The first and the most important accounting lesson relates to the double entry system. It is vital to build the foundations and understand how the double entry systems works, what are the rules that you will need to follow to accurately record business transactions and to be able to build on that so you have develop the skills to exercise judgement when required. The double entry accounting system is nothing else from a set of rules which are summarized below.
You might be wondering why the accounting system that we use is called “double entry system”. The answer is that when an accountant wants to record a transaction there are two entries that are posted. The first entry is a “debit” and the second entry is an equal (and opposite) credit. Therefore, for every debit, there should be an equal credit which will cause one of the fundamental financial statements, the balance sheet to balance. What we mean by saying “balance”? The short answer is that the assets should equal the liabilities plus the equity. If you would like to read the long answer too and learn about the accounting equation, you can read this post.
Double Entry Cheat Sheet
Two of the most important financial statements are the statement of the financial position (or the balance sheet) and the income statement. The balance sheet is divided into three sections:
The income statement also has two different “sections” or to be more precise two different categories of line items which are:
- Revenue or Income
Therefore, the debits and the credits that you will need to post depend on whether you are posting journals that relate to the income statement or the balance sheet as well as the section of these two statements. In other words, debiting the assets will increase the assets while debiting the income will decrease the income. A brief double entry cheat sheet is as follows:
The table above basically says that if you want to increase the assets or the expenses, you will need to post a debit. On the other hand, if you want to increase the liabilities, the equity or the revenue, you will credit them or post a credit entry. For decreases, it is exactly the opposite thing.
Journal Entries Examples
I think it will be easier to understand the double entry system if we give some examples of journal entries for each category or financial statements line item.
Journal Entries for Assets
As mentioned above, debiting the assets will increase the assets while posting a credit will decrease the assets. For example, if a company buys a computer (on credit) for $100, the journal entry will be:
Debit Computer (assets) $100
Credit Accounts Payable $100
If the computer was paid in cash, the journal entries would be :
Debit Computer $100
Credit Bank $100
The first example shows that increasing the assets require a debit while increasing the liabilities requires a credit. On the other hand, thee second example shows that when the computer was paid in cash, our cash balance (also an asset) was decreased and a credit was therefore required.
Journal Entries for Liabilities
We mentioned above that increasing the liabilities requires a credit while decreasing the liabilities (paying part of the liabilities back) requires a debit. Let’s assume for example that a company takes a loan of $1,000. The entries would be as follows:
Debit Bank $1,000
Credit Liabilities $1,000
Journal Entries for Capital
Similarly to the liabilities, when capital is contributed to a company, a credit is required. The drawings however require a debit in the equity section. For example, when a company is created the owner will need to buy some shares (let’s say shares worth $200) and the journal entries will be as follows:
Debit Bank $200
Credit Capital $200
Journal Entries for Income
Income is basically the sales that a company made during the year which are presented as part of the income statement. When a company makes a sale (fir example $200) the following journal entries are made:
Debit Bank or Accounts receivable $200
Credit Income $200
Journal Entries for Expenses
On the other hand, when a company incurs an expense, the transaction will be included as part of the income statement. For example, if a company pays $200 rent for the year, then the following journal entries will be made:
Debit Rent Expense $200
Credit Bank $200
It is rather uncommon nowadays to have to deal with T accounts since most companies use software for their bookkeeping needs but it is useful to know what a T account is. The name is due to the shape that is has. A T account is a ledger account where the debits are recorded on the left part of the T and the credits are recorded on the right part of the T.