Meaning, Principles and Rules of Double Entry Accounting for SS 1

Double Entry System of Accounting

Performance Objectives

By the end of the lesson, students should be able to:

1. explain double entry in accounting;
2. state the purpose of double entry in accounting;
3. state the principles of double entry in accounting;
4. differentiate between debit and credit entry;
5. record transactions using double entry principles.

Meaning of Double Entry

Double entry is an accounting system where every financial transaction is recorded in at least two accounts, with one account being debited and another credited for an equal amount.

This system ensures that for every value received, an equal value is given. It is the foundation of modern accounting and helps to maintain the accounting equation: Assets = Liabilities + Capital.

Purpose of Double Entry

The double entry system serves several important purposes in accounting:

1. Ensuring Accuracy: By requiring every transaction to have equal debits and credits, the system helps to detect errors. If the total debits do not equal the total credits, it indicates an error in recording.
2. Providing a Complete Record: It provides a comprehensive record of all financial transactions, showing both the source and the destination of every value exchanged.
3. Facilitating Financial Statement Preparation: The balanced nature of the double entry system makes it possible to prepare accurate financial statements such as the Trial Balance, Income Statement, and Statement of Financial Position.
4. Showing the Dual Effect of Transactions: Every transaction affects at least two aspects of the business, and double entry clearly shows these dual effects, providing a clearer picture of the business’s financial position.
5. Calculating Profit or Loss: By recording all income and expenses, the system allows for the accurate calculation of a business’s profit or loss over a period.

Principle of Double Entry

The fundamental principle of double entry accounting is that for every debit entry, there must be a corresponding credit entry of an equal amount.

This principle is often summarised as “for every debit, there is a corresponding credit.” It means that every financial transaction has two sides or effects, and both sides must be recorded. For example, if a business receives cash (an increase in an asset), it must also record where that cash came from (e.g., sales, a loan, or capital contribution). The total value of all debits in the accounting records must always equal the total value of all credits.

Understanding Debit and Credit Entries

In accounting, ‘debit’ and ‘credit’ are simply terms used to describe the two sides of an account. Every account has a left side and a right side. The left side is always the debit side, and the right side is always the credit side.

Accounts are often represented using a ‘T’ shape, known as a T-account, to visually separate the debit and credit sides.

The terms debit and credit do not inherently mean ‘increase’ or ‘decrease’. Their effect (increase or decrease) depends on the type of account being affected.

Rules of Debit and Credit Entries

To correctly record transactions, it is essential to know how debits and credits affect different types of accounts. Accounts are generally classified into five main types:

1. Assets: Resources owned by the business that have future economic value (e.g., Cash, Bank, Furniture, Motor Vehicles, Debtors, Inventory).
2. Expenses: Costs incurred by the business in the process of generating revenue (e.g., Rent, Salaries, Electricity, Purchases).
3. Liabilities: Obligations or amounts owed by the business to external parties (e.g., Creditors, Loans, Bank Overdraft).
4. Income (Revenue): Money earned by the business from its operations (e.g., Sales, Commission Received, Rent Received).
5. Capital (Owner’s Equity): The owner’s investment in the business, representing the owner’s claim on the assets of the business.

The rules for debiting and crediting these accounts are:

Let us look at these rules in more detail:

1. Assets:
   1. To increase an Asset account, you Debit it.
   2. To decrease an Asset account, you Credit it.

   Example: When cash is received, the Cash account (an asset) is debited. When cash is paid out, the Cash account is credited.

2. Expenses:
   1. To increase an Expense account, you Debit it.
   2. To decrease an Expense account, you Credit it.

   Example: When rent is paid, the Rent Expense account is debited. Expenses are usually only increased.

3. Liabilities:
   1. To increase a Liability account, you Credit it.
   2. To decrease a Liability account, you Debit it.

   Example: When a business takes a loan, the Loan account (a liability) is credited. When the loan is repaid, the Loan account is debited.

4. Income (Revenue):
   1. To increase an Income account, you Credit it.
   2. To decrease an Income account, you Debit it.

   Example: When goods are sold, the Sales account (an income) is credited. Income accounts are usually only increased.

5. Capital (Owner’s Equity):
   1. To increase the Capital account, you Credit it.
   2. To decrease the Capital account, you Debit it.

   Example: When the owner invests more money into the business, the Capital account is credited. When the owner withdraws money for personal use (drawings), the Capital account is debited.

Recording Transactions Using Double Entry Principles

Recording transactions using double entry involves identifying the two accounts affected by a transaction and then applying the debit and credit rules. Each transaction will have at least one debit and at least one credit, and the total debit amount must always equal the total credit amount.

The procedure for recording transactions involves the following steps:

1. Identify the Transaction: Understand what financial event has occurred.
2. Identify the Accounts Affected: Determine which two (or more) accounts are involved in the transaction.
3. Classify the Accounts: For each affected account, determine if it is an Asset, Expense, Liability, Income, or Capital account.
4. Determine the Effect: Decide if each account is increasing or decreasing as a result of the transaction.
5. Apply Debit/Credit Rules: Based on the account type and whether it is increasing or decreasing, apply the appropriate debit or credit rule.
6. Record the Entry: Write down the debit and credit entries, ensuring the amounts are equal.

Worked Examples of Recording Transactions

Let us apply these steps to some common business transactions:

Example 1: Owner starts business with N500,000 cash.

1. Transaction: Owner invests cash into the business.
2. Accounts Affected:
   1. Cash Account
   2. Capital Account
3. Classify Accounts:
   1. Cash is an Asset.
   2. Capital is a Capital account.
4. Determine Effect:
   1. Cash (Asset) is increasing.
   2. Capital (Capital) is increasing.
5. Apply Debit/Credit Rules:
   1. To increase an Asset, Debit Cash Account.
   2. To increase Capital, Credit Capital Account.
6. Record Entry:

   Debit: Cash Account N500,000

   Credit: Capital Account N500,000

Example 2: Paid N50,000 cash for rent.

1. Transaction: Business pays rent using cash.
2. Accounts Affected:
   1. Rent Expense Account
   2. Cash Account
3. Classify Accounts:
   1. Rent is an Expense.
   2. Cash is an Asset.
4. Determine Effect:
   1. Rent Expense (Expense) is increasing.
   2. Cash (Asset) is decreasing.
5. Apply Debit/Credit Rules:
   1. To increase an Expense, Debit Rent Expense Account.
   2. To decrease an Asset, Credit Cash Account.
6. Record Entry:

   Debit: Rent Expense Account N50,000

   Credit: Cash Account N50,000

Example 3: Bought goods on credit from Bola Stores for N120,000.

1. Transaction: Business purchases goods on credit.
2. Accounts Affected:
   1. Purchases Account
   2. Bola Stores Account (Creditor)
3. Classify Accounts:
   1. Purchases is an Expense.
   2. Bola Stores (Creditor) is a Liability.
4. Determine Effect:
   1. Purchases (Expense) is increasing.
   2. Bola Stores (Liability) is increasing (the business owes more).
5. Apply Debit/Credit Rules:
   1. To increase an Expense, Debit Purchases Account.
   2. To increase a Liability, Credit Bola Stores Account.
6. Record Entry:

   Debit: Purchases Account N120,000

   Credit: Bola Stores Account N120,000

Example 4: Sold goods for N80,000 cash.

1. Transaction: Business sells goods and receives cash.
2. Accounts Affected:
   1. Cash Account
   2. Sales Account
3. Classify Accounts:
   1. Cash is an Asset.
   2. Sales is an Income.
4. Determine Effect:
   1. Cash (Asset) is increasing.
   2. Sales (Income) is increasing.
5. Apply Debit/Credit Rules:
   1. To increase an Asset, Debit Cash Account.
   2. To increase an Income, Credit Sales Account.
6. Record Entry:

   Debit: Cash Account N80,000

   Credit: Sales Account N80,000

By consistently applying these rules, businesses can maintain accurate and balanced accounting records, which are essential for understanding their financial performance and position.