Double-entry bookkeeping is a hugely important concept that drives every accounting transaction and a company’s financial reporting. Business owners must understand this concept to manage their accounting process and to analyze financial results. Use this guide to review the double-entry bookkeeping system and post accounting transactions correctly.
What Is Bookkeeping?
The term bookkeeping refers to the record keeping process every business must manage. A bookkeeper reviews source documents and uses those documents to post accounting transactions. If a business ships a product to a customer, for example, the bookkeeper will use the customer invoice to record revenue for the sale and to post an accounts receivable entry for the amount owed.
Linking each accounting entry to a source document is important, because the process helps the business owner justify each transaction. Documentation is particularly important for more complex transactions, such as payroll. Fortunately, QuickBooks provides accounting software that will calculate your payroll and link the calculations to useful source documents.
Bookkeeping supports every other accounting process, including the production of financial statements and the generation of management reports for company decision-making. Double-entry bookkeeping is used to minimize accounting errors and to keep the books in balance.
The Balance Sheet Equation
Double-entry bookkeeping starts with the balance sheet equation, which is divided into three subcategories: assets, liabilities and equity. These categories can also be presented in the balance sheet equation:
Assets – liabilities = equity
Think about the equation this way: Imagine that you sell all of your firm’s assets for cash, and you use the cash to pay off all of your accounts payable balances and your long-term debt. Any cash remaining is your equity, which is the true value of your business.
Double-entry bookkeeping keeps this equation is balanced, so that the total dollar amount of (assets – liabilities) equals total equity.
Debit and Credits: The Ground Rules
Double-entry bookkeeping uses a system of debits and credits to post accounting transactions and keeps the balance sheet equation in balance. This topic is often misunderstood, so it’s important to understand these ground rules:
- Debits are on the left side of the accounting entry, and credits are on the right side. This rule never changes.
- Most asset and expense accounts are increased with a debit entry, while most liability and revenue accounts are increased with a credit entry. There are a few exceptions to this rule, but they go beyond the scope of this discussion.
- The total dollar amount of debits must always equal the total dollar amount of credits. If you attempt to post an entry into accounting software that is not balanced, you’ll get an error message. This rule does not change.
What causes confusion is the difference between the balance sheet equation and the fact that debits must equal credits. Keep in mind that every account, whether asset, liability or equity, will have both debit and credit entries. The examples below will clarify this issue.
Recording a Journal Entry
A journal entry records debits and credits to post an accounting entry, along with a description of the transaction. You post journal entries into columns, and the left-hand column lists the account number and account title. To the right, you have a column for debits and one for credits. A detailed explanation of the transaction is posted below each journal entry.
Your accounting software is formatted to post journal entries, and these entries can be simple or complex. Here’s an explanation of each type:
Simple Double-Entry Bookkeeping Example
Assume that a furniture company purchases $5,000 of wood for inventory and pays cash for the purchase. Wood is a raw material that is used to make furniture. Here is the journal entry, with account numbers included: