Double Entry Accounting And Why It Matters In Business

Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double entry is that a single transaction to be recorded will hit two accounts.

Aspect	Explanation
Concept Overview	Double Entry Accounting, also known as Double Entry Bookkeeping, is a fundamental accounting method used by businesses and organizations to record financial transactions. It is based on the principle that every transaction affects at least two accounts: one account is debited (recorded as an increase), and another account is credited (recorded as a decrease). Double entry accounting is designed to maintain the balance between assets, liabilities, and equity in the accounting equation (Assets = Liabilities + Equity).
Key Elements	Double Entry Accounting involves several key elements: – Transactions: Every financial transaction is recorded, including sales, purchases, expenses, and revenue. – Accounts: Various accounts, such as cash, accounts receivable, accounts payable, and equity accounts, are used to categorize and track transactions. – Debits and Credits: Each transaction affects at least two accounts with one being debited and the other credited. Debits and credits must balance, ensuring that the accounting equation is maintained. – Ledger: Transactions are recorded in a ledger, which is a detailed record of all financial activities. – Trial Balance: Periodically, a trial balance is prepared to check that total debits equal total credits, providing a preliminary review of financial accuracy.
Formula	There is no single formula for Double Entry Accounting, as it involves recording transactions in a systematic and balanced manner. The fundamental principle is that total debits must equal total credits for each transaction and in the overall ledger. The accounting equation (Assets = Liabilities + Equity) also represents a foundational formula for double entry accounting.
Applications	Double Entry Accounting is widely applied in various financial and business contexts: – Financial Reporting: It forms the basis for preparing financial statements, including the balance sheet, income statement, and cash flow statement. – Tax Compliance: Businesses use it to maintain accurate records for tax reporting and compliance. – Auditing: Auditors rely on double entry accounting to verify the accuracy of financial records. – Internal Control: It helps organizations maintain internal control over financial activities and detect errors or fraud. – Investor Relations: It provides transparency and reliability in financial reporting, which is important for attracting investors.
Benefits	Utilizing Double Entry Accounting offers several benefits: – Accuracy: It ensures that transactions are recorded accurately, reducing the likelihood of errors or discrepancies. – Transparency: The method provides transparency in financial reporting, which builds trust with stakeholders. – Financial Analysis: It enables financial analysts to assess a company’s financial health and performance. – Legal Compliance: It helps businesses comply with accounting standards and regulations. – Decision Making: Accurate financial data supports informed decision-making by management.
Challenges	Challenges in implementing Double Entry Accounting include the complexity of recording transactions, the need for trained accounting professionals, and the potential for errors if not applied correctly. Additionally, reconciling accounts and identifying discrepancies can be time-consuming.

The Enlightened Accountant by Gennaro Cuofano – FourWeekMBA Download

Table of Contents

Quick history of modern accounting

In a globalized world, where change happens so quickly that companies that existed for centuries – such as Lehman Brothers, founded in 1850, bankrupted in 2008 – just a few things stick for centuries.

The current accounting system is one of the few survivors. Born in 1494, when a Venetian Merchant, Luca Pacioli, in his “Summa de Arithmetica, Geometria, Proportioni et Proportionailta”, described for the first time the double entry system. This practical manual gave official birth to a system that is still used in current accounting.

Even people who hate accounting recognize the importance of it. If you either own a small business, or you are a CFO, CEO, COO, or a common citizen, you have to understand accounting to recognize what is behind each one of the 14 trillion transactions per day, just in the US.

GAAP Principles

Although the fundamental accounting system hasn’t changed, the principle and rules applied today have been updated in the last century.

The generally accepted accounting principles are standards and procedures used by organizations to submit their financial statements.

Today we have two main accepted frameworks, globally: GAAP and IFRS; in this chapter, I will focus mainly on GAAP. Indeed, after the 1929 market crash,

American government felt the necessity to create a set of rules to discipline and conform the accounting system, and avoid what had happened in the decade after the 1929 market crash institutions such as the Securities and Exchange Commission were created.

In 1934, the SEC, assisted by the American Institute of Accountants (AIA), started to work on the GAAP.

The AIA subsequently instituted an organism to specifically create these principles: The Committee on Accounting Procedure (CAP). Finally, the first set of GAAP was created and in 1973 and the CAP board was substituted by the Financial Accounting Standards Board (FASB).

From this work came out 10 basic principles that are the foundation of the modern accounting system in US:

Economic entity assumption: If you have a business, even if you are a sole proprietor, the accountant will consider yourself separate from your business.
Monetary Unit Assumption: The Business activity you undertake is considered in US Dollars.
Time Period Assumption: Business activity you undertake can be reported in separated time intervals, such as weeks, months, quarters, or fiscal years.
Cost Principle: If you buy an item in 1980 at $100, it will be reported on your balance sheet as worth $100 today, independently on inflation or appreciation of the asset.
Full Disclosure Principle: You have to report all the relevant information of the business in the financial statements or in the footnotes.
Going Concern: The accountant assumes that your business will continue its operations in the foreseeable future.
Matching Principle: If you incur an expense, it should be matched with the revenues, according to the accrual principle. If you decide to pay your employees a bonus related to 2015 but you pay it in 2016, you still will report it as 2015. You will report the expense when it was recognized and not when actual cash disbursed (accrual principle).
Revenue Recognition Principle: if you sell a product in January 2015 but you will receive the money from the customer in April 2015, you will report the sale in January, since it was the period when the actual sale was realizable.
Materiality Principle: when you report the financials, it will be allowed to round them, since if an amount is insignificant can be neglected by your accountant.
Conservatism Principle: When in doubt between $80 and $100 loss, your accountant has to choose the most conservative alternative, report $100.

These principles are the “ten commandments” for the accountant. Keep them in mind.

They will guide you throughout the book. In addition, the accrual principle in practical terms states: “Revenues and expenses are recognized when occurred, independently from cash disbursement.”

This principle is crucial to build our main financial statements, in particular the Income Statement and Balance Sheet.

Double-entry system explained

accounting-equation — The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down in assets, and how they get sources (either through equity/capital or liability/debt).

As any other language, the accounting system has its own. Indeed, in accounting in order for you to record a transaction you have to use the double-entry system.

Double entry means that each single transaction needs to be recorded twice, on the left side if debited and on the right side if credited.

Usually, when you think of debit or credit in real life is different compared to debit or credit in accounting. In fact, debit does not mean that you have a debt to be paid back; neither credit means that you have money to receive.

For example, in the accounting world, when cash is debited, it means the cash on your bank account increased. Therefore, you received cash. I know it may sound counterintuitive, but this system was created five hundred years ago and it is the system today’s accountants use to record each single transaction.

T-Accounts: The Foundation

The most effective way that accountants use to record every single transaction in the ledger is the T-Account. Although most accounting Software today do it automatically, it is helpful to know how it works.

This visual aid helps the accountant to record a single transaction. Each account, in fact, has two sides, debit and credit.

Therefore, for a transaction to satisfy the accounting requirements has to be recorded on both sides. We will see that in the next paragraph.

Eventually, all the transactions collected for a certain period flow into the General Ledger.

Journal Entry: The Double Faced Entry

Assuming you own a bakery that just sold $100 worth of biscuits. In the real world, it appears as a single transaction. Therefore you may think the same applies in the accounting world.

Instead, it is more complex since each single transaction implies two concurrent movements.

When you sold $100 of biscuits, your customer paid in cash. It means, on one hand, the $100 is debited to the cash account, while on the other hand, the $100 is credited to the income account. It will look like the following:

Accounts And Chart of Accounts (COA)

By defining Accounting as the language, we can define the accounts as the letters of the alphabet. Indeed, the accounts allow to categorize the bunch of transactions happened in a certain period, under the same umbrella.

The account is a record where all the debit and credit transactions are recorded. In the previous paragraph you saw already two of the main accounts, Assets and Revenue.

These accounts get organized under a Chart of Account (COA) or a list of items identified by an organization that will flow in the General Ledger (GL).

This will help the company to build reports such as: Balance Sheet (BS), Income Statement (P&L) and Cash Flow Statement.

Setting up a clear and consistent COA is crucial for the accounting department internal organization. Indeed, a disorganized COA can lead to many accounting mistakes and inaccuracies.

Below an example of best practice:

*Source: Chart of Accounts by Microsoft Dynamics*

As you can see, it is suggested to use four figures. In the specific example, each account has its own range. Indeed, the assets are shown under 1xxx, liability 2xxx, equity 3xxx and so on.

It is advisable, when setting up the accounts on the chart is advisable to leave some space between the sub accounts. For example, under assets we have the sub heading “current-assets”.

Within the Current Assets, we have items such as: Cash Account, Accounts Receivable, Inventories and Prepaid Expenses. Therefore, we will have: Current Assets, 1100 code; Cash Account, 1110 code; Accounts receivable 1200 code; Inventory 1300; Pre-paid Expenses 1500, code.

Give space between the sub-accounts, this allows you to set up new sub accounts when needed. For example, if two new cash accounts are opened, you can use the coding from 1111-1199.

Therefore, you have plenty of space to organize your COA. Setting up an organized COA and making sure everyone follows it rigorously in the organization is crucial.

Indeed, according to the coded generated, all the internal reports will be built. Such as historical AR, AP, P&L, BS, GL, CFS. If the coding is wrong or disorganized so your reports will be.

Glance at the main accounts

Assets: Resources owned by an organization. They will produce future benefits for the company. For example, you own a bakery that has to produce biscuits. In order for you to produce them, you have to buy a machine. The machine will be an asset for your organization.
Liabilities: Obligations (Debt) contracted by an organization. Your bakery bought $100 of raw material from the supplier and you will pay in 60 days. Until the payment will be made the $100 will show as liability (future debt) on your balance sheet.
Owner’s Equity: Amount of money or resources you endowed to your organization. The accounting definition is: Owner’s Equity = Assets – Liabilities.
Revenue or Income: The $ amount of sales occurred in a certain period. According to the accrual principle, income is recognized independently from cash receipt.
Expenses: The $ amount of costs occurred in a certain period. According to the accrual principle, expenses are recognized independently from cash disbursement.

financial-statements — Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Key Highlights:

Double-Entry Accounting and Accounting Equation:
- Double-entry accounting is based on the fundamental accounting equation: Assets = Liabilities + Equity.
- Transactions are recorded in a way that each transaction impacts two accounts, maintaining balance.
Quick History of Modern Accounting:
- Luca Pacioli introduced the double-entry system in 1494, a system still in use today.
- Accounting is vital for understanding and analyzing the vast number of daily transactions.
GAAP Principles (Generally Accepted Accounting Principles):
- GAAP are standards used by organizations to prepare financial statements.
- Economic entity, monetary unit, time period, cost, full disclosure, going concern, matching, revenue recognition, materiality, and conservatism principles form the foundation of GAAP.
Double-Entry System Explained:
- The double-entry system records each transaction twice, debiting one account and crediting another.
- Debit and credit in accounting differ from their common meanings.
T-Accounts: The Foundation:
- T-Accounts help visualize the recording of transactions, with each account having debit and credit sides.
- Transactions need to be recorded on both sides to satisfy accounting requirements.
Journal Entry: The Double Faced Entry:
- Each transaction involves two concurrent movements: debiting and crediting.
- Selling $100 of biscuits, for instance, debits cash and credits income.
Accounts And Chart of Accounts (COA):
- Accounts are like letters of the accounting language, organized in a Chart of Accounts (COA).
- COA categorizes transactions under different headings for building financial reports.
Main Account Categories:
- Assets: Resources owned by an organization that produce future benefits.
- Liabilities: Obligations or debts contracted by an organization.
- Owner’s Equity: Amount of money/resources contributed to the organization.
- Revenue or Income: Sales amount in a specific period, recognized regardless of cash receipt.
- Expenses: Costs incurred in a certain period, recognized independently of cash disbursement.

Related Frameworks, Models, or Concepts	Description	When to Apply
Accrual Basis Accounting	Accrual Basis Accounting is an accounting method that records revenues and expenses when they are earned or incurred, regardless of when cash is exchanged. It provides a more accurate depiction of a company’s financial position and performance compared to cash basis accounting, which records transactions only when cash is received or paid.	Apply Accrual Basis Accounting to accurately match revenues with expenses over time, providing a clearer picture of a company’s financial performance, liquidity, and solvency. Use it when preparing financial statements, analyzing business performance, or making financial decisions to assess profitability, cash flow, and overall financial health.
Chart of Accounts	Chart of Accounts is a structured listing of all accounts used by a company to record financial transactions and classify them into categories, such as assets, liabilities, equity, revenue, and expenses. The chart of accounts provides a standardized framework for organizing and reporting financial information, ensuring consistency and comparability across accounting records.	Apply Chart of Accounts to establish a standardized framework for recording and categorizing financial transactions. Use it to organize accounts by type, nature, or function, facilitate financial reporting and analysis, and ensure compliance with accounting standards and regulatory requirements.
Trial Balance	Trial Balance is a financial statement that lists all the accounts and their respective balances, including debits and credits, at a specific point in time. The trial balance helps verify the accuracy of double-entry bookkeeping by ensuring that total debits equal total credits, indicating that the accounting equation is in balance.	Apply Trial Balance to verify the accuracy of accounting records and ensure that debits equal credits, confirming that the accounting equation (Assets = Liabilities + Equity) is balanced. Use it as a preliminary step before preparing financial statements, identifying errors or discrepancies in accounts, and making adjustments to correct accounting records.
General Ledger	General Ledger is a central repository that contains all the financial transactions recorded in a company’s accounting system, organized by account and date. The general ledger serves as the foundation for preparing financial statements and provides a detailed record of the company’s financial activities over time.	Apply General Ledger to maintain a comprehensive record of all financial transactions and account balances in a centralized database. Use it to track transactions, post journal entries, reconcile accounts, and generate financial reports, providing management, investors, and stakeholders with timely and accurate financial information for decision-making and analysis.
Income Statement (Profit and Loss Statement)	Income Statement (Profit and Loss Statement) is a financial statement that summarizes a company’s revenues, expenses, and net income or loss over a specific period, such as a fiscal quarter or year. The income statement provides insights into a company’s profitability and operating performance by comparing revenues to expenses.	Apply Income Statement to assess a company’s revenue generation, expense management, and overall profitability over a specific period. Use it to analyze revenue trends, identify cost drivers, and evaluate the efficiency and effectiveness of business operations, guiding strategic decision-making and performance evaluation.
Balance Sheet	Balance Sheet is a financial statement that presents a company’s financial position at a specific point in time, showing its assets, liabilities, and shareholders’ equity. The balance sheet provides insights into a company’s liquidity, solvency, and capital structure by comparing its assets to its liabilities and equity.	Apply Balance Sheet to assess a company’s financial health, liquidity, and solvency by analyzing its asset composition, debt levels, and equity position. Use it to evaluate the company’s ability to meet short-term obligations, manage long-term liabilities, and generate shareholder value, guiding investment decisions and risk management strategies.
Cash Flow Statement	Cash Flow Statement is a financial statement that tracks the inflows and outflows of cash and cash equivalents from operating, investing, and financing activities over a specific period. The cash flow statement helps assess a company’s liquidity, cash flow generation, and ability to meet its financial obligations.	Apply Cash Flow Statement to analyze a company’s cash flow dynamics, liquidity position, and ability to generate and manage cash resources effectively. Use it to identify cash flow trends, assess cash flow risks, and evaluate the company’s ability to fund operations, investments, and debt repayments, supporting cash management and financial planning decisions.
Financial Ratios Analysis	Financial Ratios Analysis involves calculating and interpreting key financial ratios to assess a company’s financial performance, profitability, liquidity, solvency, and efficiency. Financial ratios provide insights into a company’s strengths, weaknesses, and overall financial health by comparing different aspects of its financial statements.	Apply Financial Ratios Analysis to evaluate a company’s financial performance and position by calculating and interpreting key ratios, such as liquidity ratios, profitability ratios, leverage ratios, and efficiency ratios. Use it to benchmark performance against industry peers, identify areas for improvement, and make informed decisions about resource allocation, capital investment, and financial strategies.
Accruals and Deferrals	Accruals and Deferrals are adjustments made to financial statements to recognize revenues and expenses in the period in which they are earned or incurred, rather than when cash is exchanged. Accruals record revenues or expenses before cash is received or paid, while deferrals defer revenues or expenses until cash is received or paid.	Apply Accruals and Deferrals to ensure that financial statements accurately reflect the economic substance of transactions and adhere to accrual basis accounting principles. Use them to recognize revenues and expenses in the appropriate accounting period, match expenses with related revenues, and comply with accounting standards and regulatory requirements for financial reporting.
Financial Statement Audit	Financial Statement Audit is an independent examination of a company’s financial statements, records, and internal controls by an external auditor to provide assurance on the accuracy, completeness, and fairness of financial reporting. Financial statement audits help stakeholders evaluate the reliability and credibility of financial information and ensure compliance with accounting standards and regulatory requirements.	Apply Financial Statement Audit to assess the reliability and credibility of a company’s financial statements, records, and internal controls. Use it to provide assurance to investors, creditors, and other stakeholders on the accuracy, completeness, and fairness of financial reporting and to identify areas for improvement in internal controls and financial management practices.