0452 · 2.1The double entry system of book-keeping

Double entry principles and rules

0:00Nia opens a stationery shop and pays her own money into its bank account. The bank balance increases, and so does the amount the business owes Nia. The business must also record the capital supplied by its owner. The double entry system records each transaction as a debit in one account and an equal credit in another. Book-keeping is the detailed recording of a business's financial transactions. In this video, we will use the double entry system of book-keeping to record purchases, sales and payments.

0:26You will learn how to prepare ledger accounts, and then how to post transactions to the ledger accounts. We will also calculate balances, interpret their meaning and follow them into financial statements. Assets are resources owned or controlled by a business that bring future benefit, while liabilities are amounts it owes to others. Owner's equity, also called capital, is the owner's investment in the business, or the amount the business owes the owner.

0:50The accounting equation says that assets equal liabilities plus owner's equity. Each transaction changes at least two items by the same amount, so the equation still balances afterwards. Under the business entity concept, Nia and her shop are treated as two separate parties. The owner's capital is therefore owed by the business to the owner. Money introduced by Nia increases the shop's assets and its capital. It is not revenue from selling stationery, because providing finance is different from earning income through the business's main activity.

1:19Revenue is the income a business earns from its main activity, such as selling goods or providing services. Rent is one example of an expense. Expenses are the costs used up in running the business and earning revenue during a period. Revenue increases owner's equity, while expenses reduce it. This connection explains why their recording rules follow opposite directions. Duality means that every transaction has two aspects. In double entry, each aspect is recorded in a different account, and the debit always equals the credit.

1:47A ledger is a collection of accounts, and each account records changes relating to one particular item. For example, the bank account brings together transactions that affect money held at the bank. A traditional ledger account has a debit side on the left and a credit side on the right. Its shape gives it the name T account. Each entry contains a date, details and an amount. The details column names the other account involved, so each record points towards its matching entry.

2:13Debit and credit identify the two sides of an account, rather than whether a transaction is good or bad. An increase in an asset goes on the debit side. Decreases belong on the credit side of that asset account. The bank account therefore receives debits when business money enters it and credits when business money leaves it. An increase in a liability or owner's equity is recorded as a credit.

2:34To record a decrease, use the debit side instead. Income follows the credit rule because it increases owner's equity. Expenses increase on the debit side because they reduce the owner's interest in the business. Drawings are money or goods taken from the business by its owner for private use. An increase in drawings is recorded as a debit. Drawings reduce owner's equity and are not a business expense, so they never reduce the profit for the year.

2:58Keeping a separate drawings account distinguishes private use from the costs of running the shop. Before posting anything, identify the two accounts affected and decide what happens to each. Then apply the rule for its category, rather than guessing from the everyday meaning of debit or credit. Finally, enter the same amount on opposite sides of those accounts. Equal entries reflect two aspects of one transaction, not two separate transactions.

Posting transactions to ledger accounts

3:21Our worked example uses Nia Stationery, a sole trader. A sole trader is a business owned and controlled by one person. We will record six transactions and follow their effects through the accounts. All money amounts are in dollars, and the shop begins with no account balances. On the first of May, Nia introduces six thousand dollars into the business bank account. Debit the bank account because this asset increases, and credit the capital account because owner's equity rises.

3:46The bank entry names Capital in its details column. In the capital account, the corresponding entry names Bank. On the second of May, the shop purchases goods for resale on credit from Cedar Supplies for fourteen hundred dollars. Buying on credit means receiving goods now and paying for them later. Debit the purchases account because the cost of goods bought for resale increases, and credit the Cedar Supplies account because this liability rises.

4:09The purchases account records goods bought for resale, rather than equipment bought for use in the business. Inventory means goods held for resale. In this recording system, purchases of these goods are entered in the purchases account. We do not automatically debit an inventory account for each purchase. Cost of sales is the cost of inventory sold during a period, and its calculation is covered when preparing financial statements. On the third of May, Nia Stationery sells goods on credit to Iris Stores for eighteen hundred dollars.

4:36Trade receivables are amounts owed by credit customers who have not yet paid for goods or services. Debit the Iris Stores account because this asset increases, and credit the sales account because revenue rises. The sale is recorded now, even though payment has not yet arrived. On the fourth of May, the shop makes cash sales of nine hundred dollars and keeps the money in its till. Debit the cash account because this asset increases, and credit the sales account because revenue rises.

5:01Cash in the till and money at the bank are separate assets. This transaction affects Cash, not Bank, because the money has not been deposited. On the fifth of May, Nia Stationery pays five hundred dollars of rent from its bank account. Debit the rent account because this expense increases, and credit the bank account because the asset decreases. Rent is a business expense because it pays for the premises used by the shop.

5:23Its details entry names Bank, while the bank entry names Rent. On the sixth of May, Nia takes three hundred dollars from the business bank account for private use. Debit the drawings account because drawings increase, and credit the bank account because money held there decreases. These entries record a reduction in owner's equity separately from business expenses. The rent payment and the drawings both reduce Bank, but their other effects are different.

5:46The bank account now contains one debit of six thousand dollars and credits of five hundred dollars and three hundred dollars. Every details entry names the other account, rather than repeating Bank. Together, the credits represent eight hundred dollars paid out. The debit represents money received from Nia, not income earned from customers. In the capital account, six thousand dollars appears on the credit side with Bank as its details.

6:08This is the matching entry for Nia's investment. Posting only the bank debit would leave the owner's contribution unrecorded. Neither entry is a second receipt of money, because both describe the same investment from different viewpoints. Purchases contains a debit of fourteen hundred dollars with Cedar Supplies as its details. Its matching credit sits in the supplier's account. Trade payables are amounts owed to credit suppliers that the business has not yet paid.

6:31Cedar Supplies is therefore a trade payable, not an expense account. The supplier's credit entry names Purchases and records fourteen hundred dollars owed by the shop. A purchase on credit increases this liability without reducing Bank immediately. Its outstanding balance tells Nia how much remains payable. The purchases account and the supplier's account answer different questions about the same transaction. Iris Stores has a debit entry of eighteen hundred dollars with Sales as its details.

6:57This represents the customer's obligation to pay Nia Stationery. The account is an asset because the shop has a right to receive that money. A debit balance here describes an amount owed to the business, rather than cash already received. Nine hundred dollars sits on the debit side of the cash account, with Sales as its details. That entry records money held in the till. Sales also receives a matching credit, just as it did for the credit sale.

7:19The payment method changes the asset account involved, but both transactions increase the shop's revenue.

Calculating and interpreting balances

7:24A balance is the difference between the debit and credit totals of an account. To calculate ledger account balances, first add the entries on each side separately. Subtract the smaller total from the larger total. The side with the larger total determines whether the account has a debit balance or a credit balance. For Bank, the debit total is six thousand dollars and the credit total is eight hundred dollars.

7:46Subtract eight hundred dollars from six thousand dollars. The difference is five thousand two hundred dollars. This is a debit balance because money received exceeds money paid out. To balance the account, enter five thousand two hundred dollars as balance carried down on the smaller credit side, dated the thirty-first of December. Both sides now total six thousand dollars. Under the totals, enter five thousand two hundred dollars as balance brought down on the debit side on the first of January.

8:11This carries the asset into the next accounting period. Balance carried down completes the arithmetic rather than recording another payment. Its position on the credit side does not change the bank balance into a liability. Look at balance brought down to identify the continuing balance. Here, five thousand two hundred dollars on the debit side represents money still held at the bank. Cedar Supplies has a credit entry of fourteen hundred dollars and an empty debit side.

8:36Place balance carried down of fourteen hundred dollars on the smaller debit side, dated the thirty-first of December. Both sides then total fourteen hundred dollars. On the first of January, bring the balance down on the credit side, because the shop still owes Cedar Supplies that amount. Iris Stores shows the opposite pattern, with a debit balance of eighteen hundred dollars that the customer owes the shop. Debit balances usually represent assets, expenses or drawings, while credit balances usually represent liabilities, income or capital.

9:02The account name is essential when interpreting ledger accounts and their balances. A bank debit balance represents money available, but a rent debit balance represents an expense incurred. The side alone does not tell you whether a balance belongs in the next period. Ledger accounts may be presented using a three-column running balance format. Alongside date and details, its amount columns are Debit, Credit and Balance. After each entry, the balance is updated and identified as debit or credit.

9:29The account contains the same information as a T account, but shows the position after every transaction. After the capital entry, the running bank balance is six thousand dollars debit. The rent payment of five hundred dollars reduces it to five thousand five hundred dollars debit. Drawings of three hundred dollars then leave five thousand two hundred dollars debit. This agrees with the T account, so changing the layout has not changed the underlying double entry.

Closing accounts and ledger types

9:52Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date. At the year end, income and expense accounts are closed when we make transfers to financial statements. Their balances contribute to the statement of profit or loss for that year. They are not carried forward as another year's revenue or expenses. Assume these are the shop's only sales for the year.

10:13Eighteen hundred dollars plus nine hundred dollars gives sales revenue of two thousand seven hundred dollars. Debit Sales and credit the statement of profit or loss with two thousand seven hundred dollars. This removes the sales credit balance and transfers the year's revenue, so both sides of Sales total two thousand seven hundred dollars. The rent account has a debit balance of five hundred dollars. Credit Rent and debit the statement of profit or loss with five hundred dollars.

10:37This removes the expense balance and transfers the cost into the year's result. Both sides of Rent total five hundred dollars, with no balance brought down. Purchases also closes into the statement of profit or loss as part of calculating cost of sales. Debit the statement of profit or loss and credit Purchases with fourteen hundred dollars to clear its debit balance. Inventory must also be considered before cost of sales is finalised.

11:01The detailed calculation belongs in the financial statements video, rather than this posting example. Assets, liabilities and capital continue into the next period and appear in the statement of financial position. Drawings are closed against capital rather than treated as an expense. Debit Capital and credit Drawings with three hundred dollars to remove the drawings balance and reduce owner's equity. The bank balance continues because the remaining money still belongs to the business.

11:26The division of the ledger into the sales ledger, the purchases ledger and the nominal, or general, ledger separates different kinds of accounts. The sales ledger contains the accounts of credit customers, including Iris Stores. Credit suppliers such as Cedar Supplies belong in the purchases ledger. These groups show the individual trade receivables and trade payables. The nominal, or general, ledger contains the other accounts, including Bank, Cash, Sales, Purchases, Rent, Drawings and Capital.

11:54Notice that the sales account belongs here, not in the sales ledger. Similarly, Purchases belongs in the general ledger rather than the purchases ledger. The customer and supplier accounts explain those specialised ledger names. Ledger accounts can be kept digitally through accounting software. After a transaction is entered and correctly classified, software can post both entries and update running balances. The same debit and credit principles still apply. A rent payment must reduce Bank and increase Rent, whether entries are written by hand or generated by software.

12:24Digital records can also be searched by customer, supplier or date. However, equal debits and credits do not guarantee that the correct accounts were selected. Classifying Nia's private payment as drawings remains a human decision. Software can process the entry, but it cannot make an incorrect classification correct merely by balancing it.

Exam mistakes and worked question

12:42Common examination mistakes involve the account category, the details column and the balance position. Use the other account's name in Details, and distinguish cash sales from sales on credit. Keep owner investment separate from revenue and drawings separate from expenses. For balancing, place balance carried down on the smaller side and balance brought down on the opposite side. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions.

13:09You may need to identify entries, prepare accounts, calculate balances or explain what those balances represent. Identify means name or select, and prepare means present information in a suitable format. When a question says calculate, it means work out from given figures. Explain means give reasons, why and how, supported by evidence. Consider an exam-style question in which Iris Stores pays seven hundred dollars into the shop's bank account on the tenth of January.

13:34Its opening debit balance is eighteen hundred dollars. State means express in clear terms, so name both accounts and their sides. Then calculate the remaining balance and explain what it represents. Debit Bank with seven hundred dollars because this asset increases, and credit Iris Stores because the trade receivable decreases. Eighteen hundred dollars minus seven hundred dollars leaves eleven hundred dollars debit. Iris Stores still owes Nia Stationery eleven hundred dollars, and this payment does not create another sale.

14:02Double entry links the two aspects of each transaction through equal debits and credits. Account categories determine the sides, while the details column connects each entry to its partner. Balances show what remains outstanding or what has accumulated during the period. Income and expenses transfer into the year's result, while continuing assets, liabilities and capital move into the next period.