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The Double Entry System Print E-mail

 

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Accounts are prepared using the double entry system. This article explains the theory behind the double entry system.

Get used to the terms Debit (DR) and Credit (CR) as they will be used throughout the site.

The double entry system is used to measure the impact of financial transactions on the net asset position of an entity.  An increase in net assets represents an increase in wealth.

An entity’s net asset position is made up of its total assets less total liabilities.

Assets generate income or an increase in the net asset position of a company. They can be liquid, fixed and tangible or intangible (paper assets). Examples are cash, plant and machinery and licences.

To be classed as an asset, they have to be able to generate future economic benefit related to the trade of the entity. Put simply, they are used in the business to produce profits.

Assets can also be short term or long term, generating economic benefits for short or long periods of time.

Liabilities are obligations to release economic benefits to another entity or person at some point in the future.

The most common liability is a bank loan that needs to be repaid with interest, or short term trade creditors that need to be paid for goods purchased on account.

The double entry system is based on the principle that income increases the net asset position of the entity, and expenses decrease it.

Where transactions do not affect income or expenses, there is no effect on the net asset position.

Profit is the excess of income over expenses, and will increase the net assets of the business.

The terms debit and credit are used to record transactions.

For each transaction, there are corresponding debits and credits, and the net effect is always zero. Thus, they cancel each other out. This can be achieved with two or more entries, but never with less than two entries.

The table below demonstrates how debits and credits affect elements in the financial statements:

 

Debit

Credit

Income

Decrease

Increase

Expense

Increase

Decrease

Asset

Increase

Decrease

Liability

Decrease

Increas


Transactions are recorded in journals to show how they affect the net asset position. For example:

 

 

Debit

Credit

Net assets

1

Trade Debtors

100

 

 

 

Income

 

100

 

 

Recording invoice to client

 

 

Increased

2

Rent

150

 

 

 

Trade creditors

 

150

 

 

Recording invoice from supplier

 

 

Decreased

3

Bank

100

 

 

 

Trade debtors

 

100

 

 

Recording receipt from client

 

 

No effect


An overall decrease in the net asset position year on year spells trouble, unless initial costs will lead to profits in the future, in which case growth is expected.

When reading financial statements, the double entry principle can be used to link the primary statements to each other to make sense of how the business is achieving its goals. A few key examples are set out below:

Profit

Profit for the period covered in the financial statements can be found in the income statement or profit and loss account. There is gross profit, operating profit before interest and tax, and net profit after tax.  The accumulated profit since the date of incorporation of the business can be found in the bottom half of the balance sheet. The recognised profit for the year can be found in the statement of recognised profit and losses. The cash profit can be found in the cash flow statement.

To link these profits, the profit in the income statement is carried to the statement of total recognised gains and losses. The closing accumulated profit in the balance sheet less the closing accumulated profit in the balance sheet for the prior year should equal the total gains or losses in the statement of total recognised gains and losses (or if there is not one, the income statement).

The cash flow statement should reconcile the profit in the profit and loss account to the cash profit. 

Therefore, if conditions could change profits, the adjustment would flow throughout the primary statements in the accounts.  When the accumulated profit changes in the balance sheet, it would affect either assets or liabilities in an equal and opposite way so that the balance sheet is always in balance. Similarly, the cash flow of the business would be affected.

A good way to test how sensitive accounting profits and cash profits are to changes in costs or income, is to change the P&L and test how the rest of the accounts would look after the adjustment has been made in the other primary financial statements.  A great tool to aid planning, budgeting and financing needs.

Fixed assets

Fixed assets are a great way to demonstrate how the double entry principle works. The balance sheet values are usually supported by a note in the accounts, showing the opening values, movements in the year and closing values.  You should be able to reconcile fixed assets by performing a simple calculation: Opening fixed assets (balance sheet) add additions (cash flow statement) less disposals (cash flow statement) less depreciation (income statement or operating profit note) = closing fixed assets (balance sheet). These amounts should tie into the note.  Additions (debit assets; credit cash) and disposals (credit assets; debit cash) are cash flow items and do not affect profit, but do affect cash flow and cash in the balance sheet.  The net effect of buying a fixed asset on the net asset position of the busienss is zero, because it decreases cash on the balance sheet and increases assets on the balance sheet. Both these items are in the top half of the balance sheet, and do not affect equity in the bottom half of the balance sheet.  However, depreciation which is a non-cashflow item, affects profit (Dr P&L depreciation Cr Fixed Assets), and reduces net assets by reducing fixed assets in the top half of the balance sheet and accumulated profit in the bottom half of the balance sheet.

Equity

An injection of capital from shareholders increases the net assets of the business without increasing profit.  When shareholders contribute cash to the business, it increases the cash balance in the top half of the balance sheet and share capital (and/or share premium) in the bottom half of the balance sheet.  However, when shareholders take dividends, cash and the accumulated profits and loss balance are reduced, as distributions are made out of distributable accumulated profits.  The initial capital introduced can only be added to the profit and loss account by applying to the courts to do a capital reduction, but is usually not distributable to protect creditors.

 

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NAZIR AHMAD  - COMMERCE GRADUATE   |175.110.0.xxx |2012-06-05 09:08:27
I AM JOINING A COMPANY AS ACCOUNTANT AND WANT TO PREPARE WHOLE ACCOUNTING SYSTEM
OF MY COMPANY. YOUR SITE GIVE ME GREAT HELP TO DO SO. I LIKE IT VERY MUCH AND
LOOKING FOR ANY GUIDE LINE TO, HOW TO PREPARE ACCOUNTING SYSTEM OF SMALL
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