Bookkeeping – Dual Entry System (Lesson 2)
Dual entry is a system of debits and credits equaling each other.
In accounting the term dual entry is used often. Other names include Double Entry and Offsetting Entry. It refers to the process of entering an economic transaction as an equation. Remember in math an equation refers to a two-sided mathematical statement. Examples include 4= 2 X 2 or more complex equations such as E= MC squared. Basically, both sides of the entry must equal each other in value. It was advocated over 600 years ago by a monk and is currently the most accepted form of entering information into the books of record for a business.
This lesson describes a succinct history of the dual entry system, explains the logic behind the concept and then augments this logic with the relationships of the six different types of accounts (Lesson 1). I’ll finish up with a short lesson on T-Accounts and how they represent the basic visual aid for entering data.
History of Dual Entry
In 1494 a monk, Luca Bartolomeo de Pacioli (Father of Accounting), wrote the first book explaining the dual entry accounting concept. This book was one section of a multi section volume on Mathematics. In this section he explains how merchants in Venice used journals and ledgers to make entries into the financial records. He introduces the concept of debits and credits whereby when a journal recorded an entry a corresponding entry was made into a ledger. For the first time the terms assets, liabilities, capital, income and expenses were introduced to the public. If you’ll notice, these terms reflect five of the six types of accounts discussed in Lesson 1.
Over the next 400 years accounting developed slowly and became more widely accepted as the method of recording financial information. In the 1800’s certain industries needed an influx of capital to expand operations. To provide a high level of confidence in their reports, railroads created standards of reporting. In addition, the automotive industry began to report information using ratios to compare different companies. Of course, there were abuses of this trust and the stock market crash of 1929 was the result. During the 1930’s an independent board of accountants developed reporting standards and created principles of accounting that are used today.
Now all publicly traded companies must follow these rules as they have become the standards via Generally Accepted Accounting Principles otherwise stated as GAAP.
Logic Behind Concept
Dual entry uses two sides of an equation to ensure balance. On one side is a debit and the corresponding offset is a credit. For every entry made the debits and credits affect an account. But the real reason this concept of recording data is used is to ensure balance. In accounting we use a document called a trial balance. This list of accounts has basically three columns. The first column is of course the name of the account, the second column lists any debit balance in that account and the third column identifies the credit balance if a balance exists. If data is entered correctly and there are no errors, the debit total should equal the credit total. The following is an example:
Debits Credits
Cash 200.00 -0-
Fixed Asset 145.00 -0-
Taxes Owed -0- 10.00
Equity -0- 235.00
Sales -0- 404.00
COGS 254.00 -0-
Expenses 50.00 -0-
Totals 649.00 649.00
By confirming debits equal credits, the bookkeeper can feel confident that data was entered in equal amounts. It may not have been entered correctly such as a particular sale misclassified as an equity transaction; but at the least the data was entered in equal amounts. This is referred to as ‘In Balance’.
If the debits do not equal the credits, then there is a problem because one of the accounts is either overstated in value or understated. This will cause a reader of financial information to be misled and therefore there is an increased possibility of making a poor decision. Remember what accounting is about. We enter economic activity and report this information so management may make decisions to continuously improve operations. If data entered is incorrect, then ultimately management is prone to make a poor decision based on their belief the information is correct.
A balanced entry increases the likelihood of more accurate information. What is interesting is that Pacioli wrote that an owner of a business should never sleep until his debits equaled his credits.
Relationship of Entries
Each of the six different types of accounts can accept debits or credits. However, one is more likely and favored for the respective type of an account. A good example is assets. In general, you would prefer assets to increase in value. For assets, debit entries increase the value. Thus, for cash, a debit adds value (a positive amount) to this account. Remember cash is an asset and absolutely the best kind of asset to have.
To get cash a business generally sells a service of a product of some sort. There is a relationship between two account types of sales and assets. When a customer comes into the store and purchases a product and entry is made in the sales journal. A credit for the sale is recorded and an equal offset of a debit is made to the cash account (asset). Notice the requirement of equilibrium? Thus, there is this ongoing relationship between all the types of account and this is the general guideline:
- Assets(debit) generally increase when Sales(credit) increase
- Liabilities increase via credits and the customer offset is either a debit to expense or to cost of sales
- Equity increases via credits because owners invest money which is recorded via a debit to cash (asset)
- Sales are almost entirely credits and the corresponding offset is to an asset type of an account via either payment in cash or on account as a receivable from a customer
- Cost of Sales is traditionally debits and the corresponding credits are applied to the inventory account (asset) or as amount owed to the supplier which is a liability
- Expenses such as rent are debited when we pay for the expense via cash (credit to an asset type of an account)
These relationships continue in many different formats and can even exist within the same type of accounts. As an example, a customer that owes money to the business may pay their account which increases cash (asset account). When this is recorded, the accounts receivable (asset account) is credited and cash is debited. So entries can stay within the same type of accounts.
Modern technology automatically records the respective debits and credits via the various forms of entry. In the past accountants used T-Accounts to visualize the entry.
T-Accounts
Imagine a large letter ‘T’. Notice how there is left branch and a right branch? The left is the debit column and the right branch is the credit column. When an entry is made, a line or row of information is recorded. Let’s use the traditional sale of a product to a customer that pays cash as the example. In a T-Account the first row represents the cash received from the customer which is physically deposited into the bank account. The row has an identifier of cash and the dollar value is placed under the left branch side of the ‘T’. The offsetting entry is a second row and is labeled ‘Sales’. Here the equal amount is placed under the credit side of the ‘T’ and now both sides are equal which is the fundamental requirement of the dual entry system. Below is my example.
Debits Credits
Cash $10.12 -0-
Sales -0- $10.12
Do you see the ‘T’? Two lines of entry for dual entry and an equal amount of value for the equation is entered.
Summary of Dual Entry System
The goal of this lesson is to teach that modern accounting uses dual entry to record financial information. It explained the history behind the concept and its logic. Essentially, dual entry requires all debits and credits equal each other in an entry and in total via the trial balance. The lesson also introduced an old tool of data entry called the ‘T’-Account which is no longer used today. However, the basic principle that visualizes debits and credits still exists today, thus the ‘T’-Account reinforces this dual entry requirement. Furthermore, this lesson also explained that the types of accounts have relationships with each other and many of your data entries in the future will consistently execute accordingly. Remember, in a sale, the offsetting debit is typically an asset of some sort. Once you begin to understand these relationships and what is normal, you’ll begin to increase your speed related to entering data. Most importantly remember that the dual entry system is used in modern accounting. ACT ON KNOWLEDGE.
Value Investing
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.