Knowledge Centre
Double Entry Book Keeping
The first book on double entry system was written by Italian mathematician Fra Luca Pacioli, and his close friend, Leonardo da Vinci. The book was entitled as “Summa de arithmetica, geometria, proportioni et proportionalita” and was first published in Venice in 1494. His theory almost certainly was influenced by the Islamic world of mathematics of 200 years earlier.
The 15th century Venetian empire was a super-power. Its traders had a monopoly on the valuable spice trade. Additionally, it had colonies across the Mediterranean. Its status as a trading market also caused Venice to become a major financial centre in Europe. The Venetians were responsible for the development of futures, credit letters and early bank notes.
The system is based on the principle that every transaction has two sides, or changes a business financially, in two ways. Rather like yin and yang, and the concept of duality. Ergo, should you sell a unit for $1(credit), you must account for the cost of the unit and the $1 (debit).
The nature of this symmetry will identify errors because every entry should be counter- balanced by a corresponding entry on the other side of the ledger. For example, were you to buy a unit, say a building for $200,000, then the value of your assets has risen by $200,000. However, the amount of cash you have has also reduced by $200,000.
A company’s assets will always equal its liabilities plus equity. Repeat: Assets = Liabilities + Equity.
Assets include all of the items that a company owns, such as inventory (stock), cash, machinery such as computers, buildings and etends to include intangible items such as patents, intellectual property, licenses and brand value. Liabilities represent everything the company owes to someone else, such as short-term accounts payable owned to suppliers or long-term notes payable owed to a bank. Equity represents the owners’ stake in the company. Equity may include any contributions the owners have made to the company, plus the company’s profits or minus the company’s losses.
The rules of debit and credit:
Asset accounts: an increase in assets is recorded on the debit side and the equivalent decrease is recorded on the credit side of the asset account.
Expense accounts: An increase is recorded on the debit side and a decrease is recorded on the credit side of all expense accounts.
Liability accounts: An increase is recorded on the credit side and a decrease is recorded on the debit side of all liability accounts.
Revenue/Income accounts: An increase is recorded on the credit side and a decrease is recorded on the debit side of all revenue accounts.
Capital/Equity accounts: An increase is recorded on the credit side and a decrease is recorded on the debit side of all equity accounts.
Contra accounts: Always opposite to the relevant normal account. The normal balance of a contra account can be a debit balance or a credit balance.
The system can basically be divided into:
- Original transaction records (journal). For example, cash receipts, payments and sales/sales returns.
- Classification (ledger accounts). This all the records in one place or statement. A running total.
- Summary (final accounts). After a certain period of time, say a week, the ledger is balanced producing a trial balance which is then used to calculate the profit or loss or Income Statement.
Let’s work through a simple example:
Mark at TEAM decides to open a book shop selling financial books (he has an online store).
Mark starts the business by putting $100,000 of his savings into the company. The first entry to the general ledger would be a debit to Cash, increasing the assets of the company, and a credit to Equity, increasing Marks’s ownership share of the company.
If Mark then buys a computer for $3,000 on the company credit card, the next entry to the general ledger would be a debit to Computer Equipment for $3,000, increasing the assets of the company, and a credit to Credit Card Due for $3,000, increasing the liabilities of the company.
A sub-ledger is kept for each individual account, which will only represent one side of the transaction.The general ledger, however, has the record for both sides of the transaction. When Mark purchases the computer, the Equipment sub-ledger would only show one side of the transaction, or entry, which is the debit to Computer Equipment for $3,000. The Credit Card Due sub-ledger would include a record of the other side of the transaction, or entry, a credit for $3,000.
The general ledger would have two lines (double entry) added, showing both the debit and credit for $3,000 each.
The advantages of double-entry are:
- The two sides of each transaction are recorded (i.e., for every debit there must be a credit, and vice versa). This creates a natural symmetry within the records which helps in detecting errors, omissions and frauds.
- A trial balance can be prepared to check the arithmetical accuracy of all entries. The trial balance can be further utilised to produce operating results, via preparing an income statement, and determining the financial position of the business by preparing a balance sheet.
- It is the most advanced and useful form of maintaining accounting records and is used the world over. It enables the user a comparison of financial statements with that of other companies, on a like-for-like basis.
- The double-entry system is highly systematic, in that it follows certain rules and principles. This makes it a relatively straightforward exercise to find information about a particular transaction, or account query, quickly and efficiently, when required.
- Almost all accounting standards and laws in the world require the use of the double-entry system of accounting.
- The financial reports and results generated by double entry book-keeping can generally be relied upon for management reports, and ultimately, corporate decision making.
CAUTION: Double-entry does not stop fraud or manipulation.
“The Shipman’s Tale”, is one of The Canterbury Tales by Geoffrey Chaucer, written between 1387 and 1400.
It tells the story of a merchant, his wife and her lover, a monk. The rich merchant is too occupied with his accounts to notice his wife is being wooed by the monk. The monk who is also a friend of the merchant borrows money from the merchant and gives the money to the merchant’s wife. Thus, settling her debts and buying her “affections”, using the merchant’s own money. Later the merchant asks the monk to repay the debt. The monk tells the merchant he has repaid the debt and to ask his wife where the money is. Her response:
“The devil take all such reckonings”
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