According to a recent Sage Research report, a majority of accountants feel there has been a cultural shift in accounting and that traditional methods are no longer enough to remain competitive. As a small business owner, this shift can make it hard to know which accounting practices you should implement.
However, you must remember the fundamental principles for your business’s finances. One crucial fundamental principle is double-entry bookkeeping.
Double-entry bookkeeping is a hugely important concept that drives every accounting transaction in 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 a business’s record-keeping process. A bookkeeper reviews source documents — like receipts, invoices and bank statements — 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.
When entering business transactions into books, accountants need to ensure they link and source the entry. Linking each accounting entry to a source document is essential because the process helps the business owner justify each transaction. Documentation is particularly relevant for more complicated operations, such as payroll. Using accounting software can automate this process, making it easier for business owners to log and track transactions.
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.
What is double-entry bookkeeping?
The double-entry accounting method is a system of bookkeeping that requires accountants to record every financial transaction twice, one time in each of two separate accounts.
The accounts that accountants use exist in the chart of accounts. The chart of accounts can have dozens, if not hundreds, of accounts. Furthermore, the double-entry accounting system also requires total debits to equal total credits in the general ledger.
As you’ll see in the accounting equations and examples that we detail below, debits are entries that increase asset and expense accounts, or decrease revenue, equity, and liability accounts.
Credits are entries that do the opposite — they increase revenue, liability and equity accounts, while they decrease asset and expense accounts. Under the double-entry system, if you increase an account with a debit, you will need to decrease an opposite account with a credit.
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 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 balanced so that the total dollar amount of assets minus liabilities equals total equity.
Why use double-entry bookkeeping instead of a single-entry method?
Why is double-entry bookkeeping more advantageous than single-entry accounting?
A single-entry system may work for small companies that have a low volume of activity. When you first start your small business, it’s possible you can get by using a single-entry system. Single-entry bookkeeping is very similar to personal bookkeeping, like keeping a checkbook.
As your business grows, however, a single-entry system will make it much more challenging to keep accounting records. Single-entry systems do not have a chart of accounts, so you can’t track things like:
- Accounts receivable
- Accounts payable
Although you can track net income and formulate an income statement using a single-entry system, you won’t be able to put together a balance sheet. A balance sheet provides you with a more accurate depiction of your business because it allows you to see the owner’s equity, which is the total net worth of your firm.
So to put it simply, double-entry bookkeeping allows you to keep more diligent, accurate records. As your business grows and you begin to have different accounts on your books, a double-entry system will allow you to track your cash flow better. It’s much easier to detect errors using a double-entry system than it is with a single-entry system.
Perhaps most important, however, is the fact that the double-entry system of accounting is mandated by law. Double-entry bookkeeping is required under the generally accepted accounting principles (GAAP), which are set by the Financial Accounting Standards Board (FASB). Publicly-traded companies are required to abide by GAAP.
As a small business owner with hopes of growing your company, it’s better to use double-entry bookkeeping from the get-go.
Recording a journal entry
Accountants will use the general journal as part of their record-keeping system. The general journal is an initial record where accountants log basic information about a transaction such as when and where it occurred along with the total amount. Accountants consider logging this information 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.
Double-entry bookkeeping uses a system of debits and credits to post accounting transactions and keep the balance sheet equation equal. This method is often misunderstood, so it’s essential to understand these ground rules:
- Debits are on the left side of the accounting entry, and credits are on the right side.
- Most asset and expense accounts are increased with a debit entry, while most liability and revenue accounts are increased with a credit entry.
- 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.
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 an asset, liability or equity, will have both debit and credit entries.
When using a double-entry system, two things must always be balanced. The general ledger, which tracks debit and credit accounts, must always be balanced. Additionally, the balance sheet, where assets – liabilities = equity, must also be balanced. The examples below will clarify the rules for double-entry bookkeeping.
A 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 used to make furniture. Here is the journal entry, with account numbers included:
|Account #||Account title||Debit||Credit|
This is a simple journal entry because the entry posts one debit and one credit entry. The company should debit $5,000 from the Wood-Inventory account and credit $5,000 to the Cash account.
Both of these accounts are asset accounts, and the balance sheet equation remains in balance:
|(+$5,000 wood - $5,000 cash)||–||$0||=||$0|
The debit entry increases the wood account, and cash decreases with a credit so that the total change in assets equals zero. Liabilities remain unchanged at $0, and equity remains unchanged at $0.
Complex double-entry bookkeeping example
A complex journal entry means that the entry may have multiple debit entries, more than one credit entry, or both. Assume, for instance, that a furniture company purchases a $30,000 machine by paying $5,000 in cash and borrowing $25,000. Here is the complex journal entry:
|Account #||Account title||Debit||Credit|
|7500||Bank loan - machine||$25,000|
In this example, the company would debit $30,000 for the machine, credit $5,000 in the Cash account, and credit $25,000 in a Bank Loan – Accounts Payable account. The total debit balance of $30,000 matches the total credit balance of $30,000.
This is a complex journal entry because the entry posts two credit entries. However, you can see that the balance sheet equation remains equal:
The company gains $30,000 in assets from the machine but loses $5,000 in assets from cash. This means assets are now $25,000. Liabilities are also worth $25,000, which in this case, comes in the form of a bank loan. So, $25,000 – $25,000 = $0. The balance sheet equation is correct.
Verify with the trial balance
At any point in time, an accountant can produce a trial balance, which is a listing of each account and its current balance. The total debits and credits on the trial balance will equal one another. Accountants frequently review the trial balance to verify that they posted journal entries correctly, as well as to correct any errors.
At the end of each month and year, accountants post adjusting entries to the trial balance and use the adjusted trial balance to generate financial statements. Accounting software provides controls to ensure your trial balance is accurate. The software will ensure that the total dollar amount of debits equals the credit balance and that each account balance is in your trial balance report.
Proper training allows for accurate record-keeping
As you can see, the entire accounting process starts with double-entry bookkeeping. Whether you do your own bookkeeping with small business bookkeeping software or hire a bookkeeper for that task, understanding this critical accounting concept is essential for the success of your small business.
If you’ve previously used a single-entry system, you may be wondering how to go about switching to a double-entry system. The best modern accounting software has double-entry concepts already built-in.
When you get started with accounting software, you can connect your various business accounts, and transactions will import automatically. From here, you can adjust and add different accounts to portray your business transactions more accurately.
Business owners who have previously operated on a single-entry system will want to make the switch to a double-entry system as soon as possible. As your business grows, so too will the complexity of your financials. Implementing a double-entry system of accounting will allow you to put your financial statements to better use so that you can measure your financial health and spot errors quickly.