Double entry accounting definition
/What is Double Entry Accounting?
Double entry accounting is a record keeping system under which every transaction is recorded in at least two accounts. There is no limit on the number of accounts that may be used in a transaction, but the minimum is two accounts. There are two columns in each account, with debit entries on the left and credit entries on the right. In double entry accounting, the total of all debit entries must match the total of all credit entries. When this happens, the transaction is said to be "in balance." If the totals do not agree, the transaction is said to be "out of balance," and you will not be able to use the resulting information to create financial statements until the transaction has been corrected.
A key reason for using double entry accounting is to be able to report assets, liabilities, and equity on the balance sheet. Without double entry accounting, it is only possible to report an income statement. This means that determining the financial position of a business is dependent on the use of double entry accounting.
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Double Entry Accounting Definitions
A double entry accounting system requires a thorough understanding of debits and credits. Their definitions are noted below
Debit. A debit is that portion of an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is positioned to the left in an accounting entry.
Credit. A credit is that portion of an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is positioned to the right in an accounting entry.
Examples of Accounts
An account is a separate, detailed record associated with a specific asset, liability, equity, revenue, expense, gain, or loss. Examples of accounts are:
Cash (asset account: normally a debit balance). This includes all cash and cash equivalents (assets that can be immediately converted into cash).
Accounts receivable (asset account: normally a debit balance). This includes both trade receivables and non-trade receivables.
Inventory (asset account: normally a debit balance). This includes raw materials, work-in-process, finished goods, and merchandise.
Fixed assets (asset account: normally a debit balance). This includes both tangible and intangible assets.
Accounts payable (liability account: normally a credit balance). This includes the liabilities for all received supplier invoices.
Accrued liabilities (liability account: normally a credit balance). This includes all liabilities for which no supplier invoices have yet been received.
Notes payable (liability account: normally a credit balance). This includes any debt obligations of the business.
Common stock (equity account: normally a credit balance). This is the amount paid by investors for shares of the company’s common stock.
Retained earnings (equity account: normally a credit balance). This includes the cumulative amount of all profits and losses, minus any dividends issued.
Revenue - products (revenue account: normally a credit balance). This includes the gross revenue generated from the sale of products.
Revenue - services (revenue account: normally a credit balance). This includes the gross revenue generated from the sale of services.
Cost of goods sold (expense account: normally a debit balance). This includes the costs of all direct labor, direct materials, and factory overhead associated with goods that have been sold during the period.
Wage expense (expense account: normally a debit balance). This includes the cost of all wages paid to employees during the reporting period, including accruals for wages earned but not yet paid.
Utilities expense (expense account: normally a debit balance)
Travel and entertainment (expense account: normally a debit balance)
Gain on sale of asset (gain account: normally a credit balance)
Loss on sale of asset (loss account: normally a debit balance)
Examples of Double Entry Accounting
Here are the double entry accounting entries associated with a variety of business transactions:
Buy merchandise. You buy $1,000 of goods with the intention of later selling them to a third party. The entry is a debit to the inventory (asset) account and a credit to the cash (asset) account. In this case, you are swapping one asset (cash) for another asset (inventory).
Sell goods. You sell the goods to a buyer for $1,500. There are two entries in this situation. One is a debit to the accounts receivable account for $1,500 and a credit to the revenue account for $1,500. This means that you are recording revenue while also recording an asset (accounts receivable) which represents the amount that the customer now owes you. The second entry is a $1,000 debit to the cost of goods sold (expense) account and a credit in the same amount to the inventory (asset) account. This records the elimination of the inventory asset as we charge it to expense. When netted together, the cost of goods sold of $1,000 and the revenue of $1,500 result in a profit of $500.
Pay employees. You pay employees $5,000. This is a debit to the wage (expense) account and a credit to the cash (asset) account. This means that you are consuming the cash asset by paying employees.
Buy a fixed asset. You pay a supplier $4,000 for a machine. The entry is a debit of $4,000 to the fixed assets (asset) account and a credit of $4,000 to the cash (asset) account. In this case, you are swapping one asset (cash) for another asset (inventory).
Incur debt. You borrow $10,000 from the bank. The entry is a debit of $10,000 to the cash (asset) account and a credit of $10,000 to the notes payable (liability) account. Thus, you are incurring a liability in order to obtain cash.
Sell shares. You sell $8,000 of shares to investors. The entry is a debit of $8,000 to the cash (asset) account and a credit of $8,000 to the common stock (equity) account.
Pay a credit card statement. You pay a credit card statement in the amount of $6,000, and all of the purchases are for expenses. The entry is a total of $6,000 debited to several expense accounts and $6,000 credited to the cash (asset) account. Thus, you are consuming an asset by paying for various expenses.
Thus, the key point with double entry accounting is that a single transaction always triggers a recordation in at least two accounts, as assets and liabilities gradually flow through a business and are converted into revenues, expenses, gains, and losses.
Alternatives to Double Entry Accounting
A simpler version of accounting is single entry accounting, which is essentially a cash basis system that is run from a check book. Under this approach, assets and liabilities are not formally tracked, which means that no balance sheet can be constructed. This approach can work well for a small business that cannot afford a full-time bookkeeper.