Double entry bookkeeping
To record every business transaction that takes place we use an accounting system known as double-entry bookkeeping. It is believed that the double-entry system of bookkeeping was introduced to Europe in the early sixteenth century by the monk, Luca Pacioli, who tutored Leonardo da Vinci in mathematics. This system has been in use in most of the developed world for over 500 years and it shows no signs of declining in its popularity in recording accounting transactions.
Double-entry bookkeeping, at first glance, appears complex and one might think that bookkeeping would need many years of practice before they can 'keep the books'. Fortunately, looks can be deceiving and almost anyone can pick up the basics of this system in a very short time. This is because the double entry system can be reduced down to some very straightforward rules.
The whole system of double entry bookkeeping can be summarised in the following two rules:
- All transactions have one entry in two different accounts (the double-entry bit)
- All transactions have one debit entry (left side of account) and one credit entry (right side of account)
If you can remember these basic rules then financial accounting will be a lot more straightforward. In fact, remembering this rule can help you out of situations where you cannot remember which side one half of the transaction should be entered - just remember, if you know the debit entry then wherever the other entry is, it must be a credit entry and vice versa.
For every type of transaction, from buying new machinery to paying a supplier, there will be separate account. And each account will look roughly as follows;
Lets, run through what each of these terms mean:
- Name of account - the area that the transaction covers. There will be an account for cash, an account for every type of expense (insurance, rent and so on), an account for each type of asset (things like equipment, premises and machinery), as well as an account for each customer we sell to and each supplier we buy from (the personal accounts).
- Date/month - the time when the transaction is undertaken
- Details - the other account that is affected by the double entry transactions. Having the details here will help us to remember that there must always be two entries for each transaction.
- Amount - the total monetary amount of the transaction.
For each different type of account there will be different rules governing which side of the account it is entered into. This rule will depend upon whether the amount in the account is increasing or decreasing, and also whether the account is an asset, liability or a capital account.
The account will always be split into two sides. It is vital that you enter the transaction not only in the correct account but also on the correct side. The two sides of each account are as follows:
Debit is often abbreviated as Dr. and Credit is often abbreviated as Cr.
To begin with, we will consider the rules for three different types of accounts:
- Asset accounts
- Liability accounts
- Capital accounts
Assets are any resources that are to be used in the business. Examples would include machinery, premises, stocks of goods and cash.
Liabilities refer to any borrowings undertaken by the firm to a third party, for example amounts owed to suppliers, bank overdrafts, loans, etc.
Capital refers to the value of the resources put into the firm by the owner(s).
Some items can be classified as both an asset and capital. For example, cash introduced into the firm by the owner would be classed as capital. However, this cash would also be classed as an asset. This is simply the result of classifying items from two points of view. Try not to see, as some students sometimes do, assets as being good and liabilities as being bad. The term liability simply refers to the source of the finance, and makes no judgement on whether it is good or bad for the firm. The rules for entering these types of transactions in the double-entry accounts are as follows:
The following transactions are all based on a firm being set up from the initial starting of the firm. The amounts of money may appear small, but this is simply to get you used to the idea of entering transactions in the double-entry accounts.
Two rules of double-entry bookkeeping:
- All transactions have two entries.
- Each transaction has one debit (left) and one credit (right) entry
Accounting for purchases and sales
Therefore, we need to keep separate accounts for stock being purchased and stock being sold. In fact, we actually keep four accounts for movements in stock and these are as follows:
Increases in stock
- Purchases account - stocks of goods bought by the firm for resale
- Returns inwards account - stocks previously sold that is returned by the customer due to the goods being unsuitable (e.g. they are damaged, the wrong type of goods, etc.)
Decreases in stock
- Sales account - stocks of goods sold to customers
- Returns outwards account - stocks previously purchased by the firm which is returned to the original supplier
The normal double entry rules apply to all these stock accounts. Stock is an asset therefore, increases in stocks will always be debited to the relevant account and decreases will always be credited.
(You may also see returns inwards referred to as sales returns, and returns outwards as purchases returns)
Accounting for expenses and revenues
All firms will have expenses to pay as part of normal business activity. This will occur on a frequent basis.
Each separate expense will have its own account. Expenses do not fall into the classification of 'asset', 'liability' or 'capital', but we can still work out the rules for making entries in the expense accounts.
Any expense will require either cash or a cheque payment. Therefore, this will require a credit entry in either the cash or the bank account. As a result, the debit entry must be in the expense account - it cannot be a credit entry as it would not fit the rules of double entry bookkeeping.
Accounting for drawings
Earlier in this section we saw that anything injected into the business for use in the business by the owner is known as capital. However, it is perfectly possible for the owner to withdraw resources (money or stock for example) from the business. This would be represented by a decrease in capital. These reductions are known as 'drawings'.
These 'drawings' are kept in a separate drawings account - which is another form of capital account and follows the same double entry rules.
Balancing off accounts
At the end of each accounting period the firm will wish to balance its accounts off. An accounting period is normally one year but most firms will wish to balance off their accounts on a more frequent basis - usually every month. The more frequently a firm balances its accounts off, the less likely it is to make mistakes.
The process of balancing accounts off should not be rushed. It is, in effect, the final part of the double entry system of bookkeeping. Once accounts have been balanced off then the firm can begin to assess whether it has made a profit and if so how much profit has been generated.
The balance on each account is simply the difference in the totals of the debit side of the account and the credit side of the account. For example, if the debit side of an account added up to £190 but the credit side of the account added up to £330, then we would say that the account had a credit balance of £330 - £190 = £140.
To balance off accounts the following guidelines should be followed:
- Each account must have its debit and credit columns totalled up - but don't write anything down yet.
- The largest total out of the two columns will become the total for both sides and this will be written underneath each column on both sides and double underlined (double - to show that this account is finished with).
- The column where the total does not add up to the total shown will need a balancing figure to make it add up. This should be entered as the 'balance to be carried down' or 'balance c/d' for short. This amount should be exactly equal to the amount needed to make the columns now both add up to the same total.
Some things to remember when balancing off accounts are:
- The totals for each column should always be on the same level on the page - never at split-levels.
- The balance brought down must always be on the opposite side to the balancing figure of the balance to be carried down.
- The actual balance on the account is the balance brought down not the balance carried down.
- An account is not really finished until the balance has been brought down to the next period.
- Double entry bookkeeping
- Daybooks and ledgers
- Cashbooks and petty cashbooks
- The sales daybook
- Purchases daybook
- Returns daybooks
- The Journal
- Trading and profit and loss accounts
- Balance sheets
- Features of the VAT system
- VAT and the double entry system
- The trial balance
- Bank reconciliation statements
- Control accounts
- Suspense accounts and the correction of errors
- Computers in accounting
These notes are aimed at people studying for AQA A Level Accounting Unit 1, but will also be suitable for other courses and exam boards.
Originally submitted by duke_stix on TSR Forums.