To understand the double entry system of bookkeeping first requires that you be acquainted with the the underlying accounting practice that every business transaction involves two accounts. For example, a $100 incoming payment from a customer will be debited to the Cash account and credited to the Revenue account.
Unlike common use of these words, in accounting “credit” means to take away from and “debit” means to add to, so in this example the payment increases Cash by $100 and reduces Revenue (money owed to you) by an equal amount. This simple concept lies at the heart of Generally Accepted Accounting Principles (GAAP) in India and elsewhere.
Two Methods – One Answer
Due to its history of British Colonialism, India’s accounting practices are almost identical to those in England. While it does not incorporate the American idea of the Accounting Equation (Assets = Liabilities + Owner’s Equity), choosing instead to adhere to the three Golden Rules of Accounting listed below, the use of a double entry system of accounting remains the same.
The UK Golden Rules:
Real account – debit what comes in and credit what goes out
Personal account – debit the receiver and credit the giver
Nominal account – debit all expenses and losses and credit all incomes and gains
Finding a Numerical Balance
Regardless of which accounting system one employs, the end result is the same; the numbers between accounts must balance. Thus was born the double entry system. The first thing to keep in mind is that you never record a transaction with a single entry in a double entry system. This will throw your books out of whack and result in errors. For the accounts to remain in balance (which is always the goal), an offsetting entry must be made into an opposing account. This practice is where the term “double entry” comes from. Remember when we mentioned earlier the idea of debits and credits as related to accounting?
Retrieve that from your memory banks because we’re going to add to it.
With the double entry system, a debit must be offset by an equal amount credit and vice versa.
A debit has the following effect on accounts:
1. Assets increase
2. Expenses increase
3. Liabilities decrease
4. Equities decrease
5. Income decreases
A credit has the following effect on accounts:
1. Assets decrease
2. Expenses decrease
3. Liabilities increase
4. Equities increase
5. Income increases
By observing these effects on accounts, your books remain in balance.
Chart of Accounts
By now you may have noticed that the double entry system of accounting requires that a bookkeeper create a series of accounts to which debits and credits are made. Don’t be alarmed at the idea. Think of an account simply as a way of organizing the inflow and outflow of money from a company. The collection of all your accounts is referred to as the Chart of Accounts and may include such entities as cash, petty cash, accounts receivable, work-in-progress, finished goods, insurance, rent, computer equipment, utilities, notes receivable, depreciation, and more.
Depending upon the size and complexity of your business, the number and type of accounts can vary greatly. Creating a chart of accounts is necessary before any actual accounting begins, since this is where your transaction entries will be recorded. Let’s take a look at a simple double entry example, the payment of a utility bill.
DEBIT Utility Expense $500 (increase expense)
CREDIT Cash $500 (decrease cash)
Don’t be thrown off by the offset alignment of the debit/credit column. Accountants do this to make it easier to visualize. What we’re looking at is a situation where $500 has been added to the Utility Expense account, because it is money owed to a creditor. In this case, it’s the local utility company. Remember, in accounting terms, a debit means we increase the balance.
The offsetting entry for this transaction comes in the form of decreasing the Cash account by $500, which signifies money leaving your checking account to pay the utility bill. At this point you have recorded an expense as well as as the payment of the expense. The transaction is now complete and your books are in balance.
The Bottom Line
The double entry accounting method was developed as a built-in way to prevent errors, but even it isn’t foolproof. One side of the transaction could be posted to the wrong account or the entries could be reversed. In either case, the books might remain in balance but wouldn’t be an accurate reflection of the underlying business activity. The bottom line is that the double entry system has been with us for a long time (since about 918 A.D. Korea), long enough that it’s safe to assume it won’t be going away in the near future. Though originally implemented back when accounting was done manually, this system has made the transition to today’s modern software packages with ease.