One question that confuses many beginners is why every accounting transaction has two effects. To answer this question, we need to understand how the double-entry system deals with business transactions.
Every transaction has at least two effects on the elements of financial statements. This is because each element is linked to one another in a way that a transaction cannot affect a single account in isolation without having another effect somewhere in the accounting books.
Don’t worry if this short answer is not making a lot of sense at the moment. In the following sections, I will explain the underlying accounting concepts to tackle the question from different angles, so make sure to stick till the end!
Before the double-entry system was invented, businesses used the single-entry system to record their payments and receipts. The problem with this system is that you cannot track accurate financial data of businesses because of the omission of critical aspects of transactions.
The accounting system has since evolved to account for the dual nature of business transactions, which we explore in the next section.
Duality of Accounting Transactions
A ‘transaction’ in accounting refers to the interaction between the various elements of financial statements. For example, when a business borrows a bank loan, the transaction is the interaction between the assets (cash at bank) of a business and its liabilities (loan from the bank).
The duality of transactions is not a new concept. Duality is present in all economic transactions of our daily lives. For example, when you buy a bar of chocolate from the grocery store, you are exchanging one thing (cash) with something else (a chocolate bar).
Duality requires us to reflect all aspects of a transaction in the financial statements, not just the obvious ones. For example, if a business acquires a delivery van, the accounting entries need to specify whether the asset was purchased from the bank account, cash in hand, exchanged with another vehicle, or if it was just hired on a lease. For completeness of information, the accounting entries should state both effects of the transaction: the increase in assets of the business as well as an explanation of its source.
Limiting the accounting to a single entry removes critical information from the financial statements, which is why all accounting transactions have at least two effects in a double-entry system.
Relationship of Accounting Elements
There are five main elements of financial statements that include assets, liabilities, equity, income, and expenses. These are the building blocks of accounting that make up the financial statements.
Elements of financial statements are not isolated sections of information but are closely linked to one another.
For example, when a business incurs an expense, the transaction affects other elements as well, such as:
- A decrease in assets that have paid for the incurred expense.
- An increasing in liabilities in case the expense is unpaid.
- A decrease in the owners’ equity.
Similarly, when a business earns revenue, it affects not only the income but also the assets and equity of the business.
You can think of financial statements as a network of accounting elements where a single transaction can cause multiple effects.
Not all accounting transactions affect multiple elements, however.
Sometimes, an accounting transaction affects the accounts of the same element.
An example of this will be the payment by a debtor of a business. In such a case, one asset account is increased (cash/bank) while another asset account is reduced (receivable), leaving the overall amount of assets unchanged.
Whether a transaction affects a single account, multiple accounts of the same element, or multiple accounts of multiple elements, there needs to be a minimum of two effects.
Double-entry accounting prohibits recording the sole impact of a transaction in the absence of another effect somewhere in the accounting books.
Dual Aspect Concept
The double-entry system divides the accounting ledger into two sides.
One effect of the transaction is recorded on the left (debit) side of the accounting ledger. These include:
- Increase in assets and expenses, and
- A decrease in liabilities, income, and equity.
The other effect is recorded on the right (credit) side, which includes:
- Increase in liabilities, income, and equity, and
- A decrease in assets and expenses.
- Income from sales
- A loan from a creditor
- Investment by the owner
- A decrease in another asset
Ben owns a fleet of taxis. He is learning accountancy so that he can prepare the financial statements for his business.
Can you suggest the double entries for the following transactions and their impact on the different elements of financial statements?
a) Purchase of a used car to add to the fleet of taxis by paying in cash.
Debit Motor Vehicles (Increase in assets)
Credit Cash in hand (Decrease in assets)
b) Cash payment to the city council for renewing the fleet’s certificate of fitness.
Debit Licence fees (Increase in expenses)
Credit Cash in hand (Decrease in assets)
c) Borrowing money from the bank.
Debit Cash at bank (Increase in assets)
Credit Bank loan (Increase in liabilities)
d) Withdrawal of cash from the business bank account for Ben’s personal use.
Debit Owner’ capital (Decrease in equity)
Credit Cash at bank (Decrease in assets)
e) Depreciation of taxis.
Debit Depreciation expense (Increase in expenses)
Credit Accumulated Depreciation (Decrease in assets)