What is Double Entry?
Double-entry accounting is the basis of bookkeeping where financial transactions are accurately and uniformly recorded through making a dual entry in two different accounts.
It was invented in the commercial and trade period in Europe and was later proven to be a very fundamental system that merchants and bankers would rely on for understanding their financial activities with greater clarity as capitalism continued to expand.
Since an account is balanced, in double-entry accounting, the reflection of a firm’s financial health is ensured, which facilitates effective decision-making processes.
Key Principles of Double-Entry Accounting
Double-entry accounting will record each and every transaction in at least two accounts. This causes equal and opposite entries termed as debits and credits.
A business will post a debit in one account and a corresponding credit somewhere else when recording every business transaction.
What is important to keep in mind here is that the total of all debits should balance with all credits as well. This principle must go by
the accounting equation
Assets=Liabilities+Equity
It is based on this principle that the balance sheet of an organization is centered. It ensures that all its assets’ requirements are always met either by liabilities or equity.
The double-entry principle therefore achieves a balance between the values of the assets and the liabilities-equalling the sum of an organization’s equity.
Mechanics of Debits and Credits
Under double-entry accounting, accounts are recorded via debit and credit. With any transaction, the debiting at least touches at least one account to be credited so that a different account simultaneously increases to meet this need to maintain an equality and equity in
Assets = Liabilities + Equity.
Debits
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The debits are recorded on the left side of the account.
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Debits increase asset accounts. Cash, inventory, and accounts receivable are examples.
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Assets decrease owner’s equity accounts. Liabilities decrease a company’s debt increase because of liabilities, such as loans payable.
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These stretch into expense and loss accounts, salaries or utilities, on the income statement.
Credits
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Credits on the right side of an account are recorded.
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Credits increase liability and equity accounts, like accounts payable or capital stock.
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Credit unbalances asset accounts. These are cash or equipment for example.
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Credits are increases in revenue accounts, such as sales or service income, but decrease expense accounts on the income statement.
Example:
If a firm borrows an amount of $50,000 from a bank. In the accounting books, there are two entries:
A debit entry of $50,000 to the cash account, which in turn increases the cash balance for the company.
A credit entry of $50,000 to the loans payable account; it represents the new liability.
This transaction increases the asset (cash) and increases the liabilities by an equal amount: loans payable, maintaining balance in the accounting equation.
Advantages of double-entry accounting
1) Clear Picture of Financial Position
As each transaction is recorded at least in two accounts, it makes it easier to ascertain how financial activities affect a business using the double-entry system.
With an understanding of the accounting equation, Assets = Liabilities + Equity, business operations can then be carried out in such a manner that records balance as well as accuracy;
while keeping stakeholders closely posting and understanding the soundness of the company’s financial health and resource allocation.
2) Error and Fraud Detection
The main advantage of double entry accounting is the self-checking mechanism it carries with it.
Since for every debit, there has to be a corresponding credit, any discrepancy between these two would itself point to an error thereby easy to realize.
Fraud is harder to be concealed since any alteration made in one account would necessarily require balancing elsewhere.
3) Informed Decision-Making
Double-entry accounting provides indispensable data that helps in making decisions.
With the accurate recording of all financial transactions, businesses can produce financial statements such as a balance sheet and income statement.
These reports show profitability, liquidity, and the overall performance of the business and can help management determine choices on investments, expenditures, and future growth strategies.
4) Assessment of Financial Health
The advantage of double-entry accounting is that it is able to produce financial statements in great detail. Therefore, under this financial system, businesses can regularly scrutinize their current financial status. This can therefore determine cash flow, profitability, and solvency, giving a comprehensive view of the financial position of the company and, therefore, where the areas for improvement or growth lie.