BAFS Study Notes: The Double Entry System

Hello! Welcome to one of the most important topics in accounting: the Double Entry System. Don't worry if it sounds complicated – it's actually a very logical system, like a set of rules for a game. Once you understand it, you'll have the master key to understanding how businesses record and track their money.

In this chapter, we'll unlock the secrets of:

  • The fundamental Accounting Equation that keeps everything in balance.
  • The core principle of Double Entry – where every action has a reaction.
  • The golden rules of Debit and Credit.
  • How to record business transactions in ledger accounts, just like a real accountant!

Think of this as learning the grammar of the language of business. Let's get started!


1. The Foundation: The Accounting Equation

What on Earth is the Accounting Equation?

At its heart, accounting is all about a simple, powerful idea that must always be in balance. This idea is captured in the Accounting Equation.

The basic version is:

$$Assets = Liabilities + Capital$$

Let's break that down with a simple analogy. Imagine your own finances:

  • Assets: These are the resources a business OWNS. They have future economic value.
    Examples: Cash in your wallet, your mobile phone, a delivery van, a shop.
  • Liabilities: These are what a business OWES to other people or businesses. They are debts.
    Examples: Money you borrowed from a friend, a bank loan for a car.
  • Capital: This is what the business OWES to its owner. It represents the owner's investment or stake in the business.
    Example: The money you used from your own savings to start your small online shop.

So, the equation simply says: What you OWN = What you OWE to others + What you OWE to yourself (the owner). It makes perfect sense!

Seeing the Equation in Action

Let's see how this equation stays balanced with a few examples. Imagine you start a small tutoring business.

Transaction 1: You invest $10,000 of your own cash into the business.

  • The business's Assets (Cash) increase by $10,000.
  • The business now owes you (the owner) $10,000, so Capital increases by $10,000.
  • Equation: $10,000 (Assets) = $0 (Liabilities) + $10,000 (Capital) ... It balances!

Transaction 2: The business buys a computer for $8,000, paying with cash.

  • The business gains a new Asset (Computer) worth $8,000.
  • The business loses an Asset (Cash) of $8,000.
  • The total value of assets is still $10,000 ($2,000 Cash + $8,000 Computer). Nothing else changed!
  • Equation: $10,000 (Assets) = $0 (Liabilities) + $10,000 (Capital) ... Still balanced!

Transaction 3: The business takes a bank loan of $5,000 to buy more equipment later.

  • The business's Assets (Cash) increase by $5,000. Total assets are now $15,000.
  • The business now has a new debt, so Liabilities (Bank Loan) increase by $5,000.
  • Equation: $15,000 (Assets) = $5,000 (Liabilities) + $10,000 (Capital) ... And it's still perfectly balanced!
Did you know?

The concept of double entry bookkeeping has been around for centuries! It was first formally documented by an Italian mathematician named Luca Pacioli in 1494. He is often called the 'Father of Accounting'.

The Expanded Accounting Equation

Businesses exist to make a profit. Profit comes from earning Revenue (e.g., sales, service fees) and paying for Expenses (e.g., rent, salaries). How do these fit in? Simple! They both affect the owner's stake (Capital).

  • Revenue makes the business more valuable, so it increases Capital.
  • Expenses make the business less valuable, so they decrease Capital.

This gives us the Expanded Accounting Equation:

$$Assets = Liabilities + Capital + Revenue - Expenses$$

This is the full version that captures everything a business does. The HKDSE syllabus sometimes shows this rearranged as C = A – L – (R – E), which is just another way of saying that the owner's capital is what's left of the assets after all debts are paid and the year's profit (Revenue - Expenses) is accounted for.

Key Takeaway for Section 1

The Accounting Equation is the foundation of accounting. It must ALWAYS balance after every single transaction. It shows that what a business owns is always funded by what it owes to others and to its owner.


2. The Core Principle: Double Entry

Every Transaction has a Twin

The double entry system is built on a simple rule: For every business transaction, there are at least two effects. You can't just get something for nothing.

Think about it: when you buy a coffee, you receive a coffee (one effect) but you give away cash (a second effect). This "give and receive" or "cause and effect" is the heart of double entry.

In accounting, we call these two effects debit (Dr) and credit (Cr).

Introducing Debit (Dr) and Credit (Cr)

Don't worry if this seems tricky at first! This is the part that confuses most students, but we'll make it easy.

Forget what you know about 'debit cards' or 'credit cards'. In accounting:

  • Debit (Dr) simply means the LEFT side of an account.
  • Credit (Cr) simply means the RIGHT side of an account.

That's it! They are just directions. Every transaction will have a debit entry and a credit entry, and the golden rule is:

$$Total Debits = Total Credits$$

To keep track of these, we use something called a T-Account. It's a simple diagram that helps us visualise the debits and credits for each account (like Cash, Bank, Sales etc.).

A T-Account looks like this:

Account Name
___________________
Debit (Dr) | Credit (Cr)
(Left Side) | (Right Side)

The Golden Rules of Debit and Credit

So, how do we know whether to put an entry on the left (Debit) or right (Credit) side? We follow a set of rules. The best way to remember them is with a mnemonic: DEAD CLIC.

MEMORY AID: DEAD CLIC

DEAD helps you remember what to DEBIT.

  • Expenses
  • Assets
  • Drawings (when the owner takes money out)

For these accounts, an INCREASE is a DEBIT. A decrease is a Credit.

CLIC helps you remember what to CREDIT.

  • Capital
  • Liabilities
  • Income (Revenue)

For these accounts, an INCREASE is a CREDIT. A decrease is a Debit.

Quick Review Box: The Rules of the Game

To INCREASE an account:
- Debit an Asset account.
- Debit an Expense account.
- Credit a Liability account.
- Credit a Capital account.
- Credit a Revenue (Income) account.

To DECREASE an account, just do the opposite!

Key Takeaway for Section 2

Every transaction has two sides: a debit and a credit. The total debits must always equal the total credits. Your new best friend to remember the rules is DEAD CLIC.


3. Putting It All Together: Recording in Ledgers

What are Ledgers?

A ledger is the main book of accounts for a business. Think of it as a big folder. Inside this folder, there is a separate page for every single account the business has. Each "page" is a T-Account for things like Cash, Bank, Sales, Rent, a specific customer, a specific supplier, etc.

The process of recording transactions in these ledger accounts is called bookkeeping.

Step-by-Step Guide to Recording Transactions

Follow these 4 simple steps for any transaction, and you can't go wrong.

Step 1: Identify - What are the two accounts involved? (e.g., Cash and Sales)
Step 2: Classify - What type of account is each one? (e.g., Cash is an Asset, Sales is Revenue)
Step 3: Apply Rules - Use DEAD CLIC. Which one is debited? Which is credited? (e.g., Asset is increasing, so Debit Cash. Revenue is increasing, so Credit Sales)
Step 4: Record - Enter the amounts into the correct sides of the T-Accounts in the ledger.

Worked Examples - Let's Be Accountants!

Let's use our 4-step process on some common transactions.

Example 1: On Jan 1, the owner started the business with $50,000 cash.

  1. Identify: The two accounts are Cash and Capital.
  2. Classify: Cash is an Asset. Capital is Capital.
  3. Apply Rules: The business's assets are increasing, so we DEBIT Cash. The owner's stake is increasing, so we CREDIT Capital.
  4. Record:

Cash Account (Asset)
___________________
Dr           | Cr
Jan 1 Capital   $50,000 |

Capital Account (Capital)
___________________
Dr | Cr
| Jan 1 Cash   $50,000

Example 2: On Jan 5, the business purchased goods for $5,000 on credit from Supplier Chan.

  1. Identify: The accounts are Purchases and Accounts Payable (Supplier Chan).
  2. Classify: Purchases is an Expense. Accounts Payable is a Liability.
  3. Apply Rules: Expenses are increasing, so we DEBIT Purchases. We owe more money, so our liabilities are increasing. We CREDIT Accounts Payable.
  4. Record:

Purchases Account (Expense)
___________________
Dr                            | Cr
Jan 5 A/P (Chan)   $5,000 |

Accounts Payable (Supplier Chan) (Liability)
___________________
Dr | Cr
| Jan 5 Purchases   $5,000

Example 3: On Jan 10, paid rent of $2,000 by cash.

  1. Identify: The accounts are Rent Expense and Cash.
  2. Classify: Rent is an Expense. Cash is an Asset.
  3. Apply Rules: Expenses are increasing, so we DEBIT Rent Expense. Our cash asset is decreasing, so we CREDIT Cash.
  4. Record:

Rent Expense Account (Expense)
___________________
Dr           | Cr
Jan 10 Cash   $2,000 |

Cash Account (Asset)
___________________
Dr           | Cr
Jan 1 Capital   $50,000 | Jan 10 Rent   $2,000

Common Mistakes to Avoid
  • Reversing the entries: Accidentally crediting what you should have debited. Always double-check with DEAD CLIC!
  • Forgetting that a decrease is the opposite: Remember, decreasing an asset (like using cash) is a CREDIT. Decreasing a liability (like paying off a loan) is a DEBIT.
  • Single entry: Only recording one side of the transaction. Remember, every transaction must have a Dr and a Cr that are equal.
Key Takeaway for Section 3

Recording transactions is a systematic process. By following the Identify, Classify, Apply Rules, and Record steps, you can confidently handle any business transaction. Practice is the key to becoming fluent in the language of accounting!