Financial Accounting - Double-Entry Bookkeeping System

 

FINANCIAL ACCOUNTING

Double-Entry Bookkeeping System

 

Introduction

Luca Pacioli, a collaborator of Leonardo da Vinci, first codified and scientifically developed the modern double-entry bookkeeping system in Venice in 1494. Pacioli is often called the "father of accounting" because he was the first to publish a detailed description of the double-entry bookkeeping system, thus enabling others to study and use it.

 

Double-entry bookkeeping, in accounting, is a system of bookkeeping where every entry to an account requires a corresponding and opposite entry to a different account. In the double-entry accounting system, at least two accounting entries are required to record each financial transaction. These entries may occur in asset, liability, owner’s equity, expense, or revenue account. Recording of a debit amount to one or more accounts and an equal credit amount to one or more accounts result in total debits being equal to total credits when considering all accounts in the general ledger. If the accounting entries are recorded without error, the aggregate balance of all accounts having Debit balances will be equal to the aggregate balance of all accounts having Credit balances.

 

The accounting entries are recorded in the "Books of Accounts". Regardless of which accounts and how many are involved by a given transaction, the fundamental accounting equation is always as follows:

Fundamental accounting equation:

Assets = Owner’s Equity + Liabilities

 

Approaches of Debit-Credit Rules

Basically, there are two different approaches to memorize which accounts are to be debited and which accounts are to be credited at the time of recording / journalising an accounting transaction under the double-entry system of bookkeeping. They are the Traditional Approach and the Accounting Equation Approach. Irrespective of the approach used, the effect on the books of accounts remains the same, with two aspects (debit and credit) in each of the transactions.

 

Traditional approach

Following the Traditional Approach (also called the British Approach) accounts are classified as real, personal, and nominal accounts. Real accounts are accounts relating to assets of the business organisation e.g. land, building, plant, machinery, furniture, etc. Personal accounts are accounts relating to persons or organisations with whom or which the business has transactions and will mainly consist of accounts of debtors, creditors and capital account of the owners. Nominal accounts are accounts relating to revenue, expenses, gains, and losses. Transactions are entered in the books of accounts by applying the following golden rules of accounting.

 

 Golden Rules of Accounting

1	Real account	Debit what comes in and credit what goes out
2	Personal account	Debit the receiver and credit the giver
3	Nominal account	Debit all expenses & losses and credit all incomes & gains

 

Accounting equation approach

This approach is also called the American approach. Under this approach transactions are recorded based on the accounting equation, i.e., Assets = Liabilities + Capital. The accounting equation is a statement of equality between the debits and the credits. The rules of debit and credit depend on the nature of an account. For the purpose of the accounting equation approach, all the accounts are classified into the following five types:

1.         Assets,

2.         Capital / Owner’s Equity,

3.         Liabilities,

4.         Revenues / Incomes, and

5.         Expenses / Losses.

 

If there is an increase or decrease in a set of accounts, there will be equal decrease or increase in another set of accounts. Accordingly, the following rules of debit and credit hold for the various categories of accounts:

 

Accounts	Debit and Credit Rules
Assets	Debit entry represents an increase in assets and Credit entry represents a decrease in assets
Capital	Credit entry represents an increase in capital and Debit entry represents a decrease in capital
Liabilities	Credit entry represents an increase in liabilities and Debit entry represents a decrease in liabilities
Incomes or Gains	Credit entry represents an increase in incomes and gains and Debit entry represents a decrease in incomes and gains
Expenses or Losses	Debit entry represents an increase in exp. and losses and Credit entry represents a decrease in exp. and losses

 

These five rules help learning about accounting entries and also are comparable with traditional (British) accounting rules.

 

The mnemonic DEADCLIC is used to help remember the effect of debit or credit transactions on the relevant accounts as shown below:

 

DEAD: Debit to increase Expense, Asset and Drawing accounts.

CLIC: Credit to increase Liability, Income and Capital accounts.

 

Direct or Practical Approach

This approach for determining which accounts are to be debited and which are to be credited at the time of recording / journalising an accounting transaction under the double-entry system of bookkeeping may be called ‘Direct Approach’ or ‘Practical Approach’. Under this approach one need to remember debit-credit rules only for the following few types of transactions:

1.         For all cash receipts (i.e. cash inflows) always cash or bank account will be debited.

2.         For all cash payments (i.e. cash outflows) always cash or bank account will be credited.

3.         For purchases of goods (on cash or credit) always purchases account will be debited and either cash account will be credited (in case of cash purchases) or creditor's account will be credited (in case of credit purchases).

4.         For sales of goods (on cash or credit) always sales account will be credited and either cash account will be debited (in case of cash sales) or debtor's account will be debited (in case of credit sales).

5.         For purchases return (i.e. return outward) always purchases return (or return outward) account will be credited and supplier’s account will be debited.

6.         For sales return (i.e. return inward) always sales return (or return inward) account will be debited and customer’s account will be credited.

7.         For purchases of fixed assets (on cash or credit) always respective asset account will be debited and either cash account will be credited (in case of cash purchase) or creditor for asset account will be credited (in case of credit purchase).

8.         For sales of fixed assets (on cash or credit) always respective asset account will be credited and either cash account will be debited (in case of cash sales) or debtor for asset account will be debited (in case of credit sales).

9.         For expenses, (either paid off or outstanding) always respective expense account will be debited. If the expense is paid off, cash or bank account will be credited, whereas if the expense is outstanding, outstanding expense (by the name of the expense) account will be credited. When later on the outstanding expense is paid off, the outstanding expense (by the name of the expense) account will be debited and cash or bank account will be credited.

 

Example: 1

On 10^th December, 2011

Electricity expenses (Rs 2,000) had become due for payment and the same was paid off. Insurance premium (Rs 5,000) also had become due for payment but the same could not be paid off.

 

On 20^th December, 2011

Insurance premium (Rs 5,000) which had become due for payment on 10^th December, 2011 was paid off by cheque.

Journalise the above transactions.

 

Solution: 1

Journal entries

Date	Particulars	LF	Dr. (Rs)	Cr. (Rs)
10.12.11	Electricity expenses A/c        Dr		2,000
	To Cash A/c			2,000
10.12.11	Insurance premium A/c         Dr		5,000
	To Outstanding Ins. Prem. A/c			5,000
20.12.11	Outstanding Ins. Prem. A/c    Dr		5,000
	To Bank A/c			5,000

 

10. For prepaid expenses always prepaid expense (by the name of the expense) account will be debited and cash or bank account will be credited. On a later date when the expenses are actually incurred, the respective expense account will be debited and prepaid expense (by the name of the expense) account will be credited.

 

 

Example: 2

On 10^th December, 2011

Rent (Rs 4,000) for the month of December, 2011 paid in advance.

 

On 1^st January, 2012

Rent (Rs 4,000) for the month of December, 2011 becomes due for payment. Journalise the above transactions.

 

Solution: 2

Journal entries

Date	Particulars	LF	Dr. (Rs)	Cr. (Rs)
10.12.11	Prepaid rent A/c                 Dr		4,000
	To Cash A/c			4,000
01.01.12	Rent A/c                              Dr		4,000
	To Prepaid rent A/c			4,000

 

11. For incomes, (either received or accrued) always respective income account will be credited. If the income is received, cash or bank account will be debited, whereas if the income is accrued, accrued income (by the name of the income) account will be debited. When later on the amount is received, the accrued income (by the name of the income) account will be credited and cash or bank account will be debited.

 

Example: 3

On 10^th December, 2011

Dividend (Rs 6,000) received by cheque. Commission (Rs 4,500) earned but not received.

 

On 20^th December, 2011

Commission (Rs 4,500) which had been earned on 10^th December, 2011 was received. Journalise the above transactions.

 

Solution: 3

Journal entries

Date	Particulars	LF	Dr. (Rs)	Cr. (Rs)
10.12.11	Bank A/c                      Dr		6,000
	To Dividend A/c			6,000
10.12.11	Accrued commission A/c  Dr		4,500
	To Commission A/c			4,500
20.12.11	Cash A/c                  Dr		4,500
	To Accrued commission A/c			4,500

 

12. For incomes received in advance always income received in advance (by the name of the income) account will be credited and cash or bank account will be debited. On a later date when the incomes are actually earned, the respective income account will be credited and income received in advance account will be debited.

 

Example: 4

On 10^th December, 2011

Rent (Rs 10,000) for the month of December, 2011 received in advance by cheque.

 

On 1^st January, 2012

Rent (Rs 10,000) for the month of December, 2011 becomes due for receipt. Journalise the above transactions.

 

Solution: 4

Journal entries

Date	Particulars	LF	Dr. (Rs)	Cr. (Rs)
10.12.11	Bank A/c                         Dr		10,000
	To Rent received in advance A/c			10,000
01.01.12	Rent received in adv. A/c   Dr		10,000
	To Rent A/c			10,000

 

13. For capital introduced by the proprietor (at the commencement of the business or at anytime thereafter) always capital account will be credited.

 

14. For drawings by the proprietor from capital always capital account will be debited.

 

15. For drawings by the proprietor from profit always drawings account will be debited.

 

Important note:

Both capital introductions and drawings by the proprietor may be in cash or in kind.