Rules of a Double Entry Accounting Method
The double entry accounting system requires that every transaction post to two different accounts. For example, if you write a check for the power bill at your manufacturing plant, the two accounts that will be affected are cash and the utility expense account. In this example, cash will be credited, or decreased, and the expense will be debited, or increased. The primary principle behind double entry accounting is that every transaction balances each other.
There are three main types accounts in double entry accounting: assets, liabilities and stockholder equity. Assets generally are made up of cash, accounts receivable, inventory and fixed assets. Cash includes any and all money in bank accounts or petty cash. Accounts receivable is money that is owed to a business for goods or services that are either delivered or contracted to be delivered. Inventory is any goods that the business has in its possession for the purpose of resale. Fixed assets can be vehicles, buildings, equipment and furniture. Liabilities are monies owed for loans, lines of credit and accounts payable. Stockholder equity is essentially the total amount the owners have invested into the business plus any retained earnings from net income.
In double entry accounting, the two parts of the transaction are called a debit and a credit. Debits and credits affect each account differently. For example, to increase an asset amount you would debit the account. A decrease to an asset would be a credit. An increase to a liability is a credit and a decrease is a debit. For equity accounts a credit increases it and a debit decreases it. Expenses are decreased with credits and increased with debits.
The accounting equation ensures that every transaction is in balance. The equation states that assets must always be equal to the sum of liabilities and stockholder equity. For example, if you write a $5,000 check for the down payment on a new $20,000 car for your business, you will be crediting cash for $5,000 and debiting the fixed asset $20,000. The effect of these debits and credits is a net asset change of $15,000. The liability is the amount of the loan, which is also $15,000. Therefore, the assets equal the sum of the liabilities and stockholder equity.
Income increases the assets either by increasing cash or accounts receivable. Expenses are not directly captured within the accounting equation. Instead, they have an indirect affect on stockholder equity. Equity is either increased or decreased by the net of income minus expenses. At the end of an accounting period, this amount, which is also known as net income, is recorded into the equity part of the accounting equation as retained earnings.