Accounts & Double Entry System

                        

 

Double Entry System

Accounting stands on the basic equation Assets= Liabilities Owner’s Equity. That means, every transaction must hit and effect the equation and support it. Left side of the equation must be equal to the right side comprising liabilities and owners’ equity. Double entry system mainly formulates the accounting equation. There are double effects of a transaction. Each transaction has at least two accounts comprising a debit and a credit. The amounts of all debits must be equal to the amounts of all credits. This is the basic term of double entry system. Luca Pacioli was the pioneer who published the book on double entry system clearly in 1494.

Cycle of Double Entry System

Financial transactions are recorded into account books maintaining certain stages. After finishing each stage, the next stage appears and all the accounting managers do the same. Accounting cycle is an ongoing process of recording financial information of a firm to derive the financial performance. The cycle starts from the identification of financial transaction to the preparation of the balance sheet of a firm. It is so named as accounting cycle because of it never gets ended. We know to that every company has an indefinite time period; the process of business must be carried. After the end of an accounting year, the company has to record financial transactions of new accounting year. And again, all the stages of accounting cycle must be filled and carried.

It has to be noted that accounting cycle has different stages but those are not same for all types organisations. It varies. There are different form factors of organisations and each organisation procures the stages of accounting cycle as per the convenience. Stages of accounting cycle can be more or less apart from other organisations compared to a specific organisation. However, the basic stages that fill the cycle of double entry system are same. This segment is going to point those stages clearly so that the readers can get clear view about the cycle of double entry system.

Transactions: It is expected that before starting to view this segment, all the learners of accounting have gained the basic knowledge and term of accounting. It has already discussed in the beginning chapter of accounting that only financial transactions are held to be recorded into accounting books. The cycle gets started with the identification of financial transactions. All transactions are events but all events are not transactions- are known to the learners of accounting. So, the very first stage of accounting cycle deals with the identification of financial transactions.

Journal: Preparing journal book is the first formal process to support the term of double entry system. After identifying which transactions are going to be recorded and analysed, the next stage of accounting cycle is to prepare journals. Journal books can be different also. It can be varied according to the differentiation of transactions. For instance, apart from general journal, there can be special journal books for adjusting entries. Transactions are recorded primarily in journal book.

Ledger: Ledger is known as the permanent asylum of all transactions. Before this stage, transactions are recorded into journal primarily. In ledger, all the accounts are transferred permanently from journal stating a certain head. For instance, all purchases are recorded under the account purchase. The same goes for sells as well. In a nutshell, preparation of ledger is the stage of posting the debits and credits perceived from journal.

Trial balance: This stage of accounting cycle is the part of ensuring the arithmetic accuracy. We know that the motive of accounting is to share financial performance to the destined users of accounting information. And such prospect is generalised by the preparation of income statement and balance sheet. But if there prevails errors in recording of transactions and calculation, the information sought from income statement and balance sheet cannot provide accurate result. So, trial balance is prepared in this stage. It is the process of verifying that all the accounts are equal in terms of debits and credits. It is the measure of correctness. Accounts of ledger are listed and then analysed. If both sides are not matched, there lies errors and the correction must be made.

Income statement: After preparing trial balance, income statement is prepared to measure the net profit of the business. All expenses and revenues are enlisted from trial balance with the necessary adjustments. The firm can denote how the business has performed as net profit or loss can be acquired.

Balance sheet: The use of trial balance gets ended here. Balance sheet is prepared from the balance of assets, liabilities and equity. Assets must be equal with the sum of liabilities and equity. The firm can acknowledge the financial position of the business on the certain date of the accounting year. It is termed as the closing balance sheet which definitely becomes the opening balance sheet of the next accounting year.

So, it is expected that the learners have gained proper idea about how accounting cycle works to record accounts and share financial information.

What is account?

It is expected that learners know the objectives of accounting relating to the business prospect. Each financial transaction carries specific account so that after the end of a certain accounting year, the accounting manager can prepare financial statements properly. Usually, an account is the representation of transactions in general ledger. An account sorts the record of each class of transactions. For example, purchase account records all the accounts of purchases. So, a user of accounting easily identifies the nature of transactions. Financial transactions can be tracked by determining each account.

Types of accounts

Accounts are of different types. Now, we are going to discuss about those accounts.

Personal account: Simply, accounts related with persons, individuals, firms and so on are denoted as personal account. Accounts are termed as personal accounts that are related to individuals to whom the business operates. Business has to operate direct transactions in this case. Purchase on account, sell on account, drawings, capital of owners, employees’ salary account and so on are the examples of personal account.

The recording process of personal account is:

Receiver    Debit

Giver         Credit

Real account: Accounts that are related to the assets or liabilities of the firm are denoted as accounts. Real account can be both tangible and intangible. Tangible real accounts have physical existence such as machinery, equipment, furniture and so on. Intangible real accounts do not have any physical existence such as goodwill, copyright, trademark and so on.

Recording process of real account is:

What comes in    Debit

What goes out    Credit

Nominal account: Transactions which are related to income or expense are termed as nominal account.  Salary, wages, rent, advertisement and so on are the examples of nominal account.

Recording process of nominal account is:

All expenses    Debit

All revenues    Credit

Accounts can be categorized as per following also:

Assets: Firms own tangible and intangible things which add value and help making profit to the firm. Building, furniture, equipment, cash in hand, bank balances and so on are termed as assets.

Liabilities: Liabilities are the obligations for which the firm has to pay money in future. Taking loans, purchasing goods on account and so on create liabilities.

Equity: The portion of assets owned by the owners of the firm.

Revenues: Accounts from which a firm earns by selling goods, serving and so on. Sales account, interest earning and so on are such accounts.

Examples: Accounts for which a firm spends to carry the operation of the business. Utilities, advertisement, salary, wages and so on are such types of account.

What is asset?

A firm owns resources that have economic value and generates future benefit to the related firm. Assets have to be acquired and controlled properly so that firms can get expected benefits. Smooth operations of every firm depend on how the firm acquires and controls the assets. Operations of business get influenced from proper management of assets.

Assets are recorded in the balance sheet of an organization. Assets can have physical existence or not. Trademark, goodwill, patent and so on do not have physical existence. Those are denoted as intangible assets whereas building, equipment and so on have physical existence. Such assets are termed as tangible assets.

Types of assets

So, learners now have basic idea about assets. Learners must know different categories of assets. So, this segment comprises different types of assets.

Tangible assets: Tangible assets are those assets which have physical evidence. The effects of such assets can be easily visible. Cash balance, bank balance, office equipment, inventory, accounts receivable, machinery, property and so on are the examples of tangible assets.

Intangible assets: Intangible assets are those assets which have no physical values. As a result, the valuation of such assets is very difficult. Examples of intangible assets are- copyrights, patents, trademark, goodwill and so on.

Fixed assets: Fixed assets are also termed as long-term assets because of having long-term existence. Fixed assets cannot be converted into cash suddenly. That’s why, fixed assets have low liquidity. Property, building, furniture and so on are the examples of fixed assets.

Current assets: Current assets have higher liquidity as such assets can instantly be converted into cash. Cash balance, bank balance, closing inventory and so on are the examples of current assets.

Financial assets: Assets that have contractual value. Companies gain benefits from investing money to different profitable sources. Bonds, derivatives, stocks and so on are the examples of such assets.

What is liability?

Liability is the debt or obligation of the firm to others. A firm owes money or other belongings as the prospect of obligations. So, liability is the obligation for which a company owes. Liabilities are recorded in the balance sheet with equity that must be equal to assets. Liabilities make obligations for which firms have to pay for. Firms get present benefits in exchange of the obligations made to other parties for future payments.

Types of liabilities

Liabilities are also different types and learners have to gain clear idea about it. This segment contains the classifications of liabilities.

Current liabilities: Liabilities that have short-term obligations and firms have to pay monetary obligations within one year. Examples of current liabilities are- accounts payable, notes payable, accrued expenses, bank overdraft, unearned revenues and so on.

Non-current liabilities: Non-current liabilities are also denoted as long-term liabilities as the obligations have to be paid overpassing a year. Non-current liabilities are underlying due to long-term financing. Long-term notes payable, bonds payable, long-term loan and so on are the examples of non-current liabilities.

Contingent liabilities: Contingent liabilities are denoted as the possible liabilities that may be derived due to certain incidents. If the firm faces a lawsuit from third party for which obligation may be paid, contingent liability exists. Examples of contingent liabilities are- product warranties, lawsuits and so on.

What is capital?

In simple terms, capital is the money invested by the owner to start a business. The owner of a firm has to invest money in the business to start or operate the business. The firm may need money when it is needed due to shortage of resources. Capital can be derived from the owner in such requirement. When the company winds up, after paying all the obligations to third party, the portion of resources is termed as capital to be paid to the owner, as he acclaims it.

Capital must be derived as the resources obtained from the owners to the business so that the firm can leverage growth of the business and at the same time making financial benefits to the firm and the owner. If the firm is a public limited company, the term is debited as share capital as required capital is derived by the issuance of shares.

What is equity?

In simple terms, equity is the representation of the book value of a firm. It is the portion of money that the shareholders receive after the liquidation of all assets. After the payment of all debts, the remaining portion of money. It is shown in the company's balance sheet denoted as shareholders’ equity. Equity can be derived after the subtraction of total liabilities from total assets.

Difference between capital and equity

It is very important to understand the meaning of equity and capital. Though both terms are used to integrate the ownership of a company, there underlies significant difference also.

Capital is the amount of money that is invested by the owner in the business. Equity is the claimable amount of money that the shareholders claim from the firm. Capital is the part of equity with the retained earnings shown in the company's balance sheet. So, equity is a broader part of finance in this context.