Double entry, a fundamental concept underlying present-day bookkeeping and accounting, states that every financial transaction has equal and opposite effects in at least two different accounts.
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Unfolding the Double Entry Bookkeeping System
The basic accounting concepts and principles that apply to double-entry bookkeeping are standard across all companies and firms. The process requires each financial transaction of a company to be recorded with an entry in at least two of its general ledger accounts. This satisfies the following equation:
Assets = Liabilities + Equity
To unwrap the concept further, it is important to understand some basic concepts that apply to double-entry bookkeeping:
Debits & Credits
In a double-entry system, transactions are either recorded as debits or credits. This is one of the golden rules of accounting. The important accounting principle that applies here is that all debits must equal all credits.
A debit is an accounting entry that results in a decrease in liabilities, or an increase in assets, while a credit entry in an asset account will reduce the account's usual debit entry.
In a financial statement, a debit is shown on the left-hand side of an account ledger, and credit is listed on the right-hand side. It is important to note here that the two sides of debit and credit must balance each other.
In financial accounting, every financial transaction or economic event is required by law, to be registered formally in its account books. There are several types of accounts maintained by bookkeepers to record the different natures of transactions:
- Assets or any resources that the company owns and provides future financial security.
- Liabilities or the company's obligations to another party that is yet not paid for.
- Equities or the values of assets minus the liabilities.
- Revenue or the sum of all income flowing into the company.
- Expenses or costs incurred to run operations.
- Gains or the net income of the company minus the losses.
- Losses or negative gain.
The double-entry bookkeeping system is designed to keep order in the middle of all the chaos that might accompany the maintenance of so many different accounts. It essentially makes the job of an accountant easier.
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General Accounting Principles
Generally Accepted Accounting Principles (GAAP) refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board.
The double-entry bookkeeping system, like any other accounting process, follows the mandates of GAAP in India. The basic accounting principles that apply to this system are described below:
Full Disclosure Principle
This principle states that all information which could affect the reader's understanding of the financial documents should be included in the finance report. Needless to say, this principle is one that most auditors and financial accountants detest due to the huge amount of paperwork involved in compiling the reports.
Full disclosure might be needed in some of these cases:
- Change from a specific accounting principle to another.
- Non-monetary transactions in a firm.
Monetary Unit Principle
The monetary unit principle is based on the assumption that money itself is considered as a unit of measurement. This means that all company-related transactions can be expressed in monetary terms, in the language of a currency, for example. This excludes non-quantifiable items that cannot be measured in a currency like a customer service quality, employee skills, or management expertise.
Revenue Recognition Principle
According to this principle, revenues are recognized for a company only when they are realized, and not when they are received. For example, client services delivered by a company may generate revenue in the future. But until the actual payment for services is done, the revenue is not recognized.
The principle also states that for revenue to be recognized, it must be earned in a particular time period, like in a given fiscal year. Revenue generated in the next fiscal year will not be accounted for in the current assessment year. Additionally, revenue and cost also need to be reported in the same accounting period.
Time Period Principle
According to this principle, a business should record or report their financial statements appropriate to a specific time period. This time period is nothing but the accounting year. The balance sheet or financial reports can be prepared and furnished monthly, quarterly, half-yearly, yearly or at an agreed-upon time period.
The time period principle has certain traits of both cash accounting and accrual accounting.
Income statements, liability accounts, asset value, balance sheets, cash flow statements, a summary of sales, and reports of changes in equity are all examples of financial reports in a certain time period. As such, they follow the time period principle.
Expense Recognition Principle
This principle states that expenses should be recognized in the same period as the revenues to which they relate. Without this principle in place, there would be a convolution in the financial journal of business. This can have serious legal implications also for a company. It also affects income taxes in a significant way.
Accrual accounting rides on the expense recognition principle. The notion that revenues are recognized when earned and expenses when spent, is derived from this principle and the revenue recognition principle.
The Process of Double Entry Bookkeeping
An accountant has to follow certain steps in order to complete the system of double-entry bookkeeping:
- Journal entry: The first step is to record the transaction. This is done in bookkeeping journals every time a transaction takes place.
- Ledger entry: This step requires the classification of the transactions. While the journal records all sorts of transactions, the ledger is a more streamlined record of categories of transactions. This smoothens the process of reading financial data later.
- Trial balance: The ledger step helps in arriving at the closing balance. This is then transferred to the trial balance for summarization.
- Final accounts: This is the final step in the double-entry bookkeeping system. This is essentially the reporting of accounts that capture a holistic view of the financial well-being of the company. Note that this last step is also critical to management decision-making.
Advantages of Double Entry Bookkeeping
The double-entry bookkeeping system offers multiple benefits to accountants and organizations, at large. Here are the top advantages of using this system:
- The double entry of credit and debit makes it easier to track the overall nature of the transaction.
- The preparation of financial statements including cash statements and profit and loss statements is easily facilitated by this process.
- The system makes easy detection of errors and inaccuracies in balance sheets possible.
- The double-entry bookkeeping system is a major driver in the overall management decisions of a company.
- The process helps in generating financial insights as well that help in making strategies.
- With the use of simple, and sometimes free software, this process eases businesses globally.
- The system is perfectly compatible with accounting software.
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Disadvantages of Double Entry Bookkeeping
Despite the upper hand, it provides to businesses and financial analysts, the double-entry bookkeeping process also has its shortcomings. These can sometimes make businesses to slow down and create impediments in their way:
- The process is complicated. It requires entry into a book in two phases, namely journal and ledger, and in two sides (debit and credit). This lengthens the process of accounting and definitely increases the size and number of accounts to be maintained.
- It is heavy on resources and time. This poses a serious challenge to any business, especially those that operate on a small scale.
- The level of expertise needed for the process makes it difficult for businesses to find and hire good resources. Moreover, the lengthy process of multiple book entries and super high amounts of paperwork are major repulsions for any good accountant.
- The convoluted system increases the chances of errors and mistakes.
Double-entry bookkeeping is still a sought after system of accounting, based on basic accounting principles, that accountants choose the world over. It is extremely useful in keeping a record of business transactions in a systematic and timely manner. This process of organization that occurs at the back end, thanks to the efforts of expert accountants, results in the smooth running of a firm and more often than not, in securing a solid future for the company in the long-run.
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