Introduction to double-entry accounting system

Double-entry accounting system is a method of accounting which is based on the principle that every business transaction has two aspects which are equal and opposite in nature. Therefore, to record a business transaction, we have to make a double entry i.e. while recording a transaction in an account, its equal and opposite aspect has to be recorded as well in one or more accounts. By following double-entry accounting system, the following equation, which is famously called the accounting equation, will always be satisfied:

Assets = Owners’ equity + liabilities

To record business transactions, double-entry accounting system uses debits and credits. It is the beauty of this system that sum of debits will always be equal to sum of credits, making it easier to identify errors in recording transactions. Double-entry accounting system is the underlying system of all the modern-day accounting being done around the world, so another benefit is the consistency and comparability that it brings to accounting being done worldwide.

In double-entry accounting system, business transactions are recorded through journal entries which are posted in relevant accounts in the general ledger. From the recorded transactions, a summary report called trial balance is generated, on the basis of which financial statements are prepared. The whole flow of data from recording journal entries to the preparation of financial statements is called the accounting cycle, which is explained in detail separately.

Let’s take a look at the following example to visualize how business transactions are recorded using double entries.

Example

Aron Wilshere is a young entrepreneur engaged in the business of manufacturing LED lights for automobile industry. During the month of August, following business transactions took place:

  1. Purchase of materials worth $20,000 on credit.
  2. Labor cost of $7,000 incurred to convert the materials into LED lights.
  3. Sale of LED lights worth $40,000 to a regular customer on credit.
  4. $20,000 paid to supplier to settle the liability for purchase of materials.
  5. $40,000 received from customer to whom the lights were sold.

Let’s record these transactions using double entries.

 

       Debit Credit
1. Materials (inventory) $20,000  
  Accounts payable   $20,000

As the business has purchased materials, so debit entry is made in the inventory account to increase it. Corresponding effect of this transaction is the liability of business as it has to pay $20,000 to the supplier in future, so credit entry is made in accounts payable.

Inventory is an asset which is debit in nature, so debit entry is made to increase its balance.

Accounts payable is a liability which is credit in nature, so credit entry is made to increase its balance.

2. Labor cost $7,000  
  Cash account   $7,000

As the business has incurred an expense by paying the wages to workers, so debit entry is made in labor cost account. Corresponding effect of this transaction is the reduction of cash account’s balance which is recorded by credit entry in cash account.

Labor cost is an expense which is debit in nature, so debit entry is made.

Cash account is an asset which is debit in nature, so to reduce its balance, credit entry is made. 

3. Accounts receivable $40,000  
  Revenue   $40,000

As the business has sold lights, so revenue is recorded through a credit entry in revenue account. As a result of this sale, the business is entitled to receive $40,000 cash, and this right to receive cash is an asset which is recorded using a debit entry in accounts receivable.

Accounts receivables is an asset which is debit in nature, so debit entry is made to increase its balance.

Revenue is credit in nature, so credit entry is made to record sales revenue.

4. Accounts payable $20,000  
  Cash account   $20,000

As the business has settled its liability, so a debit entry is made in accounts payable to reduce its balance. Corresponding effect of this transaction is the reduction of cash balance, so a credit entry is made in the cash account.

Accounts payable is a liability which is credit in nature, so to reduce its balance, a debit entry is made.

Cash account is an asset which is debit in nature, so to reduce its balance, a credit entry is made. 

5. Cash account $40,000  
  Accounts receivable   $40,000

As the business has received cash from its customer, so a debit entry is made in cash account to increase its balance whereas a credit entry is made in accounts receivable to reduce its balance.

Cash account is an asset which is debit in nature, so debit entry is made to increase its balance.

Accounts receivable is an asset which is debit in nature, so to reduce its balance, a credit entry is made.