When a firm creates its accounting system, it must decide whether to manage financial reporting and record keeping with a single entry system or a double entry system.
With single entry accounting, a single financial event calls for just one account entry. The double entry approach is so-named because each financial event (such as receipt of cash from a customer sale) calls for at least two changes in the accounts:
- Firstly, a credit entry in one account.
- Secondly, at the same time, an equal, offsetting debit entry in another account.
Most Firms Choose the Double Entry Approach
The very large majority of business firms worldwide use the double entry approach, even though it is more complex and more difficult to use than the simpler alternative, single entry accounting. And, using a double entry system requires at least some level of formal training in accounting. The user must, for instance, have a solid grasp of concepts such as debit, credit, Chart of accounts, and the so-called Accounting equations. By contrast, just about anyone who can arrange numbers in a table and add and subtract can set up and use a single entry system.
All public companies, and almost all large firms nevertheless choose the double entry approach. This is because it is simply impossible for them to meet government and regulatory requirements for reporting and record-keeping using a single-entry system. And, with a single entry system alone, large firms cannot accurately track their own assets, liabilities, equities, revenues, and expenses.
Double Entry Accounting Purposes
The practice of using two account entries for every transaction in this way serves two purposes:
1. Built In Error Checking
Firstly, the double entry system provides a "built in" form of error-checking. When the double entry system is used properly, the sum of all debit entries in the account ledgers for the accounting period must equal the sum of all credit entries. That is, at all times:
Total Debits = Total Credits
A mismatch in these two totals is a signal that the accounts contain a booking or accounting error. For more on this form of error-checking, see Trial Balance.
2. Balance Sheet Balance and Tracking All Transactions
Secondly, double entries maintain the balance in the Accounting equations:
Assets = Liabilities + Owners Equity
Debits = Credits
Maintaining the balance in these equations, in turn, means that the organization's Balance sheet provides an accurate basis for assessing the company's financial position, financial structure, capitalization, and financial statement metrics (businwss ratios).
Double Entry accounting, moreover, uses debits and credits in this way to track five kinds of transactions: Revenues, Expenses, Liabilities, Equities, and Assets. Single entry accounting, by contrast, recognizes only two kinds of transactions: Cash inflows and cash outflows.
Explaining the Double Entry System in Context
Sections below further define, explain, and illustrate double entry accounting. This term appears in context with related terms such as the following:
- What is double entry accounting?
- Midieval origins: Why would anyone use double entry accounting?
- The account as the fundamental building block of an accounting.
- Contra accounts (Valuation allowance accounts) reverse the rules.
- A double entry system begins with a Chart of Accounts.
Luca de Pacioli (1445-1517), a Franciscan friar, is usually creditied with publishing the first complete and systematic account of double entry accounting.
Upon first encountering double entry accounting, the approach at first seems needlessly complex and confusing to many. Business people and students naturally ask the obvious questions: "Why would anyone use double entry accounting?" And, "are the double entry benefits worth the trouble of using the system?"
Only Double Entry Accounting Meets Certain Business Needs
Early forms of double entry accounting are documented in Europe and Asia from the late midieval period (1100-1450), specifically as early as the 12th Century. This period was characterized by increasing activity and new complexities in business, commerce, and banking that were completely unknown in the several earlier centuries known as the "dark ages."
This period saw, for instance, rising levels of international shipping and commerce. Merchants began selling "on credit," forming partnerships and companies, obtaining funding from private banks, and covering business investments with insurance. Such activities brought new kinds of business transactions. These include certain transactions that a complex business must track and manage, but which are completely invisible to simpler accounting systems.
The double entry approach, in other words, was a response to keenly felt needs by merchants, bankers, and investors, who found simple cash basis accounting inadequate for their needs. They needed an accounting system that supports better forms of error-checking. And they needed a system that recongizes transaction concepts invloving Assets acquired, Revenues earned, Expenses incurred, Liabilities owed, and Equities owned.
Luca de Pacioli, "Father of Accounting"
Double-entry-like accounting records from the 14th century survive in Europe and in Asia, but the earliest known systematic description of the subject was written and published in 1494 by Luca de Pacioli (1445-1517). Pacioli, a fifteenth century Franciscan friar, is best known for Summa de Arithmetica, Geometria, Proportioni et Proportionalità, which provides the first printed description of double entry bookeeping. For this reason, no doubt, Pacioli is sometimes referred to as the "Father of Accounting."
Luca de Pacioli, incidentally, is also known for writing De Devina Propotione (1497), an attempt to re-discover the true shapes and proportions of the classical Roman alphabet. He was born in the villiage of Sansepolcro in Tuscany, but spent most of his working life in Venice, Milan, and Perugia. His career seems to have been driven by passions for teaching mathematics and writing—counting Leonardo da VInci among his pupils.
Pacioli did not invent the methods he wrote about in Summa de Arithmetica, but rather, summarized and published for the first time the practices used by Italian merchants of the Renaissance.
In business, each profit making company establishes an accounting system in order to manage and keep track of its assets, liabilities, equities, revenues, and expenses. The accounting system also provides the basis for the financial reports the company must file periodically.
The basic building block in the system is the account, which can be defined as a place for recording value and changes in value (additions and subtractions) for one specific purpose. In fact, "specific purposes" are divided into five categories, and these categories represent the five—the only five—kinds of accounts possible in an accounting system. Note especially that the five account categories fall into two groups: Firstly, the Balance sheet accounts, and Secondly, the Income statement accounts.
Three Balance Sheet Account Categories
- Asset accounts: Items of value that are owned and used by the firm for generating earnings in its primary line of business.
Example: Cash on hand
Example: Accounts receivable
- Liability accounts: Debts the business owes.
Example: Accounts payable
Example: Salaries payable
- Equity accounts: Owner claims (Shareholder claims) to business assets.
Example: Owner capital
Example: Retained earnings
Two Income Statement Account Categories
- Revenue accounts: Incoming revenues, primarily from the sale of goods and services.
Example: Product sales revenues
Example: Interest earned revenues
- Expense accounts: Expenses incurred in the course of business.
Example: Direct labor costs
Example: Advertising expenses
Every Transaction Impacts Two Accounts
In reality, even a very small business may identify a hundred or more such accounts for its accounting system, while a large company may identify many thousands. Nevertheless, for bookkeeping and accounting purposes, all named accounts fall into one of the five categories above (see Chart of accounts, below).
For firms that use double entry systems, every financial transaction causes two equal and offsetting account changes, the change in one account called a debit and the change in another account called a credit.
Debits and Credits Impact Differently in Different Account Categories
Just how the bookkeeper and accountant handle each transaction for an account depends on which of the five account categories the account belongs to. Whether a debit or a credit increases or decreases the account balance depends on the kind of account involved:
|Debit (DR) Entry ...||Credit (CR) Entry ...|
|Asset account||Increases (adds to) account balance||Decreases (subtracts from) account balance|
|Liability account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|Equity account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|Revenue account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|Expense account||Increases (adds to) account balance||Decreases (subtracts from) account balance|
Suppose, for example, that a company purchases an asset valued at $100,000.
The firm will register an increase (debit) of $100,000 to an an asset account. This could be, for instance, Account 163 from the Chart of Accounts below, Factory manufacturing equipment. The increase in account balance is called a debit because this is an asset account. Now, however, the Balance sheet is temporarily out of balance until the firm makes an offsetting credit of $100,000 to another account, somewhere in the accounting system. This could be, for instance:
- A credit of $100,000 to another asset account, reducing that account balance by $100,000. That could be a credit to asset Account 101, Cash on hand.
- If instead the firm finances the asset purchase with a bank loan instead of the company's cash, the offsetting $100,000 transaction could be a credit to a liability account. A credit to a liability account increases account balance. The account in this case could be Account 171, Bank loans payable.
Keeping the Balance Sheet Balance
In this way, the basic accounting equation always holds and the Balance sheet stays balanced:
Assets = Liabilities + Equities
And, for every pair of account entries that follow from a single transaction:
Debits = Credits
See the encyclopedia Double entry system for more on accounting mathematics in double entry accounting.
Not all accounts work additively with each other on the primary financial accounting reports—especially on the Income statement and Balance sheet. There are many instances where one account works to offset the impact of another account. The so-called contra accounts "work against" other accounts in this way. In some situations, the contra accounts reverse the debit and credit rules from the table above.
Contra-asset and contra-liability accounts are also called valuation allowance accounts, because they work to adjust the book value, or carrying value for assets or liabilities, as the examples below show.
Balance Sheet Contra Assets Example
The Balance sheet example running throughout this encyclopedia has several contra account examples, including these examples under Assets:
Notice especially from the example Chart of Accounts, below, that Accounts receivable (Account 110) and Allowance for doubtful accounts (Account 120) are both asset accounts. Allowance for doubtful accounts, however, is a contra asset account that reduces the impact (carrying value) contributed by Accounts receivable. The Balance sheet result is a "Net accounts receivable" less than the initial Accounts receivable value.
In the same way, Account 163, Factory Manufacturing equipment carries the value of these assets at historical cost—the actual cost of acquiring these assets. This will not decrease as long as the company owns the assets. However, the asset's book value does change downward from year to year, as shown on the Balance sheet. Contra Account 175, Accumulated depreciation, factory manufacturing equipment, is subtracted from the Account 163 value, to produce the Balance sheet result Net factory manufacturing equipment.
Impact of Contra Asset Transactions on Income Statement Accounts
In each case above, incidentally there is also an expense category account involved. These expense accounts appear on the Income statement, not the Balance sheet. In the first example, the expense account is Bad debt expense and in the second case, the expense account is Depreciation expense for factory machinery. The offsetting debit and credit transactions might look appear as follows in the bookkeeper's journal.
Journal for Fiscal Year 20YY
630 Bad debt expense
770 Depreciation expense, factory manufacturing equip
All four transactions add to the value (balance) of the accounts they impact. Debiting each of the two expense accounts adds to account value, as the table in the previous section indicates. However notice here that crediting the two asset accounts adds to their value as well—just the opposite of what the same table prescribes for asset accounts. For contra accounts in this situation the rules reverse, so that the fundamental equation Debits = Credits still holds for every pair of transactions. The examples also show why a contra asset account is said to hold a credit balance.
Contra Liability and Contra Expense Accounts
The above examples show contra-asset accounts, but there are also examples of contra-liability accounts and contra expense accounts that operate in the same way. For example, on the liabilities side of the Balance sheet, a long term liability account Bonds payable may be accompanied by another liability account, a contra liability account called Discounts on bonds payable. The value in the contra account reduces the company's actual liability from the stated figure in the Bonds payable account.
Contra liability accounts and contra expense accounts—like their contra asset counterparts—also reverse the debit/credit "rules" from the table in the previous section. An addition to a liability account, for instance, is normally a credit, but to a contra liability account, an addition is a debit. For this reason, contra liability accounts are said to carry a debit balance.