Double Entry Accounting

Double-entry accounting is a method of accounting in which each transaction is recorded such that the sum of assets is equal to the sum of the company’s liabilities and its shareholders’ equity. In double entry accounting, each journal entry affects at least two accounts.

In double-entry accounting, an increase in asset account(s) is compensated by decrease in other asset account(s) or by increase in liability account(s) or equity account(s) or both, and vice versa.

Explanation

A business is made up of buildings, equipment, copyrights, investments, bank and cash balances, etc. These resources are called assets in accounting terminology. All the assets of an entity are acquired with money invested by owners (called shareholders’ equity in accounting) or money provided by creditors (called liabilities). This relationship of all assets coming from either equity or liabilities is represented by accounting equation, which states that assets = liabilities + equity. This relationship is maintained at all times.

Double-entry accounting encompasses a complete accounting cycle which includes making journal entries for transactions, posting them to accounts in general ledger, preparing a trial balance, making adjusting entries and preparing an adjusted trial balance which forms the basis of a complete set of financial statements.

Example

Chris Miller is a CFA charter-holder who has been running a successful wealth management business for 20 years. In 20X3, he launched a business that was aimed at using information technology to automate and simplify the wealth management business. Following are some of the transactions that took place in the early days of the business.

1. On 1 October 20X3, he set aside $100,000 for this business, which he named AutoWM. This will be reflected in double-entry accounting as follows:

   Cash	$100,000
   Capital, Chris Miller		$100,000

   On 1 October 20X3, accounting equation: $100,000 cash = $100,000 equity.
2. On 15 October 20X3, he hired Excel Analytics (EA) to conduct a market research for $10,000. No journal entry is required because it is just the start of a contract and no exchange of goods or services has occurred yet.
3. On 30 October 20X3, EA completed its research and sent-in its report. Chris paid them right away, which is reflected as follows:

   Market Research Expense	$10,000
   Cash		$10,000

   This transaction affects the accounting equation by decreasing cash by $10,000 and decreasing equity by $10,000. The decrease in equity is explained below:
   Expanded accounting equation:
   assets = liabilities + (shareholders’ equity + revenue – expenses)
   Since market research is an expense, it results in decrease in shareholders’ equity.
   Accounting equation on 30 October 20X3: cash ($90,000) = shareholders’ equity ($90,000)
4. The market research report was promising. It prompted Chris to put in $200,000 more money and purchase equipment worth $150,000 on 1 November 20X3.

   Cash	$200,000
   Capital, Chris Miller		$200,000

   The purchase of equipment is reflected as follows:

   Equipment	$150,000
   Accounts payable		$150,000

   This transaction changes accounting equation: (a) it increases cash and shareholders’ equity by $200,000, (b) it introduces new asset (equipment) worth $150,000, which gives rise to a liability (accounts payable) worth $150,000
   Accounting equation: cash ($290,000) + equipment ($150,000) = accounts payable ($150,000) + shareholders’ equity ($290,000)
5. The equipment vendor is paid on 15 November 20X3

   Accounts payable	$150,000
   Cash		$150,000

   This removes the accounts payable and decreases cash by $150,000. New cash balance is $140,000
   Accounting equation: cash ($140,000) + equipment ($150,000) = shareholders’ equity ($290,000)
6. A software engineer is hired on 1 December 20X3 for $15,000 a month and a $50,000 signing bonus; and a co-working space is arranged for $5,000 a month paid in advance. The following journal entry is made on 1 December.

   Salaries expense	$50,000
   Prepaid rent	$5,000
   Cash		$55,000

   Accounting equation as at 1 February 2014: cash ($85,000) + prepaid rent ($5,000) + equipment ($150,000) = shareholders’ equity ($240,000)
7. At the end of December, adjusting entries are made to recognize the rent expense, pay salary to the software engineer and recognize monthly depreciation on the equipment (useful life is 30 months)

   Rent expense	$5,000
   Prepaid rent		$5,000

   This will remove the prepaid rent asset and decrease shareholders’ equity (both by $5,000).

   Salaries expense	$15,000
   Cash		$15,000

   This will decrease cash and shareholders’ equity (both by $15,000).

   Depreciation expense ($150,000/30)	$5,000
   Accumulated depreciation		$5,000

   At the end of first quarter, account balances are as follows:
   • Cash balance = $85,000 - $15,000 = $70,000
   • Prepaid rent balance = 0
   • Equipment balance = $150,000 – accumulated depreciation ($5,000) = $145,000
   • Liabilities balance = 0
   • Shareholders’ equity balance
     = opening ($240,000) – rent ($5,000) – salaries ($15,000) – depreciation ($5,000)
     = $215,000

Accounting equation at the end of the quarter:
cash ($70,000) + equipment ($145,000) = shareholders’ equity ($215,000).

The expanded accounting equation becomes the balance sheet (or the statement of financial position) when a complete set of financial statements is prepared.

by Obaidullah Jan, ACA, CFA and last modified on May 15, 2020