Double-entry accounting: What it is and why your business needs it
If you’re not yet using double-entry accounting, it’s time to get on board with this time-tested standard that has been keeping books balanced since the 15th century. The fundamentals of double entry haven’t changed in over 500 years for a good reason – it’s a reliable system that reduces the risk of errors slipping through the cracks. So why not join the millions of businesses worldwide that trust double-entry bookkeeping for their accounts?
In this article, you’ll learn:
- What double-entry accounting is
- How the double-entry accounting system works
- Types of accounts
- Double-entry bookkeeping examples
- Why your business should use double-entry accounting
What’s double-entry accounting?
Double-entry accounting is a method of keeping track of a company’s financial transactions. It works on the principle that every financial transaction has two equal and opposite sides — a debit and a credit.
This system ensures that every transaction is accurately recorded and the financial statements are always balanced. It also helps businesses to identify errors and prevent fraud, as any changes made to one account will automatically affect the corresponding account.
Double-entry accounting vs. single-entry accounting
The double-entry system is distinct from single-entry bookkeeping, where you just list expenses and revenues. Single-entry accounting is more straightforward and works for very small businesses with only a handful of transactions to tally.
But it’s not practical for most businesses. While both accounting methods have advantages and disadvantages, double-entry accounting is generally considered more comprehensive, accurate, and reliable than single-entry accounting.
How the double-entry system of accounting works
The double-entry system of accounting works by recording every financial transaction in two accounts, with one account debited and another credited.
The double-entry system is used for every financial transaction in a business, whether it’s a purchase, sale, payment, or cash receipt. This system provides a complete and accurate record of a business’s financial transactions. It allows for preparing financial statements, such as the balance sheet, income statement, and statement of cash flows.
By using the double-entry accounting system, businesses can ensure that their financial records are accurate, reliable, and consistent over time. This, in turn, helps businesses make informed decisions based on their financial data, such as how much inventory to order or whether to invest in new equipment.
Here’s an example of how the double-entry system works. (Don’t worry — we’ll go into a deeper example later.)
Let’s say you buy inventory for your business for $1,000. To record this transaction using the double-entry system, you would:
- Debit the inventory account by $1,000: This increases the value of the inventory on your balance sheet.
- Credit the accounts payable account by $1,000 increases your liability to pay for the inventory.
The total debits ($1,000) must always equal the total credits ($1,000), ensuring the accounting system is accurate and error-free.
Types of accounts
When using double-entry accounting, you’ll use several types of accounts, which you’re probably already familiar with. They’re the primary accounts on your balance sheet and income statements.
- Asset accounts: What a business owns, such as the cash account or the amount paid to purchase machinery
- Liability accounts: What a business owes, such as invoices that need to be paid for services and debt owed for a loan
- Income accounts: Money received from sales revenue
- Expense accounts: Money spent on things for the business, such as payroll, advertising, insurance, and rent
- Equity accounts: These accounts combined make up the shareholder’s equity
A unique account number and name represent each in a company’s chart of accounts. The double-entry system ensures that every financial transaction affects at least two accounts, with one account debited and another credited. This system provides a complete and accurate record of a business’s financial transactions and helps businesses to make informed decisions based on their financial data.
Does accounting software use double-entry bookkeeping?
If you regret not taking that accounting class in college, there’s good news. Most software systems use double-entry, so you don’t have to make all these calculations manually. But, as a business owner, it is still essential to understand how the double-entry accounting system works and why you’re using it, even if your accounting software is doing all the work.
Why your business should use the double-entry system
Double-entry accounting is too beneficial to put off if you run a public company or private business. But what do you gain from the double-entry system aside from balanced books? Here are the main benefits of double-entry bookkeeping.
#1: Get a more accurate picture of your financials
Most businesses use double-entry accounting because it offers a complete recording of financial transactions. Since every financial transaction has to be recorded into two accounts, you know that every transaction is accurately reflected in the financial records. An in-depth recording like this provides a comprehensive view of your financial activity and accurate financial reporting across your balance sheet, income statement, and cash flow statement.
#2: Stay compliant with U.S. regulations
Double-entry accounting is required by law for publicly-traded businesses. The Securities and Exchange Commission (SEC) requires publicly-traded companies to use generally accepted accounting principles (GAAP) based on the double-entry accounting system. Using GAAP and double-entry provides a standardized method for financial reporting, which helps investors compare the financial health of different companies.
#3: Scalable across businesses of all sizes
It doesn’t matter what size your business is — the double-entry bookkeeping system is a practical way to keep track of business transactions because it grows with you as your business expands. Add more asset and expense accounts to the general ledger when you have more asset and expense accounts. Adding more accounts would complicate your books if you were using the single-entry system. With double-entry, you can expand from your core financial accounts and add subaccounts as needed.
#4: Prevent fraud through fewer errors
Since transactions must be entered twice, the system helps identify errors and prevent fraud. Also, because there’s a clear and detailed record of all financial transactions, it’s harder for employees or upper management to manipulate or conceal information.
Double-entry accounting can also be integrated with other financial tracking systems to provide additional security and fraud prevention layers. Some accounting system will allow for your card transaction data to sync with your accounting system, ensuring your chart of accounts is the same across the board.
#5: Simplifying tax season and audits
Preparing financial statements for tax season is much easier with the double-entry bookkeeping system. Knowing all your accounts are organized and accurate saves time and reduces the risk of errors in tax preparation because it provides a clear audit trail. So, if you were to get audited, it’s much easier for auditors to verify your financial statements and transactions.
#6: Appeals to investors and builds trust with stakeholders
With double-entry accounting, you can generate reliable financial statements that accurately reflect their financial position, which helps investors see your financial viability and make informed decisions about investing in the company.
Plus, the accuracy and completeness of the financial records provided by double-entry accounting help build trust with stakeholders — like regulators, creditors, and customers. By maintaining accurate financial records and reporting them transparently, businesses can demonstrate their commitment to integrity and financial responsibility.
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