The amount of accounting methods known to man are vast and complicated. It can take decades of study to thoroughly understand the inner workings of the different financial systems and regulations. However, one accounting system that offers a straightforward approach to financial record keeping is the double-entry system.
Double-entry accounting, also known as double-entry bookkeeping, is the standard method of recording transactions in two or more account entries. Just like the name suggests, every transaction will be accounted for in two entries to your account ledger.
So how can you use this accounting method effectively for your small business finances?
What is the Purpose of Double-Entry Accounting?
The double-entry accounting method falls under the generally accepted accounting principles or GAAP. It is one of the most efficient and accurate ways of tracking financial records- especially for small businesses. Therefore the purpose behind using this method is to ensure accurate and balanced financial record keeping for companies. This system allows for straightforward calculations of a business’s equity and liabilities equity.
What are the two rules of double-entry accounting method?
The two rules of double-entry accounting refer to the systematic recording of transactions using debits and credits. For every transaction completed in your business, you must debit one account and credit another for the same amount.
Therefore the total debit amount must equal the total credit amount for every transaction made.
Debit vs. Credit
So what are debits and credits? A debit is a recorded entry on the left-hand side of your account, while a credit is a recorded entry on the right-hand side of an account. Some hold to the preconceived notion that debits are always bad, and credits are always good. However, debits and credits are neither good nor bad in double-entry bookkeeping. They are just separate classes of numbers.
History of the debit and credit system
The origins of the debit and credit system dates back to the late fifteenth century. A Venetian monk by the name of Luca Pacioli is considered the father of modern accounting when he published a math encyclopedia in 1494, instructing people in the way of the double entry accounting equation.
Pacioli’s instructional book was circulated throughout the world and became the standard accounting method used by virtually everyone today. Even Leonardo da Vinci read and was fascinated by this book!
What Types of Accounts are Needed for this System
This double-entry system can only work when applied to accounts. So, what type of accounts can be credited and debited accordingly? Here are the seven types of accounts that all financial transactions can be classified under:
- Equity (owner or shareholder)
- Revenue / Income
A debit entry will signify either an increase in assets or a decrease in liabilities for your company. A credit entry, on the other hand, will mean an increase in liabilities or equities, or a decrease in assets or expenses. Find these accounts within your balance sheets and income statements.
Drawing out a T-account can help you visualize and perfect this debit and credit entry method. As the name suggests, to create this visualization, draw a capital letter T on paper. This will give you room to place the account type at the top of the T while creating a left side and right side for your corresponding debit and credit entries.
Therefore, you would need two T-accounts: one showing your credit entry, and another confirming your debit entry. Using this visual is a quick and easy way to practice double-entry bookkeeping practices.
Examples of Double-Entry Accounting
For this method to work, you will have to record these entries in the proper financial statements, including your balance sheet and income statement. Check out this double-entry accounting example below.
If this were the ledger of a small business, we can see that they sold a service for $500. This means that on their balance sheet, their assets would be debited, and their revenue, or sales, would be credited. The next Assets entry shows that the business needed to pay their utility bills, so they therefore credited their assets, or cash, $300, and debited their expenses $300.
Finally, the vendor payable entry shows the business had to pay a vendor for more inventory, meaning their account was credited for the $450, while assets increased, and were debited $450.
Your accounts must always have the debit amount equal to the credit amount for this method to work. Proper recording of transactions in this way will mean an accurate tracking of cash flow and an overall balanced financial depiction of your small business.
To ensure your company’s financial statements are in order and accurately track your expenses and income, you’ll need the right accounting software to do the job. Manage your finances precisely, all in one place with Intuit QuickBooks – try it free today.