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, a 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 2013, he launched a business that 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.
- On 1 October 2013, he set aside $100,000 for this business, which he named AutoWM. This will be reflected in double-entry accounting as follows: On 1 October 2013, accounting equation: $100,000 cash = $100,000 equity.
- On 15 October 2013, 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.
- On 30 October 2013, EA completed its research and sent-in its report. Chris paid them right away, which is reflected as follows:
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 2013: cash ($90,000) = shareholders’ equity ($90,000)
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: - 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 2013.
Accounting equation: cash ($290,000) + equipment ($150,000) = accounts payable ($150,000) + shareholders’ equity ($290,000)
The purchase of equipment is reflected as follows:
These 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 - The equipment vendor is paid on 15 November 2013
Accounting equation: cash ($140,000) + equipment ($150,000) = shareholders’ equity ($290,000)
This removes the accounts payable and decreases cash by $150,000. New cash balance is $140,000 - A software engineer is hired on 1 December 2013 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. Accounting equation as at 1 February 2014: cash ($85,000) + prepaid rent ($5,000) + equipment ($150,000) = shareholders’ equity ($240,000)
- 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)
- 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 balance ($240,000) – rent expense ($5,000) – salaries expense ($15,000) – depreciation expense ($5,000) = $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.
This will remove the prepaid rent asset and decrease shareholders’ equity (both by $5,000).
This will decrease cash and shareholders’ equity (both by $15,000).
At the end of first quarter, account balances are as follows:
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