Double-entry bookkeeping

The basis of double-entry bookkeeping is the accounting equation:

$A s s e t s = L i a b i l i t i e s + E q u i t y$

Every transaction recorded will keep this equation in balance. For example, a company can buy a new piece of equipment (increasing an asset), it can spend cash (reducing an asset) or take on a loan (increasing a liability). Based upon where an account sits within the accounting equation determines its normal balance - in this example, a debit to assets increases assets, whereas a credit to liabilities increases liabilities.

The use of double-entry bookkeeping is a standard process for tracking business transactions that improves the ability of the users of financial information to read, process, and understand the financial picture of a company's operations. As the complexity and volume of transactions increases, companies use ledgers and accounting information systems to automate the tracking of individual transactions and to create financial statements.

History

The earliest extant accounting records that follow the modern double-entry system in Europe come from Amatino Manucci, a Florentine merchant at the end of the 13th century. Manucci was employed by the Farolfi firm and the firm's ledger of 1299–1300 evidences full double-entry bookkeeping. Giovannino Farolfi & Company, a firm of Florentine merchants headquartered in Nîmes, acted as moneylenders to the Archbishop of Arles, their most important customer. Some sources suggest that Giovanni di Bicci de' Medici introduced this method for the Medici bank in the 14th century, though evidence for this is lacking.

The double-entry system began to propagate between Italian merchant cities during the 14th century. Before this, there may have been systems of accounting records on multiple books which did not yet have the formal and methodical rigor necessary to control the business economy. In the course of the 16th century, Venice produced the theoretical accounting science by the writings of Luca Pacioli, Domenico Manzoni, Bartolomeo Fontana, the accountant Alvise Casanova and the erudite Giovanni Antonio Tagliente.

Benedetto Cotrugli (Benedikt Kotruljević), a Ragusan merchant and ambassador to Naples, described double-entry bookkeeping in his treatise Della mercatura e del mercante perfetto. Although it was originally written in 1458, no manuscript older than 1475 is known to remain, and the treatise was not printed until 1573. The printer shortened and altered Cotrugli's treatment of double-entry bookkeeping, obscuring the history of the subject. Luca Pacioli, a Franciscan friar and collaborator of Leonardo da Vinci, first codified the system in his mathematics textbook Summa de arithmetica, geometria, proportioni et proportionalità published 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 system, thus enabling others to study and use it.

In early modern Europe, double-entry bookkeeping had theological and cosmological connotations, recalling "both the scales of justice and the symmetry of God's world".

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Approaches

The double-entry system can be applied using two main methods: the traditional approach (British approach) and the accounting equation approach (American approach). Regardless of the method, every transaction maintains two aspects, debit and credit.

Traditional approach

Under the traditional (British) approach, accounts are divided into three categories: real accounts, personal accounts, and nominal accounts. Real accounts are accounts relating to assets both tangible and intangible in nature. Personal accounts are accounts relating to persons or organisations with whom the business has transactions and will mainly consist of accounts of debtors and creditors. Nominal accounts are accounts relating to revenue, expenses, gains, and losses. The golden rules of accounting guide the traditional approach:

Real accounts: Debit what comes in, credit what goes out.
Personal accounts: Debit the receiver, credit the giver.
Nominal accounts: Debit expenses and losses, credit incomes and gains.

The great importance of the primary journals lies in the fact that they should make it possible to trace every single business transaction back to the original voucher without great effort at any given time during the retention periods, even for past events. Thus, bank statements can be used as primary journals. To simplify or enable the tracking of business transactions in the general ledger, it is necessary to note the account assignment on the original document or to ensure corresponding digital traceability.

Accounting equation approach

Also known as the American approach, this method records transactions on the basis of the accounting equation :

$A s s e t s = L i a b i l i t i e s + E q u i t y$

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: assets, capital, liabilities, revenues/incomes, or 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.

Books of accounts

In double-entry bookkeeping, every financial transaction is entered into at least two nominal ledger accounts to ensure that total debits equal total credits, maintaining balance in the general ledger. This is a partial check that each and every transaction has been correctly recorded. Each transaction is recorded as a "debit entry" (Dr) in one account, and a "credit entry" (Cr) in a second account. Per convention, debits are posted on the left-hand side of a ledger account, while credits are posted on the right-hand side. If the total of the entries on the debit side of one account is greater than the total on the credit side of the same nominal account, that account is said to have a debit balance.

Double entry is applied within nominal ledgers, while daybooks (journals) typically serve as preliminary records and are not part of the nominal ledger itself. The information from the daybooks will be used in the nominal ledger and it is the nominal ledgers that will ensure the integrity of the resulting financial information created from the daybooks (provided that the information recorded in the daybooks is correct).

The reason for this is to limit the number of entries in the nominal ledger: entries in the daybooks can be totalled before they are entered in the nominal ledger. If there are only a relatively small number of transactions it may be simpler instead to treat the daybooks as an integral part of the nominal ledger and thus of the double-entry system.

However, as can be seen from the examples of daybooks shown below, it is still necessary to check, within each daybook, that the postings from the daybook balance.

Nominal ledger accounts form the basis for preparing a trial balance, which lists debit and credit balances in two columns to confirm that total debits equal total credits. The trial balance lists all the nominal ledger account balances. The list is split into two columns, with debit balances placed in the left hand column and credit balances placed in the right hand column. Another column will contain the name of the nominal ledger account describing what each value is for. The total of the debit column must equal the total of the credit column.

Debits and credits

A debit entry in an account represents a transfer of value to that account, and a credit entry represents a transfer from the account. Since both sides of a double-entry bookkeeping entry must remain in balance, accounts then have a normal balance, which is based upon whether a debit or a credit increases the account. Normal balance accounts for typical account types is listed below in bold:

Due to the format of a ledger, historically debits are recorded on the left side of the ledger, and credits are recorded on the right side of the ledger. This may be represented graphically with the use of a T account.

Transaction Example

Note the normal balance of the account, and whether the transaction is recorded on the left or right side of the ledger. Assume a business entity performs the following activities:

Purchases $10,000 of inventory from a vendor, on credit.
Transfers the inventory to a customer in exchange for $15,000 of cash.
Pays $10,000 of cash to the vendor for inventory purchased with credit.

Note in the example above that both sides of the transaction are equal in each case.

(Or for the reader who is scientifically literate but a layperson in accounting: if we view debits as positive amount, credits as negative amounts, and blank squares as zero, then equity = assets + liabilities in each line.)

Also note the normal balance of the account, and which transactions are written on the left or right sides of the ledger. The net impact of the above transactions are increase in cash of $5,000 and an increase in equity of $5,000 - this is reasonable because the company bought inventory for $10,000 and sold it for $15,000, leaving $5,000 as the profit in the business.

The net impact of all transactions is that the owner's equity in the business has increased by $5,000, because it purchased inventory for $10,000 and in turn sold it to an end customer for $15,000.