Managing a business's finances can often feel overwhelming, especially when it comes to keeping the books balanced and accurate. That's where double entry accounting comes in. It's a reliable method that has stood the test of time, ensuring every transaction is accurately recorded and reported. 

But what exactly is double entry accounting?

Whether you’re a solopreneur or a mid-size business owner in Canada, understanding double entry accounting is vital for maintaining financial clarity and compliance.

• In this guide, we’ll explore what double entry accounting is, how it works, and why it’s essential for your business’s success.

Table of contents

1. What is double entry accounting?
2. Why double entry accounting is important
3. The basic principles of double entry accounting
4. A double entry accounting example for small businesses
5. How to implement double entry accounting in your business
6. Common mistakes to avoid in double entry accounting
7. FAQ

What is double entry accounting?

Double entry accounting is a bookkeeping system that requires every financial transaction to be recorded in at least two accounts: a debit in one and a corresponding credit in another.

This method ensures that the accounting equation (Assets = Liabilities + Equity) always remains balanced, providing a clear picture of a business's financial health.

Every accounting entry must also be balanced, meaning the total amount debited must equal the total amount credited. For instance, if a business owner purchases office supplies worth $200 using cash, the transaction would require recording a debit of $200 to the Supplies account (an asset) and a corresponding credit of $200 to the Cash account (also an asset). This dual recording captures both the increase in supplies and the decrease in cash, maintaining the balance of the books.

By requiring each transaction to affect at least two accounts, double entry accounting provides a comprehensive view of a business's financial activities. This approach not only helps in detecting errors — such as an unbalanced entry — but also in preventing fraud by creating a clear audit trail.

For businesses, particularly small and mid-sized enterprises in Canada, using double entry accounting is crucial for generating accurate financial statements, assessing financial performance, and making informed decisions based on a complete financial picture.

Why double entry accounting is important

Double entry accounting is more than just a bookkeeping requirement — it’s a critical tool for maintaining financial accuracy. This system helps businesses avoid errors, detect fraud, and prepare accurate financial statements, which are crucial for decision-making and compliance with Canadian financial regulations.

Under generally accepted accounting principles (GAAP), double entry accounting is considered the best practice for ensuring accuracy, transparency, and compliance in financial reporting. This system is particularly essential for corporations, larger businesses, and any entity required to produce audited financial statements or file corporate tax returns.

For very small businesses, particularly sole proprietorships and partnerships with simple transactions and low volumes, single entry accounting is technically permissible under certain conditions.

Single entry accounting, which records each transaction only once (typically in a cash book), may be sufficient for internal purposes or tax reporting for these smaller entities. Nonetheless, it lacks the checks and balances of double entry accounting and is not sufficient for businesses that need to produce comprehensive financial statements.

In practice, double entry accounting is highly recommended, even for small businesses, because it provides a more accurate and complete financial picture, aids in financial decision-making, and ensures compliance with both tax regulations and GAAP.

The basic principles of double entry accounting

To fully grasp the importance of double entry accounting, it's essential to understand its foundational principles, like the accounting equation and debits and credits.

The accounting equation

At the heart of double entry accounting is the accounting equation: Assets = Liabilities + Equity. Every transaction affects at least two of these accounts, ensuring the equation always stays in balance.

Assets are resources owned by a business that have economic value and are expected to provide future benefits. They represent what the business owns or controls, which can generate cash flow or reduce expenses. Assets can be tangible, like cash, inventory, property, and equipment, or intangible, like patents, trademarks, and goodwill.

Liabilities are the financial obligations or debts that a business owes to outside parties, such as lenders, suppliers, or other creditors. They represent what the business owes and are typically settled over time through the transfer of economic benefits, including money, goods, or services.

These financial obligations can be short-term, such as accounts payable or short-term loans, which are due within a year, or long-term, such as mortgages or bonds payable, which extend beyond one year. Managing liabilities is essential for maintaining a healthy cash flow and ensuring the business can meet its financial obligations.

Equity, also known as owner's equity or shareholders' equity, represents the owner's or shareholders' residual interest in the assets of the business after deducting liabilities. It reflects the net value of the business.

Equity can come from two main sources: capital contributed by the owners, and retained earnings, which are the cumulative profits that have been reinvested in the business rather than distributed as dividends. Equity is a key measure of a company's financial health and stability, indicating the portion of the company that is owned outright by its investors and not encumbered by debt.

Together, assets, liabilities, and equity provide a complete picture of a business's financial position.

Debits and credits

In double entry accounting, debits and credits are used to make changes to the accounting equation. For every debit entry made to one account, a corresponding credit entry must be made to another. Understanding how these entries work is key to mastering double entry accounting.

Debits increase the balance in an asset account, while credits decrease the balance in an asset account. For example, when a business purchases equipment for $1,000, it records a debit to the Equipment account (an asset) for $1,000, reflecting an increase in assets. If the business used cash to pay for the equipment, it would record a credit to the Cash account (another asset), reflecting a decrease in cash.

Credits increase balances in liability accounts, while debits decrease liability balances. If a business takes out a loan for $5,000, it records a credit to the Loans Payable account (a liability) for $5,000, indicating an increase in liabilities. The other side of the entry for this transaction would be a debit to the Cash account (an asset) for $5,000, recording the increase in cash as a result of the loan.

For equity accounts, credits increase the balance, while debits decrease it. When the business earns a profit, it is recorded as a credit to the Retained Earnings account (an equity account), increasing equity. If the business pays dividends to shareholders, this is recorded as a debit to Retained Earnings, reducing equity.

A double entry accounting example for small businesses

To better understand how double entry accounting works, let's look at a practical example for a small business.

Imagine a Canadian bakery called Sweet Treats that sells baked goods both in-store and online. Here’s how double entry accounting would handle a simple transaction: purchasing ingredients.

Step 1: Recording the transaction

Sweet Treats decides to buy $500 worth of flour, sugar, and other baking ingredients from a local supplier. This transaction affects two accounts in the bakery’s books:

1. Inventory (an asset account): Sweet Treats' inventory of ingredients increases by $500.

2. Cash (an asset account): The business’s cash decreases by $500 to pay for the ingredients.

Step 2: Making the entries

In double entry accounting, every transaction involves a debit to one account and a credit to another.

Here’s how Sweet Treats records the purchase:

Debit the Inventory account for $500: This increases the inventory on hand, reflecting the new ingredients purchased.

Credit the Cash account for $500: This decreases the cash available, showing the payment made to the supplier.

Step 3: Ensuring the accounts balance

After the transaction is recorded, the total debits and credits must balance.

In this case, both the Inventory and Cash accounts are asset accounts, and the $500 debit to Inventory is perfectly balanced by the $500 credit to Cash.

This keeps the accounting equation (Assets = Liabilities + Equity) in balance and provides an accurate picture of the bakery's financial position.

Step 4: Reflecting the impact on financial statements

By using double entry accounting, Sweet Treats ensures all transactions are accurately reflected in its financial statements. The increase in inventory will be shown on the balance sheet as a current asset, while the decrease in cash will also be reflected in the assets section.

This method not only provides a clear view of the bakery's financial health, but also helps the business track its cash flow and manage inventory effectively.

How to implement double entry accounting in your business

If you’re new to double entry accounting, the idea of tracking every transaction in two places might seem daunting. However, with a step-by-step approach, you can easily implement this system and gain a clearer understanding of your business’s financial health.

Here are six steps to getting started with double entry accounting for your business:

Step 1: Set up a chart of accounts

The first step is to create a chart of accounts, which is a comprehensive list of all the accounts your business will use to record transactions. These accounts are typically categorized into five main types: assets, liabilities, equity, revenue, and expenses.

The chart of accounts should be tailored to your specific business needs, ensuring that all types of transactions your business might encounter are covered.

For example, common asset accounts include Cash, Accounts Receivable, and Inventory, while liability accounts might include Accounts Payable and Loans Payable. If you don't sell products, you don't need to include an inventory account.

Step 2: Understand how debits and credits work

Before you begin recording transactions, it’s crucial to understand how debits and credits affect different types of accounts. Knowing this, you can determine how each transaction will impact your accounts.

For instance, if you receive cash from a customer, you would debit the Cash account (an asset) and credit the Sales Revenue account (a revenue account).

Step 3: Record transactions properly

Every transaction should be recorded in a journal entry that includes both a debit and a credit.

To make this easier:

• Identify the accounts involved: Determine which accounts are affected by the transaction. For example, if you purchase office supplies with cash, you will use the Office Supplies account (an asset) and the Cash account (an asset).
• Decide on debits and credits: Decide which account is debited and which is credited. In this case, you would debit Office Supplies to increase your asset and credit Cash to decrease your asset.
• Enter the amounts: Make sure the amount entered as a debit is equal to the amount entered as a credit, ensuring your books remain balanced.

Step 4: Use accounting software to streamline the process

While it’s possible to implement double entry accounting manually, using accounting tools like QuickBooks can significantly simplify the process. These tools automate many aspects of double entry accounting, such as categorizing transactions and generating financial reports. This not only saves time, but also reduces the risk of errors that can occur with manual bookkeeping.

Step 5: Review and reconcile accounts regularly

To maintain accuracy, it’s important to review and reconcile your accounts regularly. Reconciliation involves comparing your records to external statements, like bank statements, to ensure all transactions have been recorded correctly. This process helps identify and correct any discrepancies early on, ensuring your financial statements are accurate and reliable.

Step 6: Seek professional guidance if needed

If you’re unsure about implementing double entry accounting on your own, consider consulting with a professional accountant. They can provide valuable insights tailored to your specific business needs and help you set up your accounting system correctly from the start.

Additionally, many accountants offer training and support to help you and your team understand the principles of double entry accounting.

By following these steps, you can successfully implement double entry accounting in your business, providing a solid foundation for accurate financial management and informed decision-making. This method not only enhances financial transparency but also supports compliance with Canadian accounting standards, setting your business up for long-term success.

Common mistakes to avoid in double entry accounting

Even experienced accountants can make mistakes. Some common pitfalls to watch out for when it comes to double entry accounting include failing to balance accounts, incorrectly categorizing transactions, and overlooking adjustments. Tools like QuickBooks have built-in checks to help ensure this doesn't happen.

Double entry accounting may seem complex at first, but it’s a powerful tool for maintaining your business's financial health. By understanding the basics and implementing this method, you can ensure accuracy and compliance in your financial reporting.

Ready to take control of your business finances? Explore how QuickBooks can simplify double entry accounting for your business today.