What Is Double-Entry Accounting?

What Is Double-Entry Accounting?

Double-entry accounting is the most popular method of documenting a business’ financial activities. When using it, all transactions you record must affect at least two accounts, hence the name, and balance between debits and credits.

This foundational concept is a lot like Newton’s third law, which states that every action has an equal and opposite reaction. Similarly, every time you debit one account in the double-entry accounting system, you must credit another one for the same amount.

That creates a check and balance for each transaction, improving the accuracy of your accounting records and making it easier to identify and correct mistakes.

How Does Double-Entry Accounting Work?

Debits and credits refer to the left and right sides of journal entries, which are the records bookkeepers and accountants use to document transactions in the general ledger. Typically, they look something like the following:

Debiting or crediting an account has a different effect depending on the type of account. Assets, expenses, and losses increase when you debit them and decrease when you credit them. Conversely, income, gains, liabilities, and equity accounts increase when you credit them and decrease when you debit them.

Fortunately, you typically don’t have to manually record journal entries for every transaction these days. Most modern bookkeepers and small business owners connect their bank accounts and credit cards to accounting software that automatically tracks their activities.

However, you still have to record journal entries for transactions that the software can’t pick up automatically, such as non-cash expenses. For example, you must record depreciation to track the cost of wear and tear on your physical assets, but it’s not an expense you pay for with cash or credit.

As a result, you typically have to manually enter a journal entry at the end of each year to account for depreciation, even if you’re using software to do most of the heavy lifting.

Double-Entry Bookkeeping Examples

Let’s review some practical examples of double-entry bookkeeping to help you understand how you might apply it in your own financial recordkeeping. We’ll assume you’re documenting everything manually.

First, say your business spends $1,500 on rent for office space. That decreases your cash balance by $1,500. Since cash is an asset, you must credit it to record the change.

Meanwhile, your rent increased by $1,500. To increase an expense, you must record a debit. Since that makes your debit and credit balances equal, it satisfies the requirements of the double-entry accounting system.

Second, say your business earns $800 in revenue and issues a net 30 invoice to a client. To record that increase in an income account, you credit revenue for $800.

You also have to increase your receivables by $800 for the outstanding invoice. Since that’s an asset, you must record a debit. Once again, your debits and credits are in balance, complying with the double-entry rules.

What Is The Accounting Equation In Double-Entry Accounting?

The accounting equation is one of the foundations of the double-entry accounting system. It defines the relationship between the three types of accounts on the balance sheet and is usually expressed as follows: Assets = Liabilities + Equity.

Here’s a more detailed explanation of each of those terms:

• Assets – These are resources with positive economic value that your business owns. You can use them to meet your business needs, such as paying obligations or facilitating operations. For example, cash, inventory, buildings, and equipment are all assets.
• Liabilities – These are obligations that you must fulfill and have negative economic value. They’re usually a source of financing, such as installment loans and credit cards.
• Equity – This includes contributions from owners, investments from shareholders, and profits kept in the business from previous years. It’s also what would be left over for the owners if you liquidated all your assets and paid off your debts.

The accounting equation can help you figure out how a change to one of these account types affects other accounts. For example, when recording an increase in your assets, the accounting equation tells you to record an equal increase in your liabilities or equity.

You can also use the accounting equation to verify that your debits and credits are equal. If the equation is true, you’re satisfying the requirements of double-entry accounting and your records are probably accurate.

Double Entry Vs. Single Entry Accounting

Single-entry accounting is a less commonly used form of recordkeeping. It’s more straightforward than double-entry and is usually suitable for small businesses that process all transactions through a single cash account.

Single-entry bookkeeping doesn’t use debits or credits. Instead, it simply involves tracking the changes to your cash account, categorizing them as either an income or an expense, based on whether they increase or decrease the balance.

For example, here’s what a single-entry bookkeeping record might look like.

Benefits Of Double-Entry Bookkeeping

Single-entry bookkeeping is only viable for companies with the most simplistic finances. It’s highly susceptible to human error and generally ineffective at capturing the nuances of sophisticated transactions.

Double-entry bookkeeping is more complicated, but it’s also a more effective way of organizing financial data. By mandating that you balance your debits and credits, it also creates a series of robust checks that you can use to identify and rectify mistakes.

In addition, lenders and investors will almost always want to see financial statements built with the double-entry system before they’ll work with you, making it the only option if you ever want to qualify for financing.

_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strivers to keep its content up to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}