About Double Entry Accounting

Madhuri Dange

March 25, 2022 11:25

Business transactions were defined earlier in this document as economic events that affect the financial position of a business entity. To measure a business transaction, the accountant must determine:

When the transaction occurred (recognition).
What value should be placed on the transaction.
How components of the transaction should be categorized (classification).

This topic contains the following sub-topics:

About Debits and Credits in Double Entry Accounting
About Commonly Used Accounts in Double Entry Accounting

About Debits and Credits in Double Entry Accounting

In the double-entry system each transaction must be recorded with at least one debit and one credit, in such a way that the total dollar amount of debits and the total dollar amounts of credits equal each other. As a result, the system as a whole is always in balance.

One of the best ways to illustrate double-entry accounting is with a T Account, as defined earlier in About Transaction Analysis of Debits and Credits. To summarize, debits and credits increase or decrease accounts depending on what side of the accounting equation they are on. The accounting equation is as follows:

Assets = Liabilities + Equity/Fund Balance

For this equation to stay in balance, if assets are increased by debits, then there must be a corresponding credit to liabilities or equity to increase them.

Revenues and expenses fit into this equation through Equity/Fund Balance. At the end of a given accounting period, net revenues and expenses (net income) are cleared with the net income amount increasing or decreasing Equity/Fund Balance. Since revenues are credits and expenses are debits, a net of revenues over expenses is a net credit, increasing Equity/Fund Balance.

These relationships are best illustrated in the following T Accounts.

Equity/Fund Balance
Decreases (Debits)		Increases (Credits)
Expenses		Revenues
Increases (Debits)	Decreases (Credits)	Decreases (Debits)	Increases (Credits)
Withdrawals
Increases (Debits)	Decreases (Credits)

About Commonly Used Accounts in Double Entry Accounting

Businesses use a variety of accounts to suit their needs. Exactly what accounts are used by any particular business depends on the type of business it is, how it is organized, and how the accounting system has been established. There are far too many different accounts to list in this document. Some of the more commonly used accounts are listed in the following sections:

Asset Accounts
Liabilities

Asset Accounts

Assets are probable future economic benefits obtained or controlled as a result of past transactions or events. Debits increase assets and credits decrease them.

Generally, asset accounts that normally carry a credit balance are called "contra-asset" accounts. One example of a contra-asset account would be the Allowance for Doubtful Accounts. When an organization knows that an account will not be paid, it normally writes off the receivable immediately. The Allowance for Doubtful Accounts, however, is an estimation of the amount that will not be collected in Accounts Receivable from "doubtful" accounts (accounts that the business suspects may not be paid but are not certain).

To be considered an asset, an economic resource must have the following characteristics:

The resource must have the capacity to contribute, directly or indirectly, to the company's future net cash flow.
The company must have the right to control the economic resource and obtain future benefit.
The transaction or event giving rise to the company's right to the economic resource must have already occurred.

Current assets are assets that are reasonably expected to be either converted into cash or sold or consumed within one year or the normal operating cycle, whichever is longer.
Some of the most common asset accounts are defined as follows:

Cash
Receivables
Inventories
Prepaid Expenses

Cash

The measurement of cash includes:

Coins & Currency
Unrestricted funds on deposit with a bank
Negotiable checks
Bank drafts

Commons items that are confused as cash but are actually classified other than cash are:

Item	Classified As
Certificates of Deposit	Investments
Bank Overdrafts	Liability
Post Dated Checks	Receivable
Postage Stamps	Prepaid Expense

Receivables

Receivables consist of a variety of claims against customers and other parties arising from the operations of the business enterprise. Accounts receivable is the result of credit sales to customers.
Accounts receivables are valued on the balance sheet at net realizable value. To achieve this net realizable value, an offsetting Allowance for Doubtful Accounts is set up as a contra-asset account to reflect the amount of receivables the company does not reasonably expect to collect. As a result, the net of Accounts Receivable and the Allowance for Doubtful Accounts informs the reader of the net realizable value of amounts in accounts receivable.

When bad debt expense is accrued, accounts that have been written off are never reflected on the income statement. The write-off is assumed to have been estimated at the time of sale and already recognized in the income. A write-off is recorded under this method by reducing Accounts Receivable and its corresponding allowance for doubtful accounts.

Inventories

Inventory includes all assets of a company that are:

Held for sale in the ordinary course of business.
In the process of production for sale, or
Held for use in the production of goods or services to be made available for sale.

Items should be included in inventory quantities:

When control (or risk of loss) transfers to the company even though the company does not have physical possession. One example of this would be F.O.B. Destination. In this situation, a customer has purchased an item, and the seller has shipped the item. Until that item reaches the customer and is successfully delivered, the seller retains ownership (and therefore risk of loss) of the item.
When items are on consignment, as the company (consignor) still retains ownership and control of the inventory.

Prepaid Expenses

Prepaid expenses reflect payments made for goods or services purchased by a company for use in its operations but not fully consumed by the end of an accounting period. Prepaid expenses on the balance sheet are reduced systematically and expensed on the income statement as the goods and services are used to match against current revenues.

Liabilities

Liabilities are probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services in the future as a result of past transactions or events. Credits increase liabilities and debits decrease them.

An obligation must have three characteristics to be considered a liability.

The company must have the responsibility to another company or companies that will be settled by a sacrifice involving the transfer of assets, provision of services, or other use of assets at a specified or determinable date, on occurrence of a specified event or on demand.
The company has little or no discretion to avoid the future sacrifice.
The transaction or other event obligating the entity must have already occurred.

Current liabilities are those reasonably expected to require the use of existing resources which have been classified as current assets, or the creation of other liabilities within one year or the normal operating cycle, whichever is longer.

Some of the most common liability accounts are defined as follows:

Accounts Payable
Deferred Revenue
Owner's Equity Accounts or Fund Balance
Revenue Accounts
Expense Accounts
Accrued Liabilities
Sales Tax Payable

Accounts Payable

Accounts Payable liabilities arise from the purchase of goods, materials, supplies, or services on an open charge-account basis. This account generally corresponds with the recognition of expenses and when inventory quantities are added to the current balance. At any given time, the Accounts Payable ledger account should reflect the amounts outstanding, due to be paid on goods and services already received.

Deferred Revenue

Deferred revenues reflect the receipt of cash in advance of services to be rendered. At any given point in time, the Deferred Revenues ledger account should reflect the unearned amount of revenues a company has received. As the services are rendered or the goods are sent to the customer, revenue is recognized and deferred revenue is reduced.

The reduction of deferred revenues should systematically reflect the earning process of the goods and services sold. This allows the revenue to be matched with the corresponding expenses. For example, magazine subscriptions are generally collected in advance of distributing the magazine. When magazines are shipped to the customers, inventory is reduced and recognized as an expense in Cost of Goods Sold. Additionally, since the magazine has been shipped, the company has earned the portion of related income. As such, the income is recognized with the corresponding Cost of Goods Sold.

Owner's Equity Accounts or Fund Balance

Owner's Equity represents a residual interest of owners in assets after deducting liabilities. In cases where an organization is non-profit, Fund Balance replaces the concept of Owner's Equity. The Fund Balance is equivalent to the net assets of an organization. Credits increase Equity/Fund Balance and debits decrease them.

Revenue Accounts

Revenues are inflows or other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities involving major operations. Revenues are generally the most unique portion of the financial statements to a company or industry. This is because they reflect the core products of a company or industry. Revenues should reflect the performance of a company's sales over an accounting period.

There is sometimes confusion over what items should be included in net revenues. Net revenues generally only include gross revenues, less returns, allowances, and discounts. Other expenses related to sales should be classified under expenses.

Expense Accounts

Expenses are used for funds or outflows, such as salaries, taxes, insurance, gas and oil expenses, legal expenses, and so forth.

Accrued Liabilities

Accrued liabilities are obligations that accumulate in a systematic way over time. A common example is employee compensated absences.

Sales Tax Payable

Sales Tax Payable are liabilities that are created as sales taxes charged to customers and held by the organization in order to remit a payment to the appropriate local, state, or federal authorities.