What is double entry bookkeeping?
Double entry bookkeeping is an accounting system in which a transaction is recorded twice: once at the debit side and once at the credit side. It is called double entry simply because there are always double entries i.e. left side and right side.
Let us take an example how each transaction is recorded in two separate accounts. X sells an item to Y (X and Y being hypothetical businesses).
In the books of X
Credit Sales Account
Debit Bank Account
In the books of Y
Debit Purchases Account
Credit Bank Account
The double entry system records what comes in and what goes out in the same transactions. The account which receives is debited and the one which gives is credited. The same transactions between two parties will have the opposite entries in their respective books. In our above example, X credits sales account as the item goes out and debits the bank account as it receives cash. On the other hand, Y debits purchases account as it receives the item and credits the bank account as it gives the cash out.
The logic of double entry system of accounting dictates that each entry has equal and opposite entry or entries and that the total on the debits side must equal the total on the credit side.
Double Entry System of Accounting has been in vogue since medieval times. The first persons who documented and regularised the system of Double Entry Bookkeeping were Franciscan and Luca Pacioli. As the time passed, it became wide popular and has since then been the most widely used system of recording business transactions throughout the world.
Debits and Credits
As earlier mentioned, the system works on the principle of debits and credits. For each debit there is a credit and vice versa. This makes sure that all the transactions are recorded properly and all the books are balanced.
Advantages of Double Entry System
1. In complex and large organisations, it is very important to maintain accuracy of business transactions. Such accurate calculation and balancing of books is vital to preparing Profit and Loss account and other financial statements.
2. It is easier to detect errors and correct them as the total on both sides must equal.
3. It prevents frauds and forgeries.
4. Various accurate financial statements, ratios and forecasts statements can be directly derived from the system.
Approaches of Double Entry System
There are two popular approaches used in the system. One is called traditional and the other is called accounting equation. We shall briefly discuss both the approaches here.
1. Traditional Approach
This is also known as the British system of double entries and is used in Britain. The traditional or British approach classifies accounts into three classes. First are known as real accounts, which are assets. Second are called personal accounts which include liabilities and owner’s equity. Finally, there are nominal accounts which are revenues, expenses, losses and gains of the business.
It is easy to understand the approach by using the golden rules of accounting. In this article we will give a short explanation of each golden rule.
1. Personal Account:
The Rule is: Debit the receiver and credit the giver.
Example: Scot receives $5000 loan from the bank. The bank will debit Scot with $5000 as he is the receiver. If Scot pays in $5000 to the bank, Scot is credited for the amount.
2. Real Accounts
The Rule is: Debit what comes in and credit what goes out.
Example: Business A sells apples for $5000.
In this transaction cash comes in so cash (or bank) account is debited with $5000 while the apples go out, so sale account is credited for the same amount.
3. Nominal Accounts
The Rule is: Debit all expenses and losses and credit all incomes and gains.
II. Accounting Equation Approach
This is based on the accounting equation i.e. Assets are equal to liabilities and capital. This approach is also known as the American double entry system. This method divides the accounts into five types. Here is a summary of the accounts and the rules applied.
1. Asset Accounts
The Rule: A debit increases asset while a credit decreases it.
2. Capital Account:
The Rule: This is the opposite of the Asset accounts. A credit increases capital and a debit decreases it.
The Rule: Credit means increase and debit means decrease
4. Revenues and Income Accounts
The Rule: Credit increases the account and debit decreases it.
5. Expenses or Losses accounts
The Rule: debit increases it and credit decreases it.
- Definition. The Double Entry System of account is that type of recording business transactions, in which two entries are made, both equal in value.
- Double Entry System started in medieval times and since then has been very popular.
- There are many advantages of the system such as accuracy, balancing of books, detection of errors and frauds.
- There are two main approaches i.e. traditional and accounting equation.
- The traditional approach is called British and the accounting equation approach is also known as American.
- The British system divides accounts into three types while the American systems classifies them into five types.