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 economic action (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.
Most Firms Choose the Double-Entry Approach
The majority of business firms worldwide use the double-entry approach, even though it is more complicated and more difficult to use than the more straightforward 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. They make this choice because it is nearly 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 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 applied 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 (business 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 types of operations: Cash inflows and cash outflows.
Explaining the Double-Entry System in Context
Sections below further define, describe and illustrate double-entry accounting. This concept appears in context with related terms such as the following:
- What is "double-entry" accounting?
- Medieval 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 credited with publishing the first complete and systematic account of double-entry accounting.
Upon first encountering double-entry accounting, the approach at first seems needlessly complicated 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 medieval period (1100-1450), as early as the 12th Century. This period saw new activity and new complexities in business, commerce, and banking that were 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 activities that a complicated business must track and manage, but which are entirely 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 recognizes transaction concepts involving assets acquired, revenues earned, expenses incurred, liabilities owed, and equities owned.
Luca de Pacioli, the"Father of Accounting."
Double-entry-like accounting records from the 14th century survive in Europe and 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 bookkeeping. 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 Proportione (1497), an attempt to re-discover the "true" shapes and proportions of the classical Roman alphabet. He was born in the village 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 instead, 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 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 is the name for a place or holder for recording values and value changes (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 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. For example:
"Cash on Hand"
- Liability accounts: Debts the business owes. For instance:
- Equity accounts: Owner claims (Shareholder claims) to business assets. For example:
Two Income Statement Account Categories
- Revenue accounts: Incoming revenues, primarily from the sale of goods and services. For instance:
"Product Sales Revenues"
"Interest Earned Revenues"
- Expense accounts: Expenses incurred in the course of business. For example:
"Direct Labor Expenses"
Every Transaction Impacts Two Accounts
In reality, even a small business may identify a hundred or more such accounts for its accounting system, while a large company may use 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 (DR), and the entry in another is called a credit (CR).
Debits and Credits Impact Differently in Different Account Categories
How the bookkeeper and accountant handle each transaction for an account depends on which of the five account categories includes it. Whether a debit or a credit increases or decreases the account balance depends on the account's type:
|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 asset account. This account could be, for instance, Account 163 from the Chart of Accounts below, Factory manufacturing equipment. A debit transaction increases the balance of this account 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 elsewhere in the accounting system:
- The firm could, for instance, credit $100,000 to another asset account, reducing that account balance by $100,000. That account could be 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. That could be Account 171, Bank loans payable. Note that a credit to a liability account increases account balance.
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 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. 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 value 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" while in the second case, the 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 first 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 instance, 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 "Bonds payable."
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 usually a credit, but to a contra liability account, the increase is a debit. For this reason, contra liability accounts are said to carry a debit balance.
The example chart of accounts below is merely an extract from a more realistic "Chart of accounts," and not a complete chart. This example shows the structure and general approach to account numbering and naming, but a real example—even for a small company—would no doubt list many more accounts.
|Acct No||CHART OF ACCOUNTS|
|Asset Accounts - Current Assets|
|101||Cash on hand|
|103||Regular checking account|
|105||Payroll checking account|
|120||Allowance for doubtful accounts|
|130||Work in progress inventory|
|139||Finished goods inventory|
|Asset Accounts - Fixed Assets|
|160||Furniture and fixtures|
|163||Factory manufacturing equipment|
|170||Accumulated depreciation, furniture, fixtures|
|172||Accumulated depreciation, vehicles|
|175||Accumulated depreciation, factory mfr equip.|
|179||Accumulated depreciation, buildings|
|Asset Accounts - Other Assets|
|194||Notes receivable, non-current|
|Liability Accounts - Current Liabilities|
|Liability Accounts - Long-Term Liabilities|
|270||Discount on bonds payable|
|280||Bank loans payable|
|410||Product sales revenues|
|430||Rental property revenues|
|450||Interest earned revenues|
|Expense Accounts - Cost of Goods Sold|
|520||Raw materials costs|
|530||Direct labor costs|
|540||Indirect labor costs|
|550||Manufacturing plant costs|
|Expense Accounts - Other|
|630||Bad debt Expense|
|720||Salary and Wage Expense|
|750||Equipment Lease Expense|
|770||Depreciation Expense, Factory mfr Equipment|