Chapter 07 Double Entry System
Introduction to Double Entry System
The Double Entry System is a scientific and universally accepted method of recording financial transactions in the books of accounts. It’s based on the principle that every business transaction has two-fold effects and, therefore, affects at least two accounts. One account is debited, and another is credited with an equal amount.
Developed by Luca Pacioli in Italy in 1494.
The total of all debits must always equal the total of all credits.
- Principle or Characteristics of Double Entry System
- Every business transcation affects two accounts: This is the most fundamental principle. Every business transaction has two effects on the accounts. It affects at least two accounts.
- Recording of both personal and impersonal aspects: Both personal and impersonal aspects of a transcation are recorded in double entry system.
- Recording is made according to certain specified rules: In double entry system one account is debited and the other is credited. It does not mean that any account may be debited and any account may be credited. Certain rules are there for debiting and crediting.
- Preparation of Trial Balance: One account is debited and other is credited. This helps in finding out the arithmetical accuracy of the accounting records.
- Personal Accounts: Accounts related to individuals, firms, companies, or institutions.
Rule:- Debit the Receiver, Credit the Giver.
Example: 1
Paid cash to Mohan:
Mohan A/c (Receiver – Debit)
To Cash A/c (Giver – Credit)
Example: 2
Received cash from Suresh:
Cash A/c (Receiver – Debit)
To Suresh A/c (Giver – Credit)
Types of Personal Accounts
- Natural Personal Accounts: Human beings
Example ; Ram’s A/c, Suresh’s A/c.
- Artificial Personal Accounts: Legally created entities
Example : Reliance Ltd. A/c, State Bank of India A/c, Delhi University A/c.
- Representative Personal Accounts: Accounts representing a person or group of persons.
Example: Outstanding Salaries A/c, Prepaid Rent A/c, Accrued Interest A/c,
- Real Accounts: Accounts related to assets, properties, or possessions of the business, which have a tangible or intangible existence and can be measured in terms of money.
Rule:- Debit what Comes In, Credit what Goes Out.
Example:
Purchased furniture for cash:
Furniture A/c (Comes In – Debit)
To Cash A/c (Goes Out – Credit)
Example:
Sold goods for cash:
Cash A/c (Comes In – Debit)
To Sales A/c (Goods Go Out – Credit)
Types of Real Accounts
- Tangible Real Accounts: Can be seen, touched, felt
Example: Cash A/c, Land A/c, Building A/c, Furniture A/c.
- Intangible Real Accounts: Cannot be seen or touched but have value
Example: Goodwill A/c, Patents A/c, Trademarks A/c.
- Nominal Accounts: Accounts related to expenses, losses, incomes, and gains. These accounts are temporary and are closed at the end of the accounting period by transferring their balances to the Profit & Loss Account.
Rule:- Debit all Expenses and Losses, Credit all Incomes and Gains.
Example:
Paid salaries:
Salaries A/c (Expense – Debit)
To Cash A/c (Asset – Credit)
Example:
Received commission:
Cash A/c (Asset – Debit)
To Commission Received A/c (Income – Credit)
Stages or Parts of Double Entry System
- Original Record: All the transcations are first recorded in a primary book called JOURNAL. Recording in Journal or in its subsidiary books in the first stage of double entry system. This stage is also known as original record stage.
- Classification: The information from the Journal (or subsidiary books) is then transferred to the respective Ledger accounts. This process is called “posting.”
Ledger: The principal book of accounts where all transactions relating to a particular account (e.g., Cash, Salaries Expense, Accounts Payable, Capital) are grouped together. Each account has its own page or section in the ledger.
- Summary: A statement prepared at the end of an accounting period listing the debit balances and credit balances of all ledger accounts.
Purpose:
- To check the arithmetical accuracy of the ledger accounts.
- To serve as the basis for preparing the final financial statements.
Advantages of Double Entry System:
- Scientific System: The transactions are recorded according to certain specified rukes and as such, the system is more scientific as compared to any other systems of Book-Keeping.
- Complete record of every transactions: The complete record of every transactions is maintained in this system, so that if the need arises full details of every transactions can be easily made available at any time in future.
- Preparation of Trial Balance: The amount recorded to the debit side of various accounts will always be equal to the amounts recorded on the credit sides of various accounts.
- Knowledge of financial position of the business: In double-entry system, separate accounts are opened for each and every asset and liability of the firm and as such, a Balance Sheet can be prepared which is a screen picture of the financial position of a business at a certain moment.
Preparation of Trading & Profit & Loss Account: With the help of a trial balance, a trader can prepare a Trading Account to find out the amount of gross profit or gross loss. Similarly, a p/l acc. can be prepared to find out net profit earned or net loss suffered during a particular period.
- Knowledge of various information: In double entry system the accounts are maintained in such a way that the information readily available at any point of time.
- Lesser possibility of fraud: This system of book-keeping each transacation in two accounts, as such there is hardly any scope of forgery & manipulation as compared to other systems.
Legal Approval: Complete record of each transacation is maintained under this system according to certain specified rules. Tax authorities also rely on the books maintained under this system and these are also accepted by the Court of Law as necessary documentary evidence.
- Comparative Study: Separate recording is made for each item of expenditure and income. As such, the management can compare the expenditure of current year with those of the previous year.
- Help management in Decision Making: Accurate and detailed financial information provided by the double-entry system empowers management to make informed business decisions. This includes decisions related to:
Pricing strategies
Investment opportunities
Cost control
Borrowing and lending
Expansion plans
- Suitable for all Types of Businessmen: The system is so flexible that it can be conveniently introduced in small as well as big types of business.
Disadvantages of Double Entry System:
- A number of books are to be kept under this system, as such, the system is quite expensive.
- It is quite difficult to apply the rules of debit & credit. Proper education, practical knowledge and training is required.
3) Doesn’t Guarantee Complete Accuracy:
While the Trial Balance checks for arithmetical accuracy, it does not detect all types of errors. For example:
-
- Errors of Omission: If a transaction is completely missed (not recorded at all), the debits and credits will still balance.
- Errors of Commission: If an incorrect amount is recorded for both the debit and credit, or if the correct accounts are used but for the wrong amounts.
- Compensating Errors: If one error’s effect cancels out another error’s effect.
- Errors of Principle: If a transaction is recorded in the wrong type of account (e.g., an asset treated as an expense), but the debit and credit amounts are equal.