2.1 The Double Entry System of Book-keeping

The double-entry system is the fundamental principle of book-keeping used in accounting. It ensures that every financial transaction affects at least two accounts. This system maintains the accounting equation (Assets = Liabilities + Equity) and provides a more accurate and reliable record of a business's financial position.

Key Concepts

• Debits and Credits: Transactions are recorded as both debits and credits.
• The Accounting Equation: The double-entry system ensures the accounting equation always remains in balance.
• Ledger Accounts: Individual accounts for each asset, liability, equity, income, and expense.
• The Trial Balance: A list of all ledger accounts and their balances, used to check for mathematical accuracy.

Debits and Credits Explained

Understanding debits and credits is crucial. Here's a summary:

Account	Debit (Dr)	Credit (Cr)
Assets	Increase	Decrease
Liabilities	Decrease	Increase
Equity	Decrease	Increase
Income	Decrease	Increase
Expenses	Increase	Decrease

Important Note: The rules for debits and credits depend on the type of account.

How the Double-Entry System Works

1. Identify the Transaction: Determine what has happened (e.g., a sale, a purchase, payment).
2. Identify Affected Accounts: Determine which accounts are affected by the transaction.
3. Determine Debits and Credits: Apply the debit and credit rules based on the type of account.
4. Record the Transaction: Record the debit and credit amounts in the appropriate ledger accounts.
5. Maintain the Accounting Equation: Ensure that the total debits equal the total credits for each transaction.

Ledger Accounts

Ledger accounts are individual accounts for each item in the chart of accounts. They typically include:

• Account Name
• Date
• Description
• Debit
• Credit
• Balance

Balancing Ledger Accounts

At the end of an accounting period, ledger accounts are balanced. This involves calculating the final balance of the account.

Calculating the Balance:

For most accounts, the balance is calculated as: Ending Balance = Total Credits - Total Debits

If the total debits exceed the total credits, the account will have a debit balance. If the total credits exceed the total debits, the account will have a credit balance.

Making Transfers to Financial Statements

Once the ledger accounts are balanced, the balances are transferred to the financial statements:

• Income Statement: Reports the business's income and expenses over a period. It is prepared using income and expense ledger account balances.
• Profit and Loss Account (P&L Account): Another name for the income statement.
• Statement of Financial Position (Balance Sheet): Reports the business's assets, liabilities, and equity at a specific point in time. It is prepared using asset, liability, and equity ledger account balances.

Example Transaction

A business purchases equipment for $2,000 in cash.

1. Identify the Transaction: Purchase of equipment.
2. Identify Affected Accounts: Equipment (an asset) and Cash (an asset).
3. Determine Debits and Credits: Equipment (asset) increases with a debit. Cash (asset) decreases with a credit.
4. Record the Transaction:

   Account	Debit	Credit
   Equipment	$2,000
   Cash		$2,000

5. Maintain the Accounting Equation: Assets (Equipment + Cash) remain in balance.

By consistently applying the double-entry system, businesses can maintain accurate and reliable financial records, which are essential for decision-making and reporting.