Double-entry bookkeeping system

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In record keeping, particularly accountancy, the double-entry bookkeeping (or double-entry accounting) system is the basis of the standard system used by businesses and other organizations to record financial transactions. Its premise is that a business's (or other organization's) financial condition and results of operations are best represented by several variables, called accounts, each of which reflects a particular aspect of the business as a monetary value.

This system is called double entry because each transaction is double entered. Each debit value must have a corresponding credit value, and all transactions must "balance" so that when you add up all the debit balances, the total must be the same as the total of all the credit balances.

Every transaction is recorded by entries in at least two accounts. The total of the debit values must equal the total value of the credit values. The premise for this is that any monetary transaction must logically affect two aspects of a company. For example, if an item is sold (Credit Sales), then it must also be paid for by the customer (Debit Bank Account). Alternatively, if an item is purchased (Debit Purchases), then the company must also pay for it (Credit Bank Account). Most transactions consist of two entries, but can have three or more entries e.g. Supplier Invoice Total = Net Value + Taxes.

Historically, debit entries have been recorded on the left hand side and credit values on the right hand side of a general ledger account. The ledger accounts are set up as T accounts so called because they resemble the letter T when the account is empty.

Contents

[edit] History

The origins of a primitive double-entry system have been traced as far back as the 12th century. Some sources suggest that Giovanni di Bicci de' Medici first introduced this method for the Medici bank. The earliest extant records that follow the modern double-entry form are those of Amatino Manucci, a Florentine merchant at the beginning of the 14th century[1]. 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 1494 mathematics textbook [2]. Pacioli is often called the "father of accounting" because he was the first to publish a detailed description of the double-entry system, which enabled others to study and use it.[3]

[edit] The bookkeeping and accounting process

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 recording the details of all of these source documents into a journal (also known as a book of first entry or daybook). 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.

Businesses, however, usually use a more complex double-entry system, where each document is recorded as multiple journal entries, the totals of which always have to balance.

For example, when a business receives a shipment of 100 widgets at a cost of $10 each from a supplier, the amount of inventory increases by $1000. However, the business's debt (the amount of money owed to creditors) also increases by $1000. When the supplier's invoice is paid, the debt (creditors' account) is decreased by $1000, and the bank account balance is also decreased by $1000.

This allows a business to know much more information about its current financial position than is possible using a single entry system. The double-entry journal permits the business to determine at any time the amount of funds the business has on deposit in the bank, as well as how much it owes its suppliers, how much customers owe it, how much tax is due, etc.

These journal entries are then transferred to their own accounts in the ledger, or book of accounts. The ledger contains the individual accounts that will appear on a trial balance. Posting is the process of transferring the values to a ledger. Once the journal entries have all been posted, the ledger accounts are added up in a process called balancing. Each account will now have a total value.

A working document called an unadjusted trial balance is created which lists all the balances from all the accounts in the ledger. Note that the balance on each account is not posted to the unadjusted trial balance. The amounts are copied to a two column list with debit balance amounts recorded in the left column and credit balance amounts recorded in the right column. This list contains each account's value at the date of the Trial Balance (e.g. month end date), and each account is listed to ensure that the total of all the debit account balances (left column) equals the total of all the credit account balances (right column). The two columns must have the same total, if they do not then double-entry has failed somewhere in the process and the difference must be found before further adjustments can be made.

At this point, the accountant produces a number of adjustments which ensure that the values comply with accounting principles. These values are then passed through the accounting system resulting in an adjusted trial balance. This process continues until the accountant is satisfied that the resulting figures are correct and can be used to produce financial statements.

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


[edit] An explanation of debits and credits

Double-entry bookkeeping is governed by the accounting equation. At any point in time, the following equation must be true:

assets = liabilities + equity

For a particular time period, the equation becomes:

assets = liabilities + equity + (revenue − expenses)

Finally, this equation may be rearranged algebraically as follows:

assets + expenses = liabilities + equity + revenue

This equation must be true, for any time period. If it is, then the accounts are said to be in balance. If the accounts are not in balance, an error has occurred.

For the accounts to remain in balance, a change in one account must be matched with a change in another account. These changes are known as debits and credits. 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. Asset and expense accounts (on the left side of the equation) have a normal balance of debit. Liability, equity, and revenue 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 and a matching credit, and the sum of all debits for all accounts must equal the sum of all credits.

Debits and credits are then defined as follows:

  • debit: an increase in one of the accounts with a normal balance of debit or a decrease in one of the accounts with a normal balance of credit. A debit is recorded on the left hand side of a 'T' account
  • credit: an increase in one of the accounts with a normal balance of credit or a decrease in one of the accounts with a normal balance of debit. A credit balance is recorded on the right hand side of a 'T' account
  • Debit accounts = Asset and Expenses (also debit money received into bank accounts)
  • Credit accounts = Gains (income) and Liabilities (also credit money paid out of bank accounts)

The following accounts have a normal balance of debit:

  • Assets
  • Accounts receivable: debts promised by other entities but not yet paid
  • Drawings by the owners on equity
  • Expenses
  • Losses (that is, when expenses exceed revenue)

The following accounts have a normal balance of credit:

  • Liabilities
  • Accounts payable and taxes, notes or loans payable: debts promised to outsiders but not yet paid
  • Revenue
  • Profit (that is, when revenue exceeds expenses)

Examples of debits and credits:
Purchase of a Computer
Debit = Computer A/c (Fixed Asset A/c)
Credit = Creditors A/c (Liability A/c)

Paying supplier for the computer
Debit: Creditors A/c (Liability A/c) You are reducing a Liability A/c
Credit: Bank A/c (Asset A/c) Money going Out, you are reducing an asset account

Credit and debit items are summarised at the end of a recording period in a trial balance which is a list of all the debit and credit balances. The trial balance acts as a self checking mechanism for the correctness of entries in the individual accounts and also as a starting point for the preparation of the Final Account which is made up of the balance sheet and the trading, profit and loss account.

The following table summarizes the basic accounts. A "+" indicates an increase; a "−" indicates a decrease.

Debit/credit
Account Debit Credit
Assets + −
Expenses + (−)
Liabilities − +
Shareholder Equity − +
Revenue (−) +

As a mnemonic device for students: Note that only Assets and Expenses show an Increase for Debits and Decrease for Credits. All other accounts are the reverse. First memorize the acronyms AID (Assets Increase Decrease) & EID (Expenses Increase Decrease)and then keep in mind that the table reads Debits on the left and Credits on the right.

Debit/credit
Account Debit Credit Account Debit Credit
Assets Inc. Dec. A I D
Expenses Inc. Dec. E I D
Liabilities Dec. Inc.
Shareholder Equity Dec. Inc.
Revenue Dec. Inc.

[edit] An explanation of a T account

A T account is called such because it looks like the letter "T" when drawn like so:

Debits Credits
   
   
   
   
   

Debit entries are made on the left side of the vertical line and credit entries are made on on the right side of the vertical line.

[edit] Double-entry working examples

[edit] Example 1

In this example the following will be used: Books of first entry (a.k.a. Books of prime entry)

  • Sales Invoice Daybook (records customer Invoice Daybook)
  • Bank Receipts Daybook (records customer & non customer receipts)
  • Purchase Invoice Daybook (records supplier Invoice Daybook)
  • Bank Payments Daybook (records supplier & non supplier payments)


Ledger Cards

  • Customer Ledger Cards
  • Supplier Ledger Cards

General Ledger (Nominal Ledger)
Bank Account Ledger
Trade Creditors Ledger
Trade Debtors Ledger

From the above we will create:

  • Trial Balance
  • Profit and Loss Statement (Dr & Cr Formating, classic format)
  • Profit and Loss Statement (List Format, Modern version used today)
  • Balance Sheet (Dr & Cr Formatting, classic format)
  • Balance Sheet (List Format, Modern version used today)

[edit] Purchases/creditors

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

Each individual line is posted as follows:
The amount value is posted as a credit to the individual supplier's ledger a/c
The analysis amount is posted a debit to the relevant general ledger a/c
From example above:

Line 1 - Amount value 1000 is posted as a credit to the Supplier's ledger a/c ELE01-Electricity Company
Line 1 - Electricity value 1000 is posted as a debit to the Electricity general ledger a/c code

Double-entry has been observed Dr = 1000 Cr = 1000

Line 2 - Amount value 1600 is posted as a credit to the Supplier's ledger a/c WID01-Widget Company
Line 2 - Widget value 1600 is posted as a debit to the Widget general ledger a/c code

Double-entry has been observed Dr = 1600 Cr = 1600

The totals of each column are posted as follows:

Amount total value 2600 posted as a credit to the Trade creditors control a/c
Electricity total value 1000 posted as a debit to the Profit & loss control a/c
Widget total value 1600 posted as a debit to the Profit & loss control a/c

Double-entry has been observed Dr = 2600 Cr = 2600

[edit] Bank payments daybook
Bank Payments Daybook
Date Supplier Name Reference Amount Trade Creditors Other
17 Jul 2006 Electricity Company BP701 1000 1000
19 Jul 2006 Widget Company BP702 900 900
28 Jul 2006 Owner's Wages BP703 400 400
------- ------- -------
Total 2300 1900 400
==== ==== ====
Credit Debit Debit
Profit & Trade Wages
loss Creditors control a/c
control a/c control a/c

Keys: PI = Purchase Invoice, BP = Bank Payment

Each indivdual line is posted as follows: The amount value is posted as a debit to the individual supplier's ledger a/c
The analysis amount is posted as a credit to the relevant general ledger a/c
From example above:

Line 1 - Amount value 1000 is posted as a debit to the Supplier's ledger a/c ELE01-Electricity Company
Line 1 - Trade creditors value 1000 is posted as a credit to the Bank general ledger a/c code

Double-entry has been observed Dr = 1000 Cr = 1000

Line 2 - Amount value 900 is posted as a debit to the Supplier's ledger a/c WID01-Widget Company
Line 2 - Trade creditors value 900 is posted as a credit to the Bank general ledger a/c code

Double-entry has been observed Dr = 900 Cr = 900

Line 3 - Amount value 400 is posted as a debit to the Wages general ledger a/c code
Line 3 - Others value 400 is posted as a credit to the Bank general ledger a/c code

Double-entry has been observed Dr = 400 Cr = 400

The totals' of each column are posted as follows:

Amount total value 2300 posted as a credit to the Profit & loss control a/c
Trade Creditors total value 1900 posted as a debit to the Trade creditors control a/c
Other total value 400 posted as a debit to the Wages control a/c

Double-entry has been observed Dr = 2300 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 Jul 2006 Bank Payments Daybook BP701 1000 10 Jul 2006 Invoice PI1 1000
31 Jul 2006 Balance c/f 0
------- -------
1000 1000
==== ====
01 Aug 2006 Balance b/f 0
A/c Code: WID01 - Widget Company
Date Details Reference Amount Date Details Reference Amount
19 Jul 2006 Bank Payments Daybook BP702 900 12 Jul 2006 Invoice PI2 1600
31 Jul 2006 Balance c/f 700
------- -------
1600 1600
==== ====
01 Aug 2006 Balance b/f 700

[edit] Sales/customers

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

Each indivdual line is posted as follows:
The amount value is posted as a debit to the individual customer's ledger a/c
The analysis amount is posted a credit to the relevant general ledger a/c
From example above:

Line 1 - Amount value 2500 is posted as a debit to the Customer's ledger a/c JJM01-JJ Manufacturing
Line 1 - Electricty value 2500 is posted as a credit to the Sales-parts general ledger a/c code

Double-entry has been observed Dr = 2500 Cr = 2500

Line 2 - Amount value 3200 is posted as a credit to the Customer's ledger a/c JJM01-JJ Manufacturing
Line 2 - Electricty value 3200 is posted as a debit to the Sales-service general ledger a/c code

Double-entry has been observed Dr = 3200 Cr = 3200

The totals' of each column are posted as follows:

Amount total value 5700 posted as a debit to the Trade debtors control a/c
Sales-parts total value 2500 posted as a credit to the Profit & loss control a/c
Sales-service total value 3200 posted as a credit to the Profit & loss control a/c

Double-entry has been observed Dr = 5700 Cr = 5700

[edit] Bank receipts daybook
Bank Receipts Daybook
Date Customer Name Reference Amount Customers Others
20 Jul 2006 JJ Manufacturing BR1 2500 2500 0
------- ------- -------
Total 2500 2500 0
==== ==== ====
Debit Credit Credit
Bank a/c Trade Other
control a/c Debtors control a/c
control a/c

Keys: SI = Sales Invoice, BR = Bank Receipt

Each indivdual line is posted as follows: The amount value is posted as a credit to the individual customer's ledger a/c
The analysis amount is posted as a debit to the relevantgeneral ledger a/c
From example above:

Line 1 - Amount value 2500 is posted as a credit to the Customer's ledger a/c JJM01 - JJ Manufacturing
Line 1 - Customers value 2500 is posted as a debit to the Bank general ledger a/c code

Double-entry has been observed Dr = 2500 Cr = 2500

The totals' of each column are posted as follows:

Amount total value 2500 posted as a credit to the Trade debtors control a/c
Customers total value 2500 posted as a debit to the Profit & loss control a/c

Double-entry has been observed Dr = 2500 Cr = 2500

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] Customer ledger cards
CUSTOMER LEDGER CARDS
A/c Code: JJM01 - JJ Manufacturing
Date Details Reference Amount Date Details Reference Amount
02 Jul 2006 Sales invoice daybook SI1 2500 20 Jul 2006 Bank receipts daybook BR1 2500
02 Jul 2006 Sales invoice daybook SI2 3200 31 Jul 2006 balance c/f 3200
------- -------
5700 5700
==== ====
01 Aug 2006 Balance b/f 3200

[edit] General ledger

[edit] General ledger
Sales parts
Date Details Reference Amount Date Details Reference Amount
31 Jul 2006 Balance c/f 2500 02 Jul 2006 Sales invoice daybook SI1 2500
b/f 2500
Sales service
Date Details Reference Amount Date Details Reference Amount
31 Jul 2006 Balance c/f 3200 29 Jul 2006 Sales invoice daybook SI2 3200
------- -------
3200 3200
==== ====
01 Aug 2006 Balance b/f 3200
Electricity
Date Details Reference Amount Date Details Reference Amount
10 Jul 2006 Electricity Co. PI1 1000 31 Jul 2006 Balance c/f 1000
------- -------
1000 1000
==== ====
01 Aug 2006 Balance b/f 1000
Widgets
Date Details Reference Amount Date Details Reference Amount
12 Jul 2006 Widget Co. PI2 1600 31 Jul 2006 Balance c/f 1600
------- -------
1600 1600
==== ====
01 Aug 2006 Balance b/f 1600
Other a/c
Date Details Reference Amount Date Details Reference Amount
28 Jul 2006 Owner's Wages BP703 400 31 Jul 2006 Balance c/f 400
------- -------
400 400
==== ====
01 Aug 2006 Balance b/f 400
Bank Control A/c
Date Details Reference Amount Date Details Reference Amount
31 Jul 2006 Bank receipts daybook BR-Jul 2500 31 Jul 2006 Bank payments daybook BP-Jul 2300
31 Jul 2006 Balance c/f 200
------- -------
2500 2500
==== ====
01 Aug 2006 Balance b/f 200
Trade Debtors Control A/c
Date Details Reference Amount Date Details Reference Amount
01 Jul 2006 Balance b/f 0 31 Jul 2006 Bank receipts daybook BR-Jul 2500
31 Jul 2006 Sales Invoice Daybook SI-Jul 5700 31 Jul 2006 Balance c/f 3200
------- -------
5700 5700
==== ====
01 Aug 2006 Balance b/f 3200
Trade Creditors Control A/c
Date Details Reference Amount Date Details Reference Amount
31 Jul 2006 Bank Payments Daybook BP-Jul 1900 01 Jul 2006 Balance b/f 0
31 Jul 2006 Balance c/f 700 31 Jul 2006 Purchase Daybook PI-Jul 2600
------- -------
2600 2600
==== ====
01 Aug 2006 Balance b/f 700
Profit & loss control A/c
Date Details Reference Amount Date Details Reference Amount
31 Jul 2006 Purchase invoice daybook PI-Jul 2600 31 Jul 2006 Sales invoice daybook SI-Jul 5700
31 Jul 2006 Bank payments daybook BP-Jul 400
31 Jul 2006 Balance c/f 2700
------- -------
5700 5700
==== ====
01 Aug 2006 Balance b/f 2700

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 reconcilliation statements and be able to see how much is left in each account.

The Bank control a/c keeps the total for all bank accounts. The balance of each individual bank account, when added together, must equal the balance in the bank control a/c.

[edit] Bank account
Bank A/c
Date Details Reference Amount Date Details Reference Amount
01 Jul 2006 Balance b/f 0 17 Jul 2006 Bank Payments Daybook BP701 1000
20 Jul 2006 Bank Receipts Daybook BR1 2500 19 Jul 2006 Bank Payments Daybook BP702 900
28 Jul 2006 Bank Payments Daybook BP703 400
31 Jul 2006 Balance c/f 200
------- -------
2500 2500
==== ====
01 Aug 2006 Balance b/f 200

[edit] Unadjusted trial balance
Trial balance as at 31st July 2006
A/c description Debit Credit
Sales-parts 2500
Sales-service 3200
Widgets 1600
Electricity 1000
Other 400
Bank Control A/c 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.

The individual bank accounts are not to be listed in the trial balance, as the Bank control account is the summary of each individual bank a/c. see note 2 below

The profit & loss control account is not to be listed in the trial balance, as the profit & loss control account is a summary of the trial balance.

Important notes:
1. 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.
2. In practice it is the norm to list each bank account in the trial balance. This allows you to distinguish between bank accounts which are overdrawn or not and which bank accounts are loans or savings accounts.

[edit] Journal entries
  • Depreciation
  • Wages
  • Stock
  • Accruals
  • Prepayments

[edit] Adjusted trial balance
Trial balance as at 31st July 2006
A/c description Debit Credit

[edit] Profit-and-loss statement and balance sheet

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

[edit] Modern format (list method)
Profit and loss statement
for the month ending 31st 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 31st 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] 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:

  • Purchase raw materials by using line of credit: $500,000
  • Pay workers from cash in bank to make goods: $1,500,000
  • Pay sales force from cash in bank to sell goods: $1,000,000
  • Sell goods for cash: $3,500,000

To close the books for the month, we will adjust expenses and revenue to be 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     -0-
1 Raw materials $ 500   $ 500
2 Labor $ 1500   $ 2000
3 Sales costs $ 1000   $ 3000
5 Income summary   ($ 3000) -0-
Total $ 3000 $ 3000
Revenue
Balance forward     -0-
4 Revenue from sales   $ 3500 $ 3500
6 Income summary ($ 3500)   -0-
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 -0- $ 500
Income summary
Balance forward     -0-
5 Expense $ 3000   −$ 3000
6 Revenue   $ 3500 $ 500
7 Retained earnings $ 500   -0-
Total $ 3500 $ 3500
Retained earnings
Balance forward     $10000
7 Income summary   $ 500 $10500
Total -0- $ 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] External links

Wikibooks
Wikibooks has more about this subject:
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