The double-entry bookkeeping system is one of the standard systems used by small and large companies today. Actually, it has been used for more than 500 years, tracing it back to the merchants of Venice, and still remains relevant. This guide will provide you with all you need to know about how it is used, and why it works as an accounting system.
The Theory Behind Double-Entry Bookkeeping
At the core of double-entry bookkeeping is the concept that every transaction will involve at least two accounts, if not more. If a company takes out a loan, for example, its cash account will increase with the funds from that loan, but its liability account will also increase under the account category, known as loans payable. Similarly, if a company purchases a print ad, its cash account decreases while its expense account, under the account category of advertising expense, increases.
The main idea is to always keep a balance, so the double entry bookkeeping system can use what is known as the accounting equation. I like to call this “the financial compliance” equation. The equation looks like this:
Liabilities + Owner’s Equity = Assets
Let’s look at the equation in the context of the aforementioned print ad example. The expense of the ad—a liability—led to a decrease in owner’s equity through the disbursement of cash to pay for the ad.
Another component of the double-entry concept is that amounts that are entered as debits must equal those added as credits within general ledger accounts.
In each of these components, the overall idea is that every transaction results in two effects that must be accounted for, which is also known as the Duality Principle. This principle means that, even though a company is spending cash out of their accounts, they are gaining something in return, such as the ad, or something else (e.g. office equipment, supplies). Without acknowledging that there is an asset gained for every expense, an accounting system would only provide a very limited view of how a company manages its money.
Every transaction is entered into a general ledger sheet or document—a balance sheet ledger account (asset, liability, and equity components) or income statement ledger account (income and expenditures) — which has columns for debit entries and credit entries:
- Debit entries, which are on the left side of a transaction, create certain effects, such as an increase in expenses or assets and a decrease in income, equity or liability.
- On the credit entry side, which is on the right side of a transaction, other effects occur, including a decrease in expenses or assets and an increase in income, equity or liability.
Application of the Double-Entry Accounting System
To illustrate what this theory means as part of real-world accounting, here are some examples of how it is applied:
- Purchasing a piece of equipment with cash would show a debit for the equipment and a credit for the cash, which results in a decrease in assets.
- Receiving interest from depositing money into a business bank account would result in a debit for the cash received with an accompanying credit for finance income, which would mean an increase in income.
- Issuing ordinary shares in your business for cash would result in a debit for the cash received and represent an increase in assets while there would be a credit for share capital, representing an increase in equity.
- Receiving bank loan principal from a loan would be a debit for the cash received and result in an increase in assets while the credit would be to the bank loan account and represent an increase in liability.
- Paying an electricity bill would be entered as a debit under utility expense and result in an increase in expense while a credit would be added to cash and result in a decrease in assets.
While generally straightforward, these entries can become increasingly complex when more than two accounts are involved.
Set-Up and Standard Practice for Double-Entry Accounting
When setting up financial records for a business, it’s important to create a detailed listing known as a chart of accounts. Typically, accounting software provides suggestions on the typical type of accounts that a business may require.
Once that is set up, the chart of accounts is used as a point of reference each time two or more accounts are selected in order to enter a transaction into the general ledger. Along the way, more accounts may be added to the chart of accounts while others may be deleted if you realize they will never be used.
Typically, the first entry is the account and amount that must be debited. The next line shows the account and amount that needs to be credited, which is indented so it can be easily distinguished from its accompanying entry. Each of these two-line entries is known as a general journal entry.
Thanks to accounting software, this is done automatically as you enter amounts and designate which account it is connected to. Even better is the fact that accounting software can automatically generate these entries when a sales invoice or a check is prepared. Using software to help manage common tasks like invoicing and expense tracking improves accuracy while also saving time.
Further Advantages of Double-Entry Bookkeeping
There are many advantages to using double entry bookkeeping. This includes the ability to catch math mistakes and the benefit of having detailed financial information that offers insights into financial performance. It also speeds up the process of compiling data relevant to making key financial statements, such as an income statement and net worth statement.
With these advantages, it makes sense to leverage this bookkeeping method for your business. While it will take time to master, there are numerous guides, tutorials, and tips online that can help.