what goes out for Real Accounts; Debit the receiver and credit the giver for Personal Accounts; and Debit expenses and losses and credit incomes and gains for Nominal Accounts.
Under the accounting equation approach, accounts are classified into Assets, Capital, Liabilities, Revenues or Incomes, and Expenses or Losses.
Debits are recorded on the left side and credits on the right side of a ledger account. Assets and expenses increase through debits, while liabilities, capital, and revenue increase through credits.
Nominal ledger accounts form the basis of the trial balance, where total debit balances must equal total credit balances. Luca Pacioli is known as the Father of Accounting because he first published a detailed description of the double-entry bookkeeping system in 1494.