Double entry accounting system
The recording of financial transactions by a company is called bookkeeping. Modern bookkeeping is based on the principle of double entry accounting.
All financial transactions made by a company during an accounting period are first recorded in a Journal in the form of Journal entries according to double entry accounting system. Double entry bookkeeping system takes into account the fact that every transaction affects at least two accounts. (You can refer to the last post where we discussed the financial statement elements and accounts.) For example, when property is purchased for cash, cash account is reduced (debited) and property account is increased (credited).
From the Journal the transactions are then carried to the General Ledger where they are sorted into different accounts. Each account has a debit side and a credit side to record the changes in the account. For example, when cash is spent, it is reflected as a debit to the cash account and when cash is received it is reflected as a credit to the cash account.
After netting the debits and credits each account will have either a net debit balance or a net credit balance. These balances are carried to the Trial Balance. Trial balance records only the net balances in each account. Any adjusting entries that are required to be made are made and we arrive at the Adjusted Trial Balance. This adjusted trial balance forms the basis for the preparation of the financial statements, i.e. income statement and the balance sheet. (For description of what is income statement and balance sheet refer to the post on Financial Statement Analysis) Therefore the income statement and the balance sheet are the culmination or summation of all transactions during the year and all transactions finally culminate into either an increase or decrease in an asset or a liability or owner’s equity.
Double entry accounting system basically satisfies the equation;
Assets = Liabilities + Owner’s equity
For this equation to remain in balance, an increase is an asset should be offset either by a decrease in another asset or by an increase in liabilities or owner’s equity. Let’s go back to our earlier example, of property purchased for cash. In this example, decrease in the cash account which is an asset account is offset by an increase in another asset account – property. Now let’s suppose the property is purchased with money raised by issuing debt securities. Here, increase in property, which is an asset account, is balanced by an increase in debt which is a liability.
Cash is sometimes received before a service is rendered or cash is sometimes paid before receiving a service. Therefore revenues and expenses get recorded without cash receipts and payments. This is called accrual accounting. Accrual accounting requires that revenues are recorded when they are actually earned, irrespective of whether cash was received or not and expenses are recorded when they are incurred, irrespective of whether cash has been paid or not. Accrual accounting covers four types of revenues and expenses;
Unearned revenue is the revenue earned before the service is rendered or good is delivered. Therefore it is considered a liability until the service is actually rendered or good is actually delivered. The accounts affected are cash account (asset) and unearned revenue account (liability). Both accounts increase. When the service is rendered unearned revenue account (liability) will decrease and revenue account will increase. Increase in revenue will finally increase the retained earnings which is a component of Owner’s equity. Therefore the final effect is a decrease in unearned revenue (liability) and an increase in Owner’s equity and the accounting equation assets = liabilities + owner’s equity is in balance in keeping with double entry accounting.
Accrued revenue is revenue due to us for service already rendered or good already delivered i.e. goods sold on credit. In this instance, the two accounts affected are revenue account and Accounts Receivable (asset). The revenue account increases as accrual accounting requires that revenue is recorded when it is earned, irrespective of whether cash is received or not. The increase in revenue increases the Owner’s equity as already discussed earlier. The other account that increases is the Accounts Receivable which is recorded as an asset as it would flow in during future accounting periods and reduce the net expenses of that period. Therefore the accounting equation is in balance as the final effect is an increase in the Owner’s equity and account receivables (asset).
As and when the cash is actually received, accounts receivable (asset) decreases and cash account (asset) increases. So the accounting equation is again in balance in keeping with double entry bookkeeping.
Prepaid expense is cash paid before the actual expense is incurred. Prepaid expense is considered an asset as it will reduce the expenses in the future accounting period/s when it is actually incurred. The accounts affected in this instance are the prepaid expense account (asset) which increases and cash account (asset) which decreases.
When the expense is actually incurred, the prepaid expense account (asset) decreases and expense account increases. An increase in the expense account reduces the retained earnings which in turn reduces the owner’s equity. Therefore the final effect is reduction in prepaid expense account (asset) and reduction in Owner’s equity and the accounts are in balance in keeping with double entry bookkeeping.
Accrued expenses are when the company owes cash for expenses incurred. In this instance, the expense account increases and accrued expense account (liability) increases. Increase in expense account decreases the Owner’s equity. So the final result is decrease in owner’s equity and increase in accrued expense (liability).
As and when cash is paid toward the expenses incurred, accrued expense (liability) decreases and cash account (asset) decreases.
You can read the following posts for more understanding of revenue and expense recognition.
Thus the double entry accounting system ensures that the books are always balanced. That brings us to the end of this post. Hope you liked it and won’t forget to share it. I have embedded below a summary ppt of the post for your reference…..follow the link below the attachment to download it…
In the next post we move to understanding the intricacies of the income statement ….looking forward to seeing u again then 🙂
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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