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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.
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