Double-entry book-keeping is the standard accounting practice for recording financial transactions. Its origins have been traced as far back as the 12th century, and by the end of the 15th century, it was widely used by the merchant venturers of Venice. It was codified for the first time by Luca Pacioli, a close friend of Leonardo da Vinci, in a 1494 mathematics textbook [1].
The system is based on the concept that a business can be described by a number of different variables or accounts, each describing an aspect of the business in monetary terms. Every transaction has a 'dual effect'. This is illustrated below.
Examples
Buying an asset (such as a new machine):
- The amount of fixed assets in the business increases.
- The amount of cash (also an asset) is reduced.
Selling merchandise on credit:
- The amount of trade receivables (an asset) for the business increases.
- The sales revenue for the business increases (eventually this will become part of equity).
Upon payment, the trade receivables account decreases while the cash account increases.
Should the receivable be "written off" as uncollectible debt, the receivable account decreases and the bad debt is added to expenses (which also becomes part of equity when netted against income and cost of goods sold). In larger firms, a portion of the receivable account is written off beforehand as expected to be uncollectible.
Paying a trade creditor:
- The amount of trade payables (a liability) for the business decreases.
- The amount of cash in the business is reduced.
Debits and credits
Double-entry book-keeping 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.
Credits and debits 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.
- 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.
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 (note that since it is a credit, revenue is recorded as a negative number)
- Profit (that is, when revenue exceeds expenses)
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 balance sheet and a profit and loss account.
The following table summarizes the basic accounts. A "+" indicates an increase; a "−" indicates a decrease.
| Account | Debit | Credit |
|---|---|---|
| Assets | + | − |
| Liabilities | − | + |
| Shareholder Equity | − | + |
| Revenue | (−) | + |
| Expenses | + | (−) |
Ledger example
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.
| 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.