Lesson Objectives:- What the double entry accounting system is
- Explanation behind the dual entries
- The universal application of the system
- Examples of transactions
The purpose of financial accounting is to record the effect of each economic event. The double entry accounting system operates on the fact that every transaction has 2 entries.
This system is applied universally throughout all companies because it is the most accurate way of measuring transactions. Without the concept of double entry accounting, the financial records would only be a partial representation of the company's activities.
The word double-entry is used because there are always 2 entries for every economic transaction that occurs within the company. There is both one debit and one credit for every transaction.
If there were only a single debit or just one credit, this would cause the company's account balances to be incorrect. For example, if a company uses cash to purchase a vehicle and the transaction is only recorded as a credit in the cash account. In this case, the asset's value would be incorrect as the double entry system calls for the vehicle asset to be recorded as a debit.
This system is represented in the illustration above that shows the debits and credits for each item on the balance sheet and income statement accounts.
We discussed the financial accounting equation in one of the previous lessons. The double entry accounting system further exemplifies the importance of both sides of the equation balancing out at all times.
An example of this behavior would be when the expenses of a business are increasing and their cash is decreasing, the owners' equity that is left over will subsequently decrease as well.
Let's say their expenses increased by $ 5,000. The assets would be subtracted by $ 5,000 on the left side of the accounting equation and it would balance out because the $5,000 is also deducted from the residual equity on the right side.
Here are a few things to keep in mind when thinking of the double entry accounting system:
Just as the two sides of the accounting equation must balance out, the total debit must be equal to the credit.
Debits do not necessarily reflect an outflow of cash and credits do not represent profits. Each entry represents the change in the two different accounts.
Even when the equation balances, there can still be partial recognition because there is still room for errors. Examples of errors include duplicate entries or if the wrong account is debited or credited. There is also the possibility for completely omitting a transaction.
There are two important rules to remember regarding double entry accounting.
The first rule is accounts always increase on the same side as they appear in the accounting equation A = L + SE. Assets increase on the left side of the account with liabilities and equity increasing on the right side of the account.
The second rule is left is debit and right is credit. You will use debits to increase assets and decrease liabilities and equity accounts. You will use credits to decrease assets and increase liabilities and equity.
See the chart above for an example of how this system works.
Here are just a few of the common examples that demonstrate the double entry accounting system:
Payroll transactions - You are subtracting the wages you pay out to your employees. This transaction is a credit which involves either subtracting cash or money from a payroll account and debit to payroll expense.
Purchasing machinery with cash - You will credit the cash account and debit the equipment asset account.
Making a loan payment - You will debit the liability account as the payment is reducing the amount you owe. The cash that was used to make the payment is a credit to the cash asset account as you are decreasing the assets.
We will go in more depth on the types of debits and credits in the next lesson. For the purpose of this lesson, you simply need to know that every transaction has one debit and one credit. This system is applied to all economic events as there are always two accounts affected.