Double Entry Accounting
Double-entry accounting is a method of accounting in which each transaction is recorded such that the sum of assets is equal to the sum of the company’s liabilities and its shareholders’ equity. In double entry accounting, each journal entry affects at least two accounts.
In double-entry accounting, an increase in asset account(s) is compensated by decrease in other asset account(s) or by increase in liability account(s) or equity account(s) or both, and vice versa.
A business is made up of buildings, equipment, copyrights, investments, bank and cash balances, etc. These resources are called assets in accounting terminology. All the assets of an entity are acquired with money invested by owners (called shareholders’ equity in accounting) or money provided by creditors (called liabilities). This relationship of all assets coming from either equity or liabilities is represented by accounting equation, which states that assets = liabilities + equity. This relationship is maintained at all times.
Double-entry accounting encompasses a complete accounting cycle which includes making journal entries for transactions, posting them to accounts in general ledger, preparing a trial balance, making adjusting entries and preparing an adjusted trial balance which forms the basis of a complete set of financial statements.
Chris Miller is a CFA charter-holder who has been running a successful wealth management business for 20 years. In 20X3, he launched a business that was aimed at using information technology to automate and simplify the wealth management business. Following are some of the transactions that took place in the early days of the business.
- On 1 October 20X3, he set aside $100,000 for this business, which he named AutoWM. This will be reflected in double-entry accounting as follows:
Cash $100,000 Capital, Chris Miller $100,000
- On 15 October 20X3, he hired Excel Analytics (EA) to conduct a market research for $10,000. No journal entry is required because it is just the start of a contract and no exchange of goods or services has occurred yet.
- On 30 October 20X3, EA completed its research and sent-in its report. Chris paid them right away, which is reflected as follows:
Market Research Expense $10,000 Cash $10,000
Expanded accounting equation:
assets = liabilities + (shareholders’ equity + revenue – expenses)
Since market research is an expense, it results in decrease in shareholders’ equity.
Accounting equation on 30 October 20X3: cash ($90,000) = shareholders’ equity ($90,000)
- The market research report was promising. It prompted Chris to put in $200,000 more money and purchase equipment worth $150,000 on 1 November 20X3.
Cash $200,000 Capital, Chris Miller $200,000 Equipment $150,000 Accounts payable $150,000
Accounting equation: cash ($290,000) + equipment ($150,000) = accounts payable ($150,000) + shareholders’ equity ($290,000)
- The equipment vendor is paid on 15 November 20X3
Accounts payable $150,000 Cash $150,000
Accounting equation: cash ($140,000) + equipment ($150,000) = shareholders’ equity ($290,000)
- A software engineer is hired on 1 December 20X3 for $15,000 a month and a $50,000 signing bonus; and a co-working space is arranged for $5,000 a month paid in advance. The following journal entry is made on 1 December.
Salaries expense $50,000 Prepaid rent $5,000 Cash $55,000
- At the end of December, adjusting entries are made to recognize the rent expense, pay salary to the software engineer and recognize monthly depreciation on the equipment (useful life is 30 months)
Rent expense $5,000 Prepaid rent $5,000 Salaries expense $15,000 Cash $15,000 Depreciation expense ($150,000/30) $5,000 Accumulated depreciation $5,000
- Cash balance = $85,000 - $15,000 = $70,000
- Prepaid rent balance = 0
- Equipment balance = $150,000 – accumulated depreciation ($5,000) = $145,000
- Liabilities balance = 0
- Shareholders’ equity balance
= opening ($240,000) – rent ($5,000) – salaries ($15,000) – depreciation ($5,000)
Accounting equation at the end of the quarter:
cash ($70,000) + equipment ($145,000) = shareholders’ equity ($215,000).
The expanded accounting equation becomes the balance sheet (or the statement of financial position) when a complete set of financial statements is prepared.