by Elaine Orgain
Double-Entry Accounting is a method of recording financial transactions that has been used for thousands of years. Rather than tracing its history, however, it is enough to know what it is today. At its heart, double entry accounting is a system that epitomizes the concept that there is no such thing as a ‘free lunch’. It stipulates that for every action there must be a consequence of equal value within the accounts.
In business, every transaction is an exchange, the trading for something of value for something of equal value. For example, the purchase of goods is the offer of currency for ownership of a particular item. The transaction is made when the two parties agree on what amount of currency represents the value of the property to be transferred.Accounting refers to the sides of the exchange as ‘debits’ and ‘credits’. Every transaction recorded must have an equal value in the sum of its debits and its credits. By using this double-entry process, the financial records are guaranteed to always be in balance. This is vital to insure that all transactions have been entered correctly so that reports generated from this data fairly represent the financial results (Income Statement) and financial position of the company (Balance Sheet). You can find examples of double-entry transactions at the end of this article.
The basic equation by which double entry accounting works is:
Assets = Liabilities + Equity (which includes Investments plus cumulative income less all expenses)
Effectively, for everything a company owns (Assets) there are equal claims against it in the form of either amounts owing to other parties (Liabilities), or owing to shareholders who have paid money into the company (Equity).
What is Single-entry accounting then?
Single-entry accounting records only the income or expense side of a transaction without another entry to counter it. The total of all transactions are merely added up to calculate a profit or loss.
This method, although if done carefully can produce a basic Income Statement, does not record any information on the financial obligations or ownership of the company. Without the built-in safety of double-entry, finding and correcting errors is made far more difficult under the single-entry method as is preparation of financial reports required by investors and lenders.
The Chart of Accounts is the listing of accounts used by a company and grouped in the order they will appear in financial reports. Income and Expense accounts represent the monies generated from Sales of the company’s goods or services and the funds spent in the process of operating the company and delivering the product or service. These appear on the Income Statement for each accounting period.
The Asset and Liability accounts represent what the company owns as well as obligations it has yet to meet at a particular point in time. Equity accounts include Investments in the company plus cumulative Net Income. The Balance Sheet carries the Assets, Liabilities, and Equity accounts and is used to assess the financial health of the organization. The results of changes in all of these types of accounts represent the Cash Flow for the reporting period.
Examples of double-entry transactions:
- Order and receive office supplies on credit
- Debit: Office Supply Expense $129.56
- Credit: Accounts Payable $129.56
- Pay balance due to vendor (taking the 2% discount offered for early payment)
- Debit: Accounts Payable $129.56
- Credit: Discounts $2.59
- Credit: Cash $126.97
- Purchase equipment by company check
- Debit: Fixed Assets $12,678.00
- Credit: Corp Checking $12,678.00
- Depreciate Equipment each month (using 36 month useful life)
- Debit: Depreciation Expense $352.17
- Credit: Accumulated Depreciation $352.17
- Record equity investment received via wire transfer
- Debit: Corp Checking $150,000.00
- Credit: Owner Equity at Par $1,500.00
- Credit: Equity Paid in Excess of par $148,500.00
- Run semi-monthly payroll
- Debit: Salary Expense $25,000.00 (for gross wages)
- Debit: Employer Tax Expense $1,750.00
- Debit: Worker’s Comp Expense $275.00
- Debit: Payroll Service Fees $75.00
- Credit: Corp Checking $ (for auto-deposits to employees) $17,647.89
- Credit: Corp Checking $ (for tax payments to govt.) $9,102.11
- Credit: Accrued Work Comp $275.00
- Credit: Corp Checking $75.00 (for processing fees)