What is Double-Entry Accounting?

Double entry accounting is the accounting system that is essentially universally used. However, it many it can seem overly cumbersome and pointless. So why do we bother?

First, I should explain how double entry accounting actually works. Essentially, the way it works is in the name. When a transaction happens, you have two entries for it in the accounting records. In accounting, we have debits and we have credits. For any account, each of them will serve one purpose. Either it will make the balance of the account go up, or it will make the balance of the account go down. When we have a transaction, we must always enter one debit and one credit into the accounting records. That’s it. It is really that simple.

But why would be double our work by doing two entries instead of one?

To understand this, you need to understand what is happening when a transaction takes place, and how it affects the financial statements. (For a crash course on the financial statements, check out my last blog post here ). Let’s start with a simple example. A company buys a piece of machinery for $10,000. Let’s analyse what is happening here.

  1. We are spending $10,000.
  2. We are receiving an asset worth $10,000.

So clearly, we need two separate records here. That is where double entry accounting comes in. What we do is we record a decrease in the Cash at Bank account, and an increase in our Machinery account. (For interest, this would be a credit for Cash at Bank and a debit for Machinery.)

Of course, the question that is asked at this point it, how do we record what that expense. Won’t that cash payment just get lost, since it has been cancelled out?

This is a good analysis. Since both of these accounts represent assets, there simply has been no change here in the value of our assets. If this was the only transaction that the business entered into for the year, their profit would be zero, since we have no record of the expense. However, on the cash flow statement we would see the $10,000 cash outflow for the machinery. This lies within the concept of accrual accounting.

Put simply, we do no recognise the expense for this machinery until it is actually realise. Therefore, we depreciate the machinery over its lifetime and recognise the expense gradually. So now it is worth adding another example.

This time we are one year in the future and the machine, which for our purposes can only be used for one year, is now worthless. Let’s consider what has happened here.

  1. Our assets have decreased in value by $10,000.

Because we are using double entry accounting, we need to come up with another entry here. Luckily, this entry will also fix our problem from before, where we did not recognise the expense of buying the machinery. So let’s revise our list.

  1. Our assets have decreased in value by $10,000.
  2. We recognise a depreciation expense of $10,000.

What we see here is a decrease of our asset account, and an increase of our expense account. (For interest, the asset account will be credited, and the expense account will be debited.)

Now, when we prepare our financial statements, we will have an expense listed on the income statement. For simplicity, we will assume that the machine provided us no value, so we have a loss of $10,000. However, we have a net cash flow of zero.

So, in a way, we now have recognised that cash outflow. We can also see how this method of accounting allows us to keep track of how much our assets are worth, how much we are spending, and everything else all in one handy system.

To end this post, I am going to write out another example, but this time it is for a retailer selling a product. Let’s assume they sell a T-Shirt for $15. What will our entries be?

  1. Inventory goes down by $15.
  2. Cash goes up by $15.
  3. Revenue goes up by $15.
  4. Cost of Sales goes up by $15.

So, we have recorded what happens to our assets. (Note that this example is assuming the shirt is actually worth $15. In reality, it would be worth less, hence the business would make a profit.) We have lost an asset (the shirt) worth $15 but also gained an asset (the cash) worth $15. In conjunction to this, since we have recognised that economic benefit now, accrual accounting allows us to record in income statement portion as well.

Our Revenue has gone up by $15. This is because our cash has increased. Our Cost of Sales has also gone up, to record how much that shirt cost us.

Now consider if the shirt was worth $10 and we sold it for $15, what would our entries be.

  1. Inventory goes down by $10.
  2. Cash goes up by $15.
  3. Revenue goes up by $15.
  4. Cost of Sales goes up by $10

Notice how something going up is balanced by something else going down, and also how something happening on the balance sheet (to an asset) is reflected on the Income Statement (income or expense).

We can also see that we have made $5 profit, because we have traded an asset worth $10 for an asset worth $15.

Hopefully I have made it clearer now why double entry accounting is used, and why some of the things that seem strange about the system are in place. It may also have shown you a bit more about how the financial statements are linked.

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