Why the Double Entry System is Called Double: An In-Depth Explanation
The double entry system is a fundamental principle in accounting that ensures the accuracy and reliability of financial reporting. This system is called 'double' because every transaction affects two sides, specifically by debiting and crediting accounts in a manner that maintains the accounting equation in balance. This system is the bedrock upon which modern financial accounting is built.
Basic Overview of the Double Entry System
At its core, the double entry system is designed to provide a clear and systematic approach to recording and summarizing financial transactions. Here's a brief overview:
Debits and Credits
In every transaction, one account is debited (reduced or increased, depending on the account type) and another is credited with the opposite effect. For example, if an asset increases, a liability must decrease (or vice versa) to maintain the balance. This dual aspect of recording ensures that the financial statements are accurate and reliable.
How the Double Entry System Works
The double entry system is based on the principle that every financial transaction must have two entries: one debit and one credit. This ensures that the accounting equation (Assets Liabilities Equity) remains in balance. Here’s how it works:
Debits and Credits
For every transaction
- One account is debited, which increases or decreases depending on the type of account (assets increase, liabilities decrease, income increases, expenses decrease).
- Another account is credited, with the opposite effect (assets decrease, liabilities increase, income decreases, expenses increase).
Ensuring Balance and Detecting Errors
The primary purpose of the double entry system is to maintain a balance in the financial records. The total amount debited must always equal the total amount credited. This balance check is crucial for identifying any errors in the recording process. If the debits and credits do not match, it indicates a mistake somewhere in the transaction.
Accountability and Transaction Recording
Transaction recording under the double entry system goes beyond simply listing a single entry. It requires providing context and ensuring accountability. For instance, if a transaction involves an increase in cash, simply recording "increase in cash balance" doesn't explain the source or reason for the cash inflow. The double entry system captures this by recording both sides of the transaction:
Example 1: Borrowing Money
- If you borrow money, your transaction would be recorded as: "Increase in cash asset" and "increase in loan liability."
- This dual entry ensures that you know the source of the cash (loan liability) and the increase in assets (cash).
Example 2: Selling Trading Stock
- If you sell trading stock to receive cash, your transaction would be recorded as: "Increase in cash asset" and "increase in revenue equity."
- This dual entry confirms that the cash was received from the sale of inventory (assets) and that the revenue has increased (equity).
These examples illustrate how the double entry system ensures that every transaction is recorded with complete and accurate details, providing a transparent and reliable financial record.
Conclusion
The double entry system is not just a method of accounting; it is a system designed to ensure that financial records are accurate, complete, and reliable. By recording every transaction in two parts (debits and credits), it maintains the balance in the accounting equation and helps identify and correct errors. This system is essential for businesses and individuals looking to manage their finances effectively and transparently.