Accounting is a profession as old as time. As long as humans have run businesses and lived in complex civilizations, there’s been a need for a rigorous and reliable method of reviewing and organizing company finances.
It’s not only death and taxes that are certain – bookkeeping can certainly join their esteemed ranks.
Double-entry accounting is one of the best ways to track and organize your company’s finances, helping to keep your accounts healthy. In this article, we’ll investigate:
- What double-entry accounting is
- How it differs from single-entry accounting
- Why it’s so important
What Is Double-Entry Accounting?
Double-entry accounting is an accounting system where every financial transaction is recorded twice in at least two accounts: the debit and the credit account. Together, it shows the money flowing in and out of your business.
This provides a check and balance for each transaction. Regular views, also known as a trial balance, mean accounts are checked to see if they are accurate. One of the major upsides of double-entry accounting is that it ensures top-level accuracy and can help prevent fraud and error.
When it comes to getting started with double-entry accounting, you should invest in accounting software. In fact, it’s worth getting behind the trend and exploring AI accounting software, which can use algorithms to analyze and predict data, automatically collect data from different sources, and provide insight into your company’s financial health.
Why Is Double-Entry Accounting Important for Businesses?
Double-entry accounting is essential for businesses because it provides a more comprehensive and accurate view of a company’s financial position than single-entry accounting. It allows businesses to:
- Track all financial activities: By recording both debits and credits, double-entry ensures every transaction is logged, giving a complete picture of the company’s finances.
- Prepare financial statements: It helps create balance sheets, income statements, and cash flow statements, which are crucial for making informed decisions.
- Comply with financial regulations: Double-entry bookkeeping is required by law for many businesses, especially tax compliance.
- Detect errors and fraud: Since evert entry affects at least two accounts, discrepancies are easier to spot, which minimizes the risk of fraud.
Understanding Double-Entry Accounting
Let’s dive a little deeper into what double-entry accounting actually is.
Double-entry accounting is an accounting system where every financial transaction is composed of two sides: a debit side and a credit side. Finances will be tracked in different accounts to account for money not yet received (accounts receivable) as well as money that has been paid (accounts payable) and goods that are held for sale (inventory).
As mentioned, double-entry accounting is an accounting system that provides two entries of a financial transaction. One of these entries shows the source of money of a transaction, whereas the other shows its destination.
The heart of the double-entry accounting method is based on this accounting equation:
Assets = liabilities + equity
To put this into plain English, the equation means that the total value of a company’s assets must be equal to its liabilities – meaning its debts owed – combined with its equity.
If a company has $10,000 in assets and $650 in liabilities, its equity must equal $9350. If these numbers don’t add up, a problem must be fixed somewhere.
This assets equation creates a business’s balance sheet, one of three vital financial statements used in bookkeeping alongside the income and cash flow statements. It’s called a balance sheet because all of a company’s assets must equal or balance any debts or liabilities used to finance them.
In an ideal world, assets amount to a higher sum than a company’s debt or liabilities, with the difference contributing to company equity. Equity constitutes the dollar value of a stake in the company, whether it’s a small business or a sprawling corporation with many different stakeholders.
The Different Accounts Used in Double-Entry Accounting
Now, let’s take a quick look at the five different types of accounts used in double-entry accounting:
- Asset account: This represents the resources of a business, such as cash, inventory, equipment, or accounts receivable.
- Liability accounts: This represents the debts of a business – think bank loans, accounts payable, credit cards, and customer credits.
- Income accounts: This represents business revenue, such as sales and interest income.
- Expense accounts: This represents business costs, including wages, rent, utilities, and phone bills.
- Equity accounts: This represents funds invested in the business and any profit left over after operation costs.
Debits and Credits In Double Entry Accounting
In double-entry accounting, debits, and credits are used to describe a transaction's different sides. Debits are recorded on the left-hand side of ledger sheets. They will either increase the asset and expense accounts or decrease the revenue, equity, and liability accounts.
An example may include money paid towards a bank loan – this debits (decreases) the revenue accounts. Indeed, an essential part of keeping track of debits is using business receipts. As these also act as proof of purchase, which is usually required, it's important that you set up a system for collecting and reviewing said receipts.
As for credits, these are recorded on the right-hand side of the ledger. They will either decrease the asset and expense accounts or increase the revenue, equity, and liability accounts. An example may include receiving payment for a service you provided – this credits (increases) the revenue account.
As you have seen, double-entry bookkeeping is an extensive and, at times, complicated method of tracking your company's finances. However, it is crucial for preparing accurate financial statements, such as balance sheets or income statements. In fact, the list of benefits is pretty extensive – but before we consider all the advantages (and potential downsides) to this method, it's time for a quick detour. Namely, what is the difference between single-entry and double-entry accounting?
How Do You Record Transactions in Double-Entry Accounting?
To record transactions in double-entry accounting, follow these steps:
- Identify the accounts involved: Determine which accounts will be affected by the transaction.
- Classify the transaction: Decide if the accounts will be debited or credited.
- Record the entry: Use your accounting software or general ledger to record the entry with a description of the transaction.
For example, if you buy $1,000 worth of inventory on credit:
- Debit: Inventory (Asset) $1,000
- Credit: Accounts Payable (Liability) $1,000
Single Entry Vs Double Entry Accounting
As the name suggests, single-entry accounting is a bookkeeping method where transactions are only recorded once. This can be either a debit or a credit in one account. In contrast, double-entry bookkeeping records each transaction twice in at least two accounts. This gives a more complete picture of a company’s finances and is typically used by larger businesses.
Single-entry accounting may be appropriate for very small businesses, as there is much less data and variables to account for. However, managing small business finances can present its own unique set of challenges, so be sure to implement structure. For example, establishing a financial plan, separating personal and business finances, and managing cash flows are also helpful tips.
Here are some more differences between single-entry and double-entry accounting:
Single-Entry Accounting Example
Single-entry accounting is a simplified method of tracking finances, much like maintaining a cash book. Each entry typically includes the date, transaction description, amount, and updated account balance.
For example, if you paid utilities and received a loan in October 2023 with an initial balance of $50,000, your cash book would reflect the following transactions:
While it may look like your business is $20,000 ahead of where it initially started at the beginning of the month, this table doesn’t tell the full picture. You still have $30,000 in liabilities, which you would need to pay back to the bank with interest. This is why single-entry accounting doesn’t work for most businesses.
Double-Entry Accounting Examples
Let’s take the same situation as above but now use a double-entry accounting system instead of a single entry.
Now you know that the bank loan has created $30,000 in liabilities. You also know you paid the utilities bill from our cash account. Money flowing in and out of your business now has a clear source and destination.
With that in mind, it’s now time to consider the benefits of double-entry accounting. In other words, why is this bookkeeping method so important?
Advantages Of Double Entry System
When it comes to double-entry accounting, there are innumerable benefits to enjoy. Let's explore them.
Improved Accuracy
By its very nature, double-entry accounting is an accounting system that encourages – in fact, demands – high levels of accuracy. Businesses can better track income and expenses with every transaction being recorded in at least two accounts. This accuracy also allows for better accountability, which helps establish trust across the company.
Enhanced Analysis
Double-entry accounting gives you an extensive understanding of your accounts and cash flow. This level of analysis is crucial for understanding your company's financial position. This deep understanding of your company's financial health will put you in a much stronger position when you need to make decisions (big or small). This may look like allocating resources or deciding to expand the business. Whatever it is, accurate financial data will be your guiding light.
Better Detection Of Errors And Fraud
When it comes to single-entry bookkeeping, there's much more scope for error – whether intentional or not. For example, a single-entry transaction can be removed; this mistake would go unnoticed with no other trace in the accounting system.
Double-entry bookkeeping dramatically diminishes the chance of this happening because transactions must be recorded in two separate records. Additionally, because this bookkeeping method creates different records for assets and liabilities, it's much harder for individuals to commit fraud.
Improved Transparency
With every transaction recorded twice, your company will have a clear record of all money entering and leaving your accounts. This level of transparency makes it easier for everyone in the company to understand the business's financial health. This, in turn, makes it easier for cooperation and accord when it comes to making joint business decisions.
Easier Tax Preparation
Double-entry bookkeeping creates detailed and extensive records of transactions. This makes preparing your taxes much easier when the time comes! Firstly, identifying and tracking transactions and expenses will be easy, which will help calculate deductions.
Better Lending
This method of bookkeeping allows for much more detailed financial statements. This gives outside actors, such as banks and investors, a reliable and accurate representation of your company's condition. This is crucial for securing lending or making equity investments.
However, there are some limitations when it comes to using double-entry bookkeeping:
- It's complicated. Double-entry bookkeeping deals with more accounts than single-entry bookkeeping and different accounting principles.
- It takes a lot of time.
- It's expensive, which can be off-putting for much smaller businesses.
With that in mind, double-entry accounting is still the best option for most companies. This is because this bookkeeping method provides a strong and structured process to account for your business's finances. Though it may take time to establish, the benefits are innumerable.
This structured, detailed approach is seen in many business areas, as companies try to slash wasted time and energy by getting things right the first time. Consider a sales department: many prefer to use a sales call script so that team members don't waste energy and imagination thinking up different opening lines. A script helps streamline customer conversations and provides a reliable structure for delivering results.
You can think of double-entry accounting similarly: by implementing structure from the very beginning, your company's finances will be much healthier.
What Is the Disadvantage of the Double-Entry Accounting System?
- Complexity: Double-entry bookkeeping is more complicated and requires knowledge of accounting principles.
- Time-Consuming: Recording each transaction in two accounts takes more time than single-entry systems.
- Costs: Professional accountants or advanced accounting software may be needed, which can be expensive for small businesses.
What Is an Example of Double Entry?
A company sells a product for $100 to a customer on credit. The company's accountant would record two journal entries for this transaction:
Debit: Accounts receivable - $100
Credit: Sales revenue - $100
This entry records the increase in accounts receivable (an asset) and the increase in sales revenue (an equity account).
Debit: Cost of goods sold - $50
Credit: Inventory - $50
This entry records the decrease in inventory (an asset) and the expense incurred in selling the product (cost of goods sold expense).
The total debits must equal the total credits in both journal entries, ensuring that the accounting equation (assets = liabilities + equity) remains balanced.
Also Read:
- 5 Bookkeeping Challenges (And How to Tackle Them With Confidence)
- The 21st Century Bookkeeper: What's Changed?
Double-Entry Bookkeeping: The Reliable Option
We hope we've convinced you that double-entry bookkeeping is the way for your company – unless you're running a single-person operation.
And fear not. You don't need to understand this complex system's ins and outs! In fact, we'd recommend bringing in an expert who is aware of financial regulations to navigate this world. Hiring an accountant allows you to relax (at least a little!) and focus on running your business.
Success awaits!
