Chapter 3: Double-Entry Bookkeeping

Chapter 3: Double-Entry Bookkeeping Double-entry bookkeeping underpins accounting A way of systematically recording the financial transactions of acompany so that each transaction is recorded twice. Basic accounting equation:Assets Liabilities Equity Profit (Income-Expenses)Assets Expenses Liabilities Equity Income1

Basic Rules1. For every transaction there will be a debit and credit entry.2. These debits and credits will be equal and opposite.3. E.g. in bank account all records are paid in on debit side and paidout on credit side. The choice of the right account sideis the core of the art of bookkeepingdebiting an account Æ make an entry on the left-hand side of anaccountcrediting an account Æ make an entry on the right-hand side of anaccount2

Derived rulesRecall the basic accounting equationAssets Expenses Liabilities Equity IncomeÖ if a debit increases assets, then a credit counter item has toincrease liabilities or owner‘s equityÖ i.e. increases and decreases in assets and liabilities (orowner‘s equity) must be recorded opposite to each other! Increases in assets are debited. Decreases in assets are credited.Increases in liabilities are credited. Decreases in liabilities LiabilitiesDebitforDecreaseCreditforIncrease3

Owner‘s Equity Recall that owner‘s investments and revenues increase owner‘sequity, while owner‘s withdrawals and expenses decrease owner‘sequity.Frequently separate accounts are kept for these items.(a) Owner‘s Capital. This account is affected by, for example,owner‘s investment.Increases in owner‘s capital are credited. Decreases in owner‘scapital are debited.Owner's CapitalDebitforDecreaseCreditforIncrease4

Owner‘s Withdrawals(b) Owner‘s Withdrawals The owner may, for example, withdraw cash for personal use. Itcould be debited directly to Owner‘s Capital but a separate accountis kept to determine total withdrawals. Increases in owner‘s withdrawals are debited. Decreases in owner‘swithdrawals are credited.Owner's WithdrawalDebitforIncreaseCreditforDecrease5

Revenues and Expenses Revenues increase owner‘s equity, just as an increase in owner‘scapital does. Thus, debiting and crediting of a revenue account isthe same as debiting and crediting of owner‘s capital account.Expenses, however, have the opposite effect.RevenuesDebitforDecrease DecreaseIncreases in revenues are credited. Decreases in revenues aredebited.Increases in expenses are debited. Decreases in expenses arecredited.6

Balancing off the accountsWhen all entries completed, we need to balanceoff the accounts All Income Statement items will be closed off All Balance Sheet items brought forward Balancing off enables us to:1.Prepare a trial balance2.Close down income and expense accounts3.Bring forward assets, liabilities and equity7

Balancing off the cash account1. Sum the entries on the larger side below the line2. repeat the sum below the line on the other side3. strike the balance: insert the amount missing such that the sums ofentries on both sides are equal (i.e. solving the account equation)4. enter the counter item to the appropriate account e.g. Trial BalanceCashTrial BalanceBeginning balance 100 Outflows 400Inflows400 3. Balance 6002003001. 10004. Beginning balance 6002. 10008

Debit and Credit Balancetotal of debit amounts total of credit amountsdebit balancetotal of debit amounts total of credit amountscredit balance note that a debit balance occurs on the credit side on accountclosing and vice versa. normal balance side (debit or credit) that increases the stock orflow represented in the account9

Booking of the counter item (in theory) appropriate account need not be the trial balance– could be a hierarchically superior closing account, e.g. “cash and cashequivalents”– this could be closed to the balance sheet– in order to reopen accounts for the next period the line item cash andcash equivalents in the balance sheet could be counterbooked to anaccount which is closed by booking out the individual items to therespective accounts, e.g. the cash account for the next period This is not the practical procedure, this theoretically possibleprocedure shall only make clear the mechanics of double entrybookkeeping10

ExampleA small company named ZiscoSys. The transactions are stated inchronological order:(1) 8.000 Owner‘s Investment to start up the business(2) Purchase of equipment for 4.000 paid in cash(3) Purchase of supplies on credit for 500(4) 400 payment of a liability (accounts payable resulting fromdelivery of supplies)(5) 5.000 revenues earned on credit(6) 3.000 collection of accounts receivable(7) Incurring expenses of 500 for rent (cash) and 200 (on credit) forutility and prepaid insurance of 1.200(8) reception of a down payment of 2.400 for services to beperformed (unearned revenue or deferred revenue), and(9) Owner‘s withdrawal of 800.11

Transaction 1 – initial investmentCashOwner's Equity8.0008.000Increase in cash is debited; increase in owner‘s equity is credited.Transaction 2 – purchase of equipmentCashEquipment4.0004.000Decrease in cash is credited; increase in equipment is credited.12

Transaction 5 – services rendered on creditAccounts ReceivableRevenues5.0005.000Increase in accounts receivable is debited; incr. in revenues is credited.Transaction 7 – insurance policy boughtPrepaid Insurance1.200Cash1.200Increase in prepaid insurance is debited; decrease in cash is credited.13

Asset AccountsCash8.0003.0002.400Accounts quipmentSupplies4.0005001.2004.0005001.200 Owner's Equity AccountsOwner's InvestmentLiability AccountsAccounts Payable400Unearned Revenue5002002.4003002.400Prepaid Insurance Owner's 2005.00070014

Commonly Used Accounts Different enterprises may use different accounts the number andtype (and name) depends on the nature of business and the size ofthe enterpriseCaretaker service9 sole proprietorship9 one account for wageexpenses. rather low number of accounts9 (probably) no account forplant and propertyAutomobile manufacturer9 corporate giant. numerous accounts9 separate accounts for wage expensesof, say, production and clerical workers9 certainly (at least) one account forplant and property15

Some important accounts commonto most enterprisesChart of Accounts for a Small BusinessAssetsCashNotes ReceivableAccounts ReceivableFees ReceivableOffice SuppliesPrepaid RentPrepaid 114115116117141142148Notes PayableAccounts PayableWages PayableUnearned RevenuesRevenues211212213231Owner's EquityCapitalWithdrawalIncome Summary311312313SalesCommissions Earned411412ExpensesWages ExpenseUtility ExpenseTelephone ExpenseInsurance ExpenseDepreciation Expense,EquipmentDepreciation Expense,Building511512513514521522 For tractability reasons, accounts are numbered!16

The Recording ProcessStep 1: Journalizing The journal is a complete and chronological list of all transactionsthat occurred.journal is the book of original entry! common to have more than one kind of journal special purposejournals, e.g. cash receipts journal or sales journal general journal: all transactions are recorded in this journal a complete entry provides the following information–––––date of recordingdate of transactionaccounts and amounts to be debited and creditedshort explanation of the transactionnumber of account (if posted)17

ZiscoSys‘ general journalGeneral JournalDateDescription2013Sept.138Page 1CreditPost. Ref. DebitCashOwner s InvestmentPersonal funds transferred tothe account of ZiscoSys8.000EquipmentCashEquipment bought with cashpayment4.000SuppliesCashAccounts PayablePurchase of supplies partiallywith cash and on credit500Simple entry one debit and credit entry8.000Simple entry4.000Compound entry400100Compound entry more than one debit and/or credit entry18

Journal: the basic accounting document The journal contains the complete information on transactions thatenter the accounting system– it is the basic documentation and serves as instrument of evidence inlitigation– it is not allowed to cancel journal entries mistaken entries have to be reversed by a contra-entry In electronic accounting systems the journal is the only data base ontransactions– the system has to assure that once an entry is made, it can no longer beinfluenced or altered by anyone– ledger accounts are „views“ of the data base that are generated online,they are not records in their own right (Principle of data integrity: anyinformation is only stored once) the system of ledger accounts can thus be altered at any timeaccording to new needs for analysis– A sufficient number of safety copies (mirror images) of the journal haveto be kept up-to-date.19

Step 2: Posting all accounts taken together in one file the ledgerprocess of transferring journal entries to the ledger accounts postingas with journals, there may be more than one kind of ledgergeneral ledger contains all accountsgeneral ledgerasset accountscashliability accountsnotes payableaccounts receivableprepaid expensesequipmentaccounts payableunearned revenuesbondsowner‘s equity accountsowner‘s capitalowner‘s withdrawalexpensesrevenues20

Posting – ZiscoSys MagdeburgGeneral JournalDate2013 Sept.Page 2DescriptionEquipment3Post. Ref. Debit148CashEquipment bought withcash payment111Item23Post. Ref. DebitCreditJ11.000J24.000General LedgerCashDate2013 Sept.Item134.000datepage in journalGeneral LedgerEquipmentDate2013 Sept.Credit4.000Post. Ref. DebitCreditJ18.000J2Account No. 148BalanceDebitCredit1.0005.000account numbersAccount No. 111BalanceDebitCredit8.00040004.00021

The Trial Balance . is a list of accounts and their balances at any equal point in time usually prepared periodically (end of accounting period) used to double-check equality of debits and credits limitations: omission errors cannot be detected!possibly offsetting errors! Input to preparation of financial statements (we‘ll see that later)22

Trial Balance – ZiscoSys MagdeburgTrial BalanceZiscoSys MagdeburgTrial BalanceSeptember 30, 2013CashAccounts ReceivableEquipmentSuppliesPrepaid InsuranceAccounts PayableUnearned RevenueOwner s InvestmentOwner s 002.4008.0008005.00070015.70015.70023

Chapter 3: Double-Entry Bookkeeping Double-entry bookkeeping underpins accounting A way of systematically recording the financial transactions of a . Cash Accounts Receivable Equipment Supplies Prepaid Insurance 8.000 4.000 5.000 3.000 4.000 500 1.200 3.00