Double-entry bookkeeping system

The double-entry bookkeeping system refers to a set of rules to record financial information in a financial accounting system wherein any single transaction or event always impacts at least two different accounts. In modern accounting this is done using debits and credits, and serves as a kind of error detection; if at any point the sum of debits do not equal the corresponding sum of credits, an error has occurred.

History

The origins of a primitive double-entry system may possibly be traced as far back as the Roman Empire, in ""ex Oratione Ciceronis pro Roscio Comaedo", and Naturalis Historiae Plinii, lib. 2, cap. 7 where the advised system was "That the one side of their booke was used for Debitor, the other for Creditor" (Huic Omnia Expensa. Huic Omnia Feruntur accepta et in tota Ratione mortalium sola. Utramque Paginam facit.

Later there are traces of the double-entry system in the accounting of the Islamic world from at least the 12th century.

Some sources suggest that Giovanni di Bicci de' Medici introduced this method for the Medici bank in the 14th century. The earliest extant records that follow the modern double-entry form are those of Amatino Manucci, a Florentine merchant at the end of the 13th century. By the end of the 15th century, the merchant ventures of Venice used this system widely. Luca Pacioli, a monk and collaborator of Leonardo da Vinci, first codified the system in a mathematics textbook of 1494. Pacioli is often called the "father of accounting" because he was the first to publish a detailed description of the double-entry system, thus enabling others to study and use it.

Accounts

An accounting system records financial information relating to financial transactions only. Elements of financial position, including property, money received, or money spent, are assigned to one of the primary groups i.e. assets, liabilities, and equity.

Within these primary groups each distinctive asset, liability, or equity is represented by its respective "account". An account is simply a record of financial inflows and outflows in relation to the respective asset, liability, income or expense. Income and expense accounts are considered temporary equity accounts, since they only represent the income and expenses of the most recent time period.

Types of Accounts

The accounts are classified into three main categories:

Real Accounts: Real Ledger accounts represent physically tangible things in the real world i.e. Plant and Machinery, Furniture and Fixtures, Computers and Information Processing Equipment etc. However, certain intangible things not having any physical existence are also included in real accounts i.e. Goodwill, Patents and copyrights

Personal Accounts: Personal Ledger Accounts represent business and legal entities which would include individuals, partnership firms, corporate entities, non-profit organizations, any local or statutory bodies including governments are country, state or local levels.

Nominal Accounts: Nominal Accounts are accounts which are created temporarily for recognition of the implications of the financial transactions during each financial period. These accounts unlike real or personal accounts are closed at the end of each financial period.

e.g.: Sales account is opened for recording the sales of goods or services and at the end of the financial period the total sales are transferred to the revenue statement account (Profit and Loss Account           or Income and Expenditure Account).

Similarly expenses during the financial period are recorded using the respective Expense accounts which are also transferred to the revenue statement account. The net positive or negative balance (profit or loss) of the revenue statement account is transferred to reserves or capital account as the case may be.

Classification of accounts

The classification of accounts into real, personal and nominal is based on their nature i.e. physical asset, liability, juristic entity or financial transaction.

The further classification of accounts is based on the periodicity of their inflows or outflows in context to the financial period.

Income is immediate inflow during the financial period.

Expense is the immediate outflow during the financial period.

Asset is long term outflow with implications extending beyond the financial period and hence represents un-amortized expense as per the traditional view. Conversely, an asset could be valued at the present value of its future inflows.

Liability is long term inflow with implications extending beyond the financial period and hence could represent un-claimed income as per traditional view. Conversely, a liability could be valued as the present value of future outflows.

Items in accounts are classified into five broad groups, also known as the elements of the accounts: Asset, Liability, Equity, Revenue and Expense.

The classification of Equity as a distinctive element for classification of accounts is disputable on account of the "Entity concept" as for the objective analysis of the financial results of any entity the external liabilities of the entity should not be distinguished from any contribution by the shareholders.

Accounting Entries

·         The double entry accounting system records financial transactions in relation to asset, liability, income or expense related to it through accounting entries.

·         Any accounting entry in double entry accounting system has two effects one of increasing one account and decreasing another account by equal amount.

·         As any financial transaction has two different effects on two different accounts, it is known as "double entry" book keeping system.

·         If the accounting entries are recorded without any errors, at any point of time the aggregate balance of all accounts having positive balances will be equal to the aggregate balance of all accounts having negative balances.

·         The double entry bookkeeping system ensures that the financial transaction has equal and opposite effects in two different accounts.

·         The accounting entries use terms such as debit and credit to avoid confusion regarding the opposite effect of the accounting entry e.g. If a accounting entry debits a particular account, the opposite account will be credited and vice versa.

·         The rules for formulating accounting entries are known as "Golden Rules of Accounting".

·         The accounting entries are recorded in the "Books of Accounts".

Books of Accounts

It does this by ensuring that each individual financial transaction is recorded in at least two different nominal ledger accounts within the financial accounting system. The two entries have equal amounts and opposite signs, so that when all entries in the accounts are summed, the total is exactly the same, in other words the accounts balance. This is a partial check that each and every transaction has been correctly recorded. The transaction is recorded as a "debit entry" (Dr.) in one account, and a "credit" (Cr.) entry in the other account. A debit entry generally means that value has been added to the account, and a credit entry means that value is being subtracted from the account. The debit entry will be recorded on the debit side (left hand side) of a nominal ledger account and the credit entry will be recorded on the credit side (right hand side) of a nominal ledger account. A nominal ledger has a Debit (left) side and a Credit (right) side. If the total of the entries on the debit side is greater than the total on the credit side of the nominal ledger account then that account is said to have a debit balance.

As there are two entries for each transaction, the expression Double-Entry is used. As the total of the debit entries equals the total of the credit entries, when the nominal ledger accounts are listed in columns, the left column for accounts with net Debit balances and the right column for accounts with net Credit balances, then the total of all the Debit balances will equal the total of all the Credit balances. If this does not happen then an error has been made somewhere, for instance one of the transactions may not have been recorded twice, i.e. once as a debit and once as a credit as required in the double-entry bookkeeping system.

An example of an entry being recorded twice for double-entry bookkeeping would be a supplier's invoice for stationery costing $100. The expense or Debit entry is Stationery Nominal Ledger a/c $100 Dr (showing that $100 has been spent on stationery) and the Credit entry is to the Supplier's Control Nominal Ledger a/c $100 Cr (showing that we now owe the supplier $100). This transaction has now been recorded twice in the financial accounting system and the total value is $100 for both Debit and Credit values.

Double entry is only used within the nominal ledgers. It is not used in the daybooks, which normally do not form part of the nominal ledger system. The information from the daybooks themselves will be taken and used within the nominal ledger and it is the nominal ledgers that will ensure the integrity of the resulting financial information created from the daybooks (provided that the information recorded in the daybooks is correct).

(The reason for this is to limit the number of entries in the nominal ledger: entries in the daybooks can be totaled before they are entered in the nominal ledger. If there are only a relatively small number of transactions it may be simpler instead to treat the daybooks as an integral part of the nominal ledger and thus of the double entry system.)

However as can be seen from the examples of daybooks shown below, it is still necessary to check, within each daybook that the postings from the daybook balance.

The double entry system uses nominal ledger accounts. From these nominal ledger accounts a Trial balance can be created. The trial balance lists all the nominal ledger account balances. The list is split into two columns, with debit balances placed in the left hand column and credit balances placed in the right hand column. Another column will contain the name of the nominal ledger account describing what each value is for. The total of the debit column must equal the total of the credit column.

From the Trial balance the Profit and Loss Statement and the Balance Sheet can then be produced. The Profit and Loss statement will contain nominal ledger accounts that are Income or Expense type nominal ledger accounts. The Balance Sheet will contain nominal ledger accounts that are Asset or Liability accounts.