Double Entry System: 5 Important things to know about recording transactions

For every transaction made in a business, you must record a debit entry and a credit entry in the ledger accounts. This rule is called the double entry system.

The debit entry goes on the left side of one T account and it must have the same amount as the credit entry on the right side of another T account.

If you invest cash into your business, two accounts are affected. To record this transaction, the double entry is debit Cash account with the money received in the business and credit Capital account with the money given to the business.

Learn ALICE accounts to know debit and credit of accounts

To understand the double entry system and know which accounts are debited and credited when they increase or decrease, you must know your ALICE accounts. These accounts are assets, liabilities, income, capital and expenses. In the double entry system, you:

Debit

• Increase of assets and expenses
• Decrease of liabilities, income and capital

Credit

• Decrease of assets and expenses
• Increase of liabilities, income and capital

The diagram below should help you to know which accounts are assets, liabilities, income, capital and expenses and when to debit or credit them in transactions.

Once you memorise your ALICE accounts, use the guide in this article to master the double entry system quickly.

5 Significant things to know about the double entry system

While every transaction has a debit and a credit entry, some accounts are a bit trickier than others. Here are 5 important things to know about the double entry system.

1. Debit and credit are not the same as increase and decrease

It is easy to confuse the terms debit and credit with increase and decrease. The terms cannot be used interchangeably.

Remember, while every transaction has a debit and a credit entry, assets and expenses are debited when they increase and credited when they decrease.

Liabilities, income and capital are credited when they increase and debited when they decrease.

In other words, when you use the term increase, it must be clear that you are debiting assets and expenses or crediting liabilities, income and capital.

When you use the term decrease, it must be clear that you are debiting liabilities, income and capital or crediting assets and expenses.

Here are 4 scenarios with these transactions:

i. One account increases while one decreases

If a business buys a motor vehicle with cash, the double entry is Motor Vehicle account increases with a debit entry and Cash account decreases with a credit entry.

ii. Both accounts increase

If the motor vehicle is bought on credit (to pay at a later date), then two accounts increase at the same time. The double entry is Motor Vehicle account increases with a debit entry and the Accounts payable account increases with a credit entry.

iii. Both accounts decrease

If the business pays off the debt with cash, then two accounts decrease at the same time. The double entry is Accounts payable account decreases with a debit entry and Cash account decreases with a credit entry.

iv. More than two accounts are affected

If a customer pays half the cost for goods in cash and owes the other half at the end of the accounting period, then 3 accounts are affected in this transaction.

The entries made are still referred to as double entry because you are making a debit and a credit, except that one entry is being split into two accounts.

Cash account increases with a debit entry of half the cost, Accounts receivable account increases with a debit entry of the other half of the cost, and Sales account increases with a credit entry of the full amount.

2. Purchases, Sales, Returns and Carriages accounts only record goods for resale

When the business buys, sells, returns or transports goods for resale, these accounts are called Purchases, Sales, Returns inwards, Returns outwards, Carriage inwards and Carriage outwards.

These accounts do not record the purchase, sale, return or transport of assets like vehicles and expenses like stationery.

Recording the double entry with these accounts is dependent on whether the transactions involve cash or credit. Here is the double entry for recording cash and credit transactions for these accounts.

Purchases account is an expense and is debited. If cash is spent, the Cash account is credited. If goods were bought on credit, then Accounts payable is credited.

Sales account is income and is credited. If cash is received, the Cash account is debited. If goods were sold on credit, then Accounts receivable is debited.

Returns inwards account is an expense and is debited. The Accounts payable account is credited. If cash has to be refunded to the customer, another step is to debit Accounts payable account and credit the Cash account.

Returns Outwards account is income and is credited. The Accounts receivable account is debited. If cash has to be refunded to the business from the supplier, another step is to debit the Cash account and credit the Accounts receivable account.

Both Carriage inwards and Carriage outwards accounts are expenses to the business and are debited. The Cash account is credited.

3. All credit transactions are recorded in Accounts receivable and Accounts payable accounts

Credit transactions in a business are recorded in Accounts receivable and Accounts payable accounts.

Accounts Receivable account records the debit entry of money owed to the business by debtors or customers of goods for resale, assets sold, rent revenue and stationery sold.

Accounts Payable account records the credit entry of money that the business owes to suppliers for goods for resale, assets bought, rent for space and stationery purchased.

These two accounts fill the gap for money not being present at the point of the transaction. They are closed off with an entry on the opposite side when money is finally received or spent.

4. Returned goods and withdrawals are recorded in Returns and Drawings accounts

The ledger accounts Purchases, Sales and Capital do not have reversing entries occurring in them.

This means that if the business returns goods to the supplier, the Purchases account is not credited.

If a customer returns goods to the business, the Sales account is not debited.

Also, if the owner withdraws money from the business for personal use, the Capital account is not debited.

Returns outwards account records the credit of the Purchases account.

Returns inwards account records the debit of the Sales account.

Drawings account records the debit of the Capital account.

5. Accruals and prepayments are recorded in 2 adjusting accounts

When money is owed or paid in advance for expenses, the adjusting accounts Accrued expense or Prepaid expense records the transaction. Learn more about the difference between accruals and accounts payable and the concept of prepayments.

Related article: Accruals: How to record owed expenses and revenues in the Accounting Cycle

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