Double-entry bookkeeping system

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A double-entry bookkeeping system is a set of rules for recording financial information in a financial accounting system in which every transaction or event changes at least two different accounts.[1]

It was first codified in the 15th century. In modern accounting this is done using debits and credits within the accounting equation: Equity = Assets - Liabilities. The accounting equation serves as a kind of error-detection system: if at any point the sum of debits does not equal the corresponding sum of credits, an error has occurred.

Since several different types of errors result in equal sums for debits and credits, double-entry accounting is not a guarantee that no errors have been made.

Contents

[edit] Timeline

Century Development Stage
12th Later there are traces of the double-entry system in the accounting of the Islamic world from at least the 12th century.[2]
13th The earliest extant records that follow the modern double-entry form are those of Amatino Manucci, a Florentine merchant at the end of the 13th century.[3]
14th Some sources suggest that Giovanni di Bicci de' Medici introduced this method for the Medici bank in the 14th century.
15th By the end of the 15th century, the merchant venturers of Venice used this system widely. Luca Pacioli, a monk and collaborator of Leonardo da Vinci, first codified the system in a mathematics textbook of 1494.[4] Pacioli is often called the "father of accounting" because he was the first to publish a detailed description of the double-entry system, thus enabling others to study and use it.[5][6]

[edit] Significance

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Double-entry bookkeeping has been considered a fundamental innovation and a cornerstone of Capitalism by such thinkers as Werner Sombart and Max Weber, Sombart writing in "Medieval and Modern Commercial Enterprise" that:[7]

"The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double-entry bookkeeping. Capital can be defined as that amount of wealth which is used in making profits and which enters into the accounts."

[edit] Accounts

Main article: Account (accountancy)

An accounting system records, retains and reproduces financial information relating to financial transaction flows and financial position. Financial Transaction Flows encompass primarily inflows on account of incomes and outflows on account of expenses. Elements of financial position, including property, money received, or money spent, are assigned to one of the primary groups i.e. assets, liabilities, and equity.[8]

Within these primary groups each distinctive asset, liability, income and expense is represented by its respective "account". An account is simply a record of financial inflows and outflows in relation to the respective asset, liability, income or expense. Income and expense accounts are considered temporary accounts, since they represent only the inflows and outflows absorbed in the financial-position elements on completion of the time period.

[edit] Account types (nature)

Type Represent Examples
Real Physically tangible things in the real world and certain intangible things not having any physical existence Tangibles - Plant and Machinery, Furniture and Fixtures, Computers and Information Processing Equipment etc. Intangibles - Goodwill, Patents and Copyrights
Personal Business and Legal Entities Individuals, Partnership Firms, Corporate entities, Non-Profit Organizations, any local or statutory bodies including governments at country, state or local levels
Nominal Temporary Income and Expenditure Accounts for recognition of the implications of the financial transactions during each fiscal year till finalisation of accounts at the end Sales, Purchases, Electricity Charges

Example: A sales account is opened for recording the sales of goods or services and at the end of the financial period the total sales are transferred to the revenue statement account (Profit and Loss Account or Income and Expenditure Account).

Similarly expenses during the financial period are recorded using the respective Expense accounts, which are also transferred to the revenue statement account. The net positive or negative balance (profit or loss) of the revenue statement account is transferred to reserves or capital account as the case may be.

[edit] Account types (periodicity of flow)

The classification of accounts into real, personal and nominal is based on their nature i.e. physical asset, liability, juristic entity or financial transaction.

The further classification of accounts is based on the periodicity of their inflows or outflows in the context of the fiscal year.

Income is immediate inflow during the fiscal year.

Expense is the immediate outflow during the fiscal year.

An asset is a long-term inflow with implications extending beyond the financial period and by the traditional view could represent unclaimed income. Alternatively, an asset could be valued at the present value of its future inflows.

Liability is long term outflow with implications extending beyond the financial period and by the traditional view could represent unamortised expense Alternatively, a liability could be valued at the present value of future outflows.

Type of accounts Long term inflows Long term outflows Short term inflows Short term outflows
Real accounts Assets
Personal accounts Assets Liability
Nominal accounts Incomes Expenses

Items in accounts are classified into five broad groups, also known as the elements of the accounts:[9] Asset, Liability, Equity, Revenue, Expense.

The classification of Equity as a distinctive element for classification of accounts is disputable on account of the "Entity concept", since for the objective analysis of the financial results of any entity the external liabilities of the entity should not be distinguished from any contribution by the shareholders.

[edit] Accounting entries

[edit] Books of accounts

It does this by ensuring that each individual financial transaction is recorded in at least two different nominal ledger accounts within the financial accounting system. The two entries have equal amounts and opposite signs, so that when all entries in the accounts are summed, the total is exactly the same: the accounts balance. This is a partial check that each and every transaction has been correctly recorded. The transaction is recorded as a "debit record" (Dr.) in one account, and a "credit record" (Cr.) entry in the other account. The debit entry will be recorded on the debit side (left-hand side) of a General ledger and the credit entry will be recorded on the credit side (right-hand side) of a General ledger account. A General ledger has a Debit (left) side and a Credit (right) side. If the total of the entries on the debit side is greater than the total on the credit side of the nominal ledger account, that account is said to have a debit balance..

An example of an entry being recorded twice for double-entry bookkeeping would be a supplier's invoice for stationery costing 100. The expense or Debit entry is Stationery Nominal Ledger a/c 100 Dr (showing that 100 has been spent on stationery) and the Credit entry is to the Supplier's Control Nominal Ledger a/c 100 Cr (showing that we now owe the supplier 100). This transaction has now been recorded twice in the financial accounting system and the total value is 100 for both Debit and Credit values.

Double entry is used only in nominal ledgers. It is not used in daybooks, which normally do not form part of the nominal ledger system. The information from the daybooks will be used in the nominal ledger and it is the nominal ledgers that will ensure the integrity of the resulting financial information created from the daybooks (provided that the information recorded in the daybooks is correct).

(The reason for this is to limit the number of entries in the nominal ledger: entries in the daybooks can be totalled before they are entered in the nominal ledger. If there are only a relatively small number of transactions it may be simpler instead to treat the daybooks as an integral part of the nominal ledger and thus of the double-entry system.)

However as can be seen from the examples of daybooks shown below, it is still necessary to check, within each daybook, that the postings from the daybook balance.

The double entry system uses nominal ledger accounts. From these nominal ledger accounts a trial balance can be created. The trial balance lists all the nominal ledger account balances. The list is split into two columns, with debit balances placed in the left hand column and credit balances placed in the right hand column. Another column will contain the name of the nominal ledger account describing what each value is for. The total of the debit column must equal the total of the credit column.

From the trial balance the profit and loss statement and the balance sheet can then be produced. The profit and loss statement will contain nominal ledger accounts that are Income or Expense type nominal ledger accounts. The balance sheet will contain nominal ledger accounts that are asset or liability accounts.

[edit] Bookkeeping process

The bookkeeping process refers primarily to recording the financial effects of financial transactions only into accounts. The variation between manual and any electronic accounting system stems from the latency [disambiguation needed] between the recording of the financial transaction and its posting in the relevant account. This delay, absent in electronic accounting systems due to instantaneous posting into relevant accounts, is not replicated in manual systems, thus giving rise to primary books of accounts such as Sales Book, Cash Book, Bank Book, Purchase Book for recording the immediate effect of the financial transaction.

In the normal course of business, a document is produced each time a transaction occurs. Sales and purchases usually have invoices or receipts. Deposit slips are produced when lodgements (deposits) are made to a bank account. Cheques are written to pay money out of the account. Bookkeeping involves, first of all, recording the details of all of these source documents into multi-column journals (also known as a books of first entry or daybooks). For example, all credit sales are recorded in the Sales Journal, all Cash Payments are recorded in the Cash Payments Journal. Each column in a journal normally corresponds to an account. In the single entry system, each transaction is recorded only once. Most individuals who balance their cheque-book each month are using such a system, and most personal finance software follows this approach.

After a certain period, typically a month, the columns in each journal are each totaled to give a summary for the period. Using the rules of double entry, these journal summaries are then transferred to their respective accounts in the ledger, or book of accounts. For example the entries in the Sales Journal are taken and a debit entry is made in each customer's account (showing that the customer now owes us money) and a credit entry might be made in the account for "Sale of Class 2 Widgets" (showing that this activity has generated revenue for us). This process of transferring summaries or individual transactions to the ledger is called posting. Once the posting process is complete, accounts kept using the "T" format undergo balancing, which is simply a process to arrive at the balance of the account.

As a partial check that the posting process was done correctly, a working document called an unadjusted trial balance is created. In its simplest form, this is a three column list. The first column contains the names of those accounts in the ledger which have a non-zero balance. If an account has a debit balance, the balance amount is copied into column two (the debit column). If an account has a credit balance, the amount is copied into column three (the credit column). The debit column is then totalled and then the credit column is totalled. The two totals must agree - this agreement is not by chance - because under the double-entry rules, whenever there is a posting, the debits of the posting equal the credits of the posting. If the two totals do not agree, an error has been made either in the journals or during the posting process. The error must be located and rectified and the totals of debit column and credit column recalculated to check for agreement before any further processing can take place.

Once the accounts balance, the accountant makes a number of adjustments and changes the balance amounts of some of the accounts. These adjustments must still obey the double-entry rule. For example, the "inventory" account asset account might be changed to bring them into line with the actual numbers counted during a stock take. At the same time, the expense account associated with usage of inventory is adjusted by an equal and opposite amount. Other adjustments such as posting depreciation and prepayments are also done at this time. This results in a listing called the adjusted trial balance. It is the accounts in this list and their corresponding debit or credit balances that are used to prepare the financial statements.

Finally financial statements are drawn from the trial balance, which may include:

[edit] Abbreviations used in bookkeeping

[edit] Debits and credits

Main article: Debits and credits

Double-entry bookkeeping is governed by the accounting equation. If revenue equals expenses, the following (basic) equation must be true:

assets = liabilities + equity

For the accounts to remain in balance, a change in one account must be matched with a change in another account. These changes are made by debits and credits to the accounts. 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. Assets, Expenses, and Drawings accounts (on the left side of the equation) have a normal balance of debit. Liability, Revenue, and Capital 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 made to one or several accounts and a credit made to one or several accounts. The sum of all debits made in any transaction must equal the sum of all credits made. After a series of transactions, therefore, the sum of all the accounts with a debit balance will equal the sum of all the accounts with a credit balance.

Debits and credits are then defined as follows:

[edit] Double entry example 1

In this example the following will be used:

Books of prime entry (Books of original entry)

The books of prime entry are where transactions are first recorded. They are not part of the Double-entry system.

Ledger Cards

[edit] Purchase invoice daybook
Purchase Invoice Daybook
Date Supplier Name Reference Amount Electricity Widgets
10 July 2006 Electricity Company PI1 1000 1000  
12 July 2006 Widget Company PI2 1600   1600
------- ------- -------
Total 2600 1000 1600
==== ==== ====
Credit Debit Debit
Trade Electricity Widgets
Creditors G/L G/L
control a/c a/c a/c

Each individual line is posted as follows:

From example above:

The totals of each column are posted as follows:

Double-entry has been observed because Dr = 2600 and Cr = 2600.

[edit] Bank payments daybook

The payments book is not part of the double-entry system.

Bank Payments Daybook
Date Supplier Name Reference Amount Suppliers Wages
17 July 2006 Electricity Company BP701 1000 1000
19 July 2006 Widget Company BP702 900 900
28 July 2006 Owner's Wages BP703 400 400
------- ------- -------
Total 2300 1900 400
==== ==== ====
Credit Debit Debit
Bank Trade Wages
Account Creditors control a/c
control a/c

Keys: PI = Purchase Invoice, BP = Bank Payment

Each individual line is posted as follows:

From example above:

The totals of each column are posted as follows:

Double-entry has been observed because Dr = 2300 and Cr = 2300.

The daybooks are the key documents (books) to the double entry system. From these daybooks we create the ledger accounts. Each transaction will be recorded in at least two ledger accounts.

[edit] Supplier ledger cards
Supplier Ledger Cards
A/c Code: ELE01 - Electricity Company
Date Details Reference Amount Date Details Reference Amount
17 July 2006 Bank Payments Daybook BP701 1000 10 July 2006 Invoice PI1 1000
31 July 2006 Balance c/d 0
------- -------
1000 1000
==== ====
1 August 2006 Balance b/d 0
A/c Code: WID01 - Widget Company
Date Details Reference Amount Date Details Reference Amount
19 July 2006 Bank Payments Daybook BP702 900 12 July 2006 Invoice PI2 1600
31 July 2006 Balance c/d 700
------- -------
1600 1600
==== ====
1 August 2006 Balance b/d 700

[edit] Sales/customers

[edit] Sales daybook
Sales Invoice Daybook
Date Customer Name Reference Amount Parts Service
2 July 2006 JJ Manufacturing SI1 2500 2500  
29 July 2006 JJ Manufacturing SI2 3200   3200
------- ------- -------
Total 5700 2500 3200
==== ==== ====
Debit Credit Credit
Trade Sales Sales
debtors Parts Service
control a/c alabiebi a/c a/c

Each individual line is posted as follows:

From example above:

The totals of each column are posted as follows:

Double-entry has been observed because Dr = 5700 and Cr = 5700.

[edit] Customer ledger cards

Customer Ledger cards are not part of the Double-entry system. They are for memorandum purposes only. They allow you to know the total amount an individual customer owes you.

CUSTOMER LEDGER CARDS
A/c Code: JJM01 - JJ Manufacturing
Date Details Reference Amount Date Details Reference Amount
2 July 2006 Sales invoice daybook SI1 2500 20 July 2006 Bank receipts daybook BR1 2500
29 July 2006 Sales invoice daybook SI2 3200 31 July 2006 balance c/d 3200
------- -------
5700 5700
==== ====
1 August 2006 Balance b/d 3200

[edit] General (nominal) ledger

GENERAL (NOMINAL) LEDGER
Sales parts
Date Details Reference Amount Date Details Reference Amount
31 July 2006 Balance c/d 2500 2 July 2006 Sales invoice daybook SDB 2500
------- -------
2500 2500
==== ====
1 August 2006 Balance b/d 2500
Sales service
Date Details Reference Amount Date Details Reference Amount
31 May 2006 Balance c/d 3200 29 July 2006 Sales invoice daybook SDB 3200
------- -------
3200 3200
==== ====
1 June 2010 Balance b/d 3200
Electricity
Date Details Reference Amount Date Details Reference Amount
10 May 2010 Electricity Co. PDB 1000 30 May 2010 Balance c/d 1000
------- -------
1000 1000
==== ====
1 June 2010 Balance b/d 1000
Water
Date Details Reference Amount Date Details Reference Amount
12 May 2010 water Co. Pdb 1600 31 May 2010 Balance c/d 1600
------- -------
1600 1600
==== ====
1 August 2010 Balance b/d 1600
Other a/c
Date Details Reference Amount Date Details Reference Amount
28 July 2006 Owner's Wages BPDB 400 31 July 2006 Balance c/d 400
------- -------
400 400
==== ====
1 August 2006 Balance b/d 400
Bank Control A/c
Date Details Reference Amount Date Details Reference Amount
31 July 2006 Bank receipts daybook BRDB 2500 31 July 2006 Bank payments daybook BPDB 2300
31 July 2006 Balance c/d 200
------- -------
2500 2500
==== ====
1 August 2006 Balance b/d 200
Trade Debtors Control A/c
Date Details Reference Amount Date Details Reference Amount
1 July 2006 Balance b/d 0 31 July 2006 Bank receipts daybook BRDB 2500
31 July 2006 Sales Invoice Daybook SDB 5700 31 July 2006 Balance c/d 3200
------- -------
5700 5700
==== ====
1 August 2006 Balance b/d 3200
Trade Creditors Control A/c
Date Details Reference Amount Date Details Reference Amount
31 July 2006 Bank Payments Daybook BPDB 1900 1 July 2006 Balance b/d 0
31 July 2006 Balance c/d 700 31 July 2006 Purchase Daybook PDB 2600
------- -------
2600 2600
==== ====
1 August 2006 Balance b/d 700

The customers ledger cards shows the breakdown of how the trade debtors control a/c is made up. The trade debtors control a/c is the total of outstanding debtors and the customer ledger cards shows the amount due for each individual customer. The total of each individual customer account added together should equal the total in the trade debtors control a/c.

The supplier ledger cards shows the breakdown of how the trade creditors control a/c is made up. The trade creditors control a/c is the total of outstanding creditors and the suppliers ledger cards shows the amount due for each individual supplier. The total of each individual supplier account added together should equal the total in the trade creditors control a/c.

Each Bank a/c shows all the money in and out through a bank. If you have more than one bank account for your company you will have to maintain separate bank account ledger in order to complete bank reconciliation statements and be able to see how much is left in each account.

[edit] Bank account
Bank A/c
Date Details Reference Amount Date Details Reference Amount
1 July 2006 Balance b/d 0 17 July 2006 Bank Payments Daybook BP701 1000
28 July 2006 Bank Payments Daybook BP703 400
31 July 2006 Balance c/d 200
------- -------
2500 2300
==== ====
1 August 2006 Balance b/d 200
[edit] Unadjusted trial balance
Trial balance as at 31 July 2006
A/c description Debit Credit
Sales-parts 2500
Sales-service 3200
Widgets 1600
Electricity 1000
Other 400
Bank 200
Trade Debtors Control A/c 3200
Trade Creditors Control A/c 700
------- -------
6400 6400
===== =====
Both sides must have the same overall total
Debits = Credits.

The individual customer accounts are not to be listed in the trial balance, as the Trade debtors control a/c is the summary of each individual customer a/c......

The individual supplier accounts are not to be listed in the trial balance, as the Trade creditors control a/c is the summary of each individual supplier a/c.

Important note: this example is designed to show double entry. There are methods of creating a trial balance that significantly reduce the time it takes to record entries in the general ledger and trial balance.

[edit] Profit-and-loss statement and balance sheet
Profit and loss statement
for the month ending 31 July 2006
Dr
x Sales
x Sales-parts 2500
x Sales-service 3200
x -------
x 5700
x Widgets 1600
x -------
x Gross Profit 4100
x Less expenses
x Electricity 1000
x Other 400
x -------
x 1400
x -------
x Net Profit 2700
x ====
Balance sheet
as at 31 July 2006
Dr
x Current Assets
x Bank A/c 200
x Trade Debtors 3200
x -------
x 3400
x Current Liabilities
x Trade Creditors 700
x -------
x 700
x -------
x Net Current Assets 2700
x ====
x Capital & Reserves
x Revenue Reserves a/c 2700
x -------
x 2700
x ====

[edit] Double Entry Example 2

[edit] Transactions

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 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.

[edit] Ledgers

General Ledger (in 000s)
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 -
Total 3000 3000
Revenue
Balance forward     -
4 Revenue from sales   3500 3500
6 Income summary 3500   -
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 - 500
Income summary
Balance forward     -
5 Expense 3000   3000
6 Revenue   3500 500
7 Retained earnings 500   -
Total 3500 3500
Retained earnings
Balance forward     10000
7 Income summary   500 10500
Total - 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.

[edit] See also

[edit] Notes and references

  1. ^ Double Entry Bookkeeping
  2. ^ Subhi Y. Labib (1969), "Capitalism in Medieval Islam", The Journal of Economic History 29 (1): 79–96 [92–3]
  3. ^ G. A. Lee (1977), "The Coming of Age of Double Entry: The Giovanni Farolfi Ledger of 1299-1300", Accounting Historians Journal, 4(2): 79-95
  4. ^ Luca Pacioli: The Father of Accounting
  5. ^ La Riegola De Libro
  6. ^ Livio, Mario (2002). The Golden Ratio. New York: Broadway Books. pp. 130–131. ISBN 0-7679-0816-3. 
  7. ^ Lane, Frederic C; Riemersma, Jelle, eds (1953). Enterprise and Secular Change: Readings in Economic History. R. D. Irwin. p. 38.  (quoted in "Accounting and rationality")
  8. ^ Woodford, William; Wilson, Valerie; Freeman, Suellen; Freeman, John (2008). Accounting: A Practical Approach (2 ed.). Pearson Education. pp. 24. ISBN 978-0-409-32357-3. 
  9. ^ IASB Framework for the Preparation and Presentation of Financial Statements, Paragraph 47

[edit] External links

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