Understanding Double Entry Accounting

Written, February 2009

Don HofstrandDon Hofstrand                                 
Co-Director, AgMRC

Iowa State University Extension
dhof@iastate.edu

Laura Hofstrand
Accountant

Des Moines Diocese, Catholic Church

Farm families have traditionally used the single entry (often referred to as cash) method of accounting for their farm business.  This is a relatively simple method of accounting where items are listed as income and expenses when a cash transaction occurs.  For example, grain is recorded as income when it is converted to cash, that is, sold and delivered.  Also, production inputs like seed, feed and fertilizer are recorded as expenses when they are paid for rather than when they are used or ordered.


The single entry method of accounting does a poor job of recording the true profitability of a business within or between accounting periods.  For example, crops can be sold in a year other than when they are grown and expenses can be paid in the year before or after the inputs are used.

To correct this problem, cash accounting uses an adjustment where inventories of production inputs and inventories of crops and livestock are taken at the beginning and end of the accounting period (e.g. calendar year) to adjust the income statement to a form of accrual accounting.  The inventories shift production inputs and inventories of crops and livestock into the year in which they are used or produced rather than when they are purchased or sold. 

Double entry accounting goes a step further.  Every time an income or expense transaction occurs and an entry is made, the net worth statement is updated at the same time.

The two financial statements encompassed in double entry accounting are the net worth statement (also called the balance sheet or equity statement) and the income statement (also called the profit and loss statement).  Actually the income statement becomes part of the net worth statement, as described below. 

Traditionally, in single entry accounting, the net worth statement is only prepared or updated at a specific point in time.  Often this is the beginning of a new year.  The net worth statement is usually not updated again until the following year.  In double entry accounting, the net worth statement is updated every time an entry is made.  So the balance sheet changes from being a static financial statement (updated only periodically) to a dynamic financial statement that is always current.

In double entry accounting, the net worth statement is constructed using cost basis values rather than market values.  This means that assets are valued at their original cost (adjusted for depreciation) rather than their current market value.  So net worth or equity only increased or decreases as a result of profit or loss from the business, or from a non-business cash infusion or withdrawal. 

With single entry accounting, the profit or loss for the accounting period is transferred from the income statement to the balance sheet when a new balance sheet is prepared, usually on January 1.  With double entry accounting, the income statement is part of the equity section of the net worth statement, so net worth is updated every time an entry is made. As a result, the equity portion of the net worth statement increases or decreases every time revenues or expenses are posted.  Noncash income, such as grain placed into storage, can be entered when harvest is completed.  Noncash expenses, such as depreciation, are usually entered at the end of the accounting year.    

Net Worth Statement (Balance Sheet)

In its standard format, assets are listed on the left side of the new worth statement and liabilities and equity are listed on the right side.  The statement balances (hence the balance sheet title) because the assets on the left side equal liabilities plus equity on the right side.

Assets = Liabilities + Owners Equity (net worth)

T ACCOUNTS

Double entry accounting utilizes “T” accounts.  The name of the account is listed on the top of the T.  The debit is always the listing on the left side of the account and the credit is always the listing on the right side.  Actually the words left and right could be substituted for debt and credit.

Name of Account
Debit          Credit

A basic rule of double entry accounting is that an amount that is entered as a debit must also be entered as a credit in a different account.  For example, a $2,000 entry as a debit in account one is also entered as a credit in account two.  This keeps the books “in balance”.

Account One
Debit          Credit
$2,000                      

Account Two
Debit          Credit
                    $2,000

The amounts can be split among two or more accounts, but the total amount entered as debit must always equal the total amount entered as credit.

Account One
Debit          Credit
$3,000                      

Account Two
Debit          Credit
$1,000                      
   
Account Three
Debit          Credit
                         $2,000      

Account Four
Debit          Credit
                    $2,000
 

Asset Accounts
A debit in an asset account will increase the account balance.  Conversely, a credit in an asset account will decrease the account balance. 

Account 1
Debit          Credit
+                   -

Example Transaction 1   
For example, a farmer purchases $1,000 of seed corn and writes a check for the amount.  The Seed Corn Inventory asset account is debited (increased) by $1,000 and the Cash asset account is credited (decreased) by $1,000.  This results in a $1,000 increase in seed corn inventory and a $1,000 decrease in cash.

Seed Corn Inventory
Debit (+)          Credit (-)
$1,000                       

Cash
Debit (+)          Credit (-)
                           $1,000

Example Transaction 2       
The seed corn is held in inventory until it is planted.  At that time the Seed Corn Inventory asset account is credited by $1,000 and the Growing Corn asset account is debited by $1,000.  The seed corn is no longer in inventory but part of the growing corn crop.  The balance in the Seed Corn Inventory account is now zero.

Seed Corn Inventory
Debit (+)             Credit (-)
$1,000                  $1,000
                                  0

Growing Corn
Debit (+)              Credit (-)
$1,000                            

Example Transaction 3   
Other production inputs such as the application of fertilizer are moved from inventory asset accounts to the Growing Corn asset account when the fertilizer is applied.  In the example below, $2,000 of fertilizer is applied.  Assuming this was the amount of fertilizer previously in the account, the Fertilizer Inventory asset account is now reduced to zero.  The Growing Corn account is now $3,000.

Fertilizer Inventory
Debit (+)          Credit (-)
$2,000               $2,000
                               0   

Growing Corn
Debit (+)            Credit (-)
$1,000                         
$2,000                         
$3,000                         

Example Transaction 4   
When the corn is harvested and placed in storage, the entire amount in the Growing Corn asset account is debited and the Corn Inventory asset account is credited.  The Growing Corn asset account is reduced to zero and the Corn Inventory asset account contains the value of the corn based not on market value of the corn but on the value of the production inputs invested in growing the crop.

Growing Corn
Debit (+)           Credit (-)
$3,000               $3,000
                             0

Corn Inventory
Debit (+)            Credit (-)
$3,000                           

Note that through this entire process the total asset value has not changed.  In every entry, when an individual asset account is increased, another asset account is decreased by the same amount, leaving     the total value of the assets unchanged.  The value of the corn is not changed to its market value until the corn is sold.  At this time the profit (loss) is transferred to the income statement portion of the equity account.
   
Liability Accounts
Contrary to an asset account, a debit in a liability account will decrease the account.  Conversely, a credit in a liability account will increase the account.

                                                    Assets                                                                         Liabilities

                                                  Account 1                                                                      Account 2
                                             Debit    Credit                                                                Debit    Credit
                                                +            -                                                                            -           +

Example Transaction 5   
Using the example above, assume that the seed corn is purchased on account.  Once again the Seed Corn Inventory asset account is debited  and increased).  But now the Accounts Payable liability account is credited and also increased.

Seed Corn Inventory
Debit (+)            Credit (-)
$1,000                           

Accounts Payable
Debit (-)            Credit (+)
                           $1,000

Using the equation “Assets – Liabilities = Equity”, note that when the Seed Corn Inventory asset account is increased, the Accounts Payable liability account is also increased by the same amount.  So the increase in assets is offset by an equal increase in liabilities, leaving equity unchanged.  

Example Transaction 6   
When the seed corn is paid for, the Accounts Payable liability account is debited (decreased) and the Cash asset account is credited (decreased).  The Accounts Payable liability account is now zero.

Cash
Debit (+)             Credit (-)
                               $1,000

Accounts Payable
Debit (-)            Credit (+)
$1,000                 $1,000
                                  0   

Once again the two entries offset each other leaving equity unchanged.

Equity Accounts

The equity accounts are structured similar to the liability accounts.  Debiting an equity account decreases the account and crediting it increases the account.  Several types of equity accounts can be created.  For example, retained earnings is an equity account that contains profits from previous years that are kept in the business. 

                                                Asset Accounts                                                  Liability Accounts

                                           Debit                Credit                                             Debit                  Credit
                                               +                        -                                                      -                            +

                                                                                                                                   Equity Accounts

                                                                                                                            Debit                    Credit
                                                                                                                                 -                            +

Income Statement

The Income Statement records revenues and expenses and shows the profits (losses) generated by the business.  The formula for the income statement is shown below.

Revenues (income) – Expenses = Profit (Loss)

Instead of a document separate from the net worth statement, the income statement can be part of the equity section of the net worth statement.  Revenues increase equity and expenses decrease it.  So expenses debit (decrease) the equity account and are listed on the left side, and revenues credit (increase) the equity account and are listed on the right side. 

                                                  Asset Accounts                                              Liability Accounts

                                                Debit            Credit                                            Debit            Credit
                                                   +                      -                                                     -                   +

                                                                                                                               Equity Accounts

                                                                                                               Debit (expense)     Credit (revenue)

                                                                                                                              -                               +

However, in addition to being part of an equity account, revenue is also a category of accounts.  For individual revenue accounts, a debit decreases the account and a credit increases it.  So, crediting a revenue account increases revenue which subsequently increases equity because a revenue account increases the equity account.  Conversely, debiting a revenue account decreases revenue which subsequently decreases equity.

Likewise, in addition to being part of an equity account, expense is also a category of accounts.  For individual expense accounts, a debit increases an expense account and a credit decreases it.  So, debiting an expense account increases expenses which subsequently decreases equity because an expenses account debits (decreases) the equity account. Also, crediting an expense account decreases expense which subsequently increases equity.

                                                Asset Accounts                                              Liability Accounts

                                              Debit                Credit                                          Debit            Credit
                                                 +                         -                                                    -                     +

                                                                                                                              Equity Accounts

                                                                                                    Expense Accounts (-)    Revenue Accounts (+)       
                                                                                                      Debit          Credit               Debit            Credit
                                                                                                          +                 -                          -                   +

Example Transaction 7   
Continuing the example from above, when the corn in the Corn Inventory asset account is sold, the following transactions occur.  First the production expense of $3,000 (seed and fertilizer) that has been carried forward into the Corn Inventory asset account is credited and this account becomes zero.  The Corn Expense account that is one of the expense accounts that is part of an Equity Account is debited.  This increases an expense account that, in turn, decreases an equity account. 

Corn Inventory
Debit (+)            Credit (-)
$3,000                 $3,000
0                           

Corn Expense
Debit (+)           Credit (-)
$3,000                           

Example Transaction 8   
Next, the sale value of the corn (e.g. $5,000) is debited to the Cash asset account and credited to the Corn Sales revenue account.  So both the cash and corn sales accounts increase by $5,000. 

Cash
Debit (+)            Credit (-)
$5,000                           

Corn Sales
Debit (-)             Credit (+)
                         $5,000

The result is that total assets increase by $2,000 because $3,000 of corn inventory is converted to $5,000 of cash, and equity is increased by $2,000 because $3,000 of expenses and $5,000 of revenues are posted to total equity.  The balance in the net worth statement is maintained.

Example Transaction Summary
A layout of all of the transactions and their respective T accounts is shown below.  The number of the transaction is shown in parenthesis so you can follow the progression of how the transactions occurred. 

                                     Assets                                                                                    Liabilities

                                                   Cash                                                                                      Accounts Payable
                                   Debit (+)        Credit (-)                                                                  Debit (-)            Credit (+)
                                  $5,000 (8)    $1,000 (2)                                                              $1,000 (2)          $1,000 (1)
                                  $2,000 (3)                                                                                     
                                  $3,000                                                                                         
                                                                                                                                                            Equity       
                                    Seed Corn Inventory                                                               Expenses               Revenues       
                                   Debit (+)        Credit (-)                                                                                                              
                                    1,000 (1)      $1,000 (4)                                                       Corn Expense              Corn Sales
                                                                                                                              Debit (+)    Credit (-)       Debit (-)   Credit (+)
                                                                                                                             $3,000 (7)                                          $5,000 (8)
                                    Fertilizer Inventory                                                                                                                  
                                   Debit (+)          Credit (-)                                                                                                                
                                  $2,000 (3)       $2,000 (5)                                                                                                              

                                         Growing Corn                                                                                                                  
                                   Debit (+)           Credit (-)                                                                                                            
                                  $1,000 (4)        $3,000 (6)                                                                                                            
                                  $2,000 (5)                                                                                                                                      
                                  $3,000                                                                                                                                           

                                         Corn Inventory                                                                                                               
                                   Debit (+)           Credit (-)                                                                                                            
                                  $3,000 (6)          $3,000 (7)                                                                                                          

The debits and credits offset each other in all but three of the accounts.  Equity is increased by $2,000 because revenue is increased by $5,000 and expenses are increased by $3,000.  Likewise cash is increased by $2,000. 

                                  Assets                                                                                                Equity
                                                                                                                                           Expenses               Revenue

                                                Cash                                                                               Corn Expense          Corn Revenue
                                   Debit (+)    Credit (-)                                                              Debit (+)    Credit (-)    Debit (-)    Credit (+)
                                   $5,000         $3,000                                                               $3,000                                                $5,000
                                   $2,000                                                                                                                                      

The Net Worth Statement is still in balance because assets are increased by $2,000 and equity is also increased by $2,000.

                                 Assets                                                                                             Equity
                                   Debit (+)           Credit (-)                                                                    Debit (-)