Double-Entry Accounting: Everything You Need to Know
Your accounting systems should grow along with your business. Eventually, you will have to switch from single-entry to double-entry bookkeeping.
The latter provides a more accurate overview of your financial situation. More importantly, it can help you reduce errors in asset and expense accounts.
This article will explain what double-entry accounting is and how it works. Also, we will contrast it with the single-entry system. Later, you will see which one is best for your business.
What is double-entry accounting?
Double-entry bookkeeping divides transactions into two categories: debits and credits. Debit refers to transactions that add money to your business, while credit deducts funds from it.
The system lets you understand how money moves in and out of your asset account. Moreover, double-entry accounting can reduce errors.
Accounting equation: Debit vs. credit
The double-entry method has three important components. First, you must record every financial transaction in at least two accounts.
Second, the recorded debits and credits must equal the total credits recorded. Third, total assets must always equal total liabilities added to a business’s capital or net worth.
[forminator_form id="101900"]The Accounting Equation represents the third rule. Both sides of the equation must be the same, or there is a mistake in the cash account bookkeeping. Here is the equation:
Assets = Liabilities + Equity (net worth or capital)
For example, let us say your company buys $1,000 worth of inventory via credit. Consequently, the assets or inventory account will reflect a $1,000 increase. On the other hand, the liabilities or accounts payable book.
As a result, both sides of the accounting equation are the same. You can confirm by putting the books side-by-side and checking if the amount appears on both.
Keeping track of debits and credits can be challenging, especially if you have not used double-entry accounting before. Fortunately, the cheat sheet below could help you:
Debits:
- Increase in an asset account
- Increase in an expense account
- Decrease in revenue
- Decrease in an equity account
- Always recorded on the left side
Credits:
- Decrease in an asset account
- Decrease in an expense account
- Increase in revenue
- Increase in an equity account
- Always recorded on the right side
Double-entry bookkeeping accounts
One cash account is not enough for this system. Double-entry accounting requires five types of accounts:
Asset accounts record the cash value of what a business owns. These include money from an income statement, funds in a checking account, tools, equipment, and buildings.
Liability accounts list the amount of money that a business owes. For example, they could list mortgages or lines of credit.
Equity refers to the difference between Assets and Liabilities. Moreover, some people call it the book value of a business.
Income accounts take note of money entering a cash account, such as revenue. On the other hand, Expense accounts record what you spent money on, like advertising and payroll.
It is not easy to understand double-entry bookkeeping by yourself. Yet, reading a few examples could help you learn:
#1: Business transactions using credit
Let us say you purchased $500 worth of inventory on credit. As a result, you should record a decrease in account payable by $500, and your cash goes down by $500.
In other words, the account payable has a debit of $500 and a credit in the cash account of $500. Also, your inventory increases by $500, and your account payable increases by the same amount.
#2: Getting a business loan
Let us say you received a business loan of $10,000. Consequently, your cash goes up by $10,000, and your loan payable increases by $10,000.
Your general ledger will record the cash as debit. Moreover, it will note the loan payable as credit. Remember that debit goes on the left, and credit goes to the right.
#3: Paying for business costs
You paid $10 for your business’s new website domain. In turn, your advertising expense increases by $10, and your cash decreases by $10.
Your general ledger will record the advertising expense as debit. Meanwhile, you will consider that as credit under double-entry accounting.
#4: Providing a capital contribution
You invested $20,000 in personal money to start your new restaurant by depositing it in your checking account. As a result, your cash goes up by $20,000, and your equity rises by $15,000.
Your general ledger will record the contribution as debit. Meanwhile, you will consider that as your equity or capital account credit.
What is single-entry bookkeeping?
Small businesses and startups may use single-entry accounting. It is a simple method of bookkeeping where a single journal records every transaction.
You start recording your remaining cash for a specific period. Add the money you received, then deduct your expenses. Consider all these factors at the end of that duration.
Finally, you calculate the cash balance you still have. Your cash book will contain the following details:
- The Date when the transaction took place
- Brief description of each transaction
- Transaction value, either incoming (debit) or outgoing (credit)
- The remaining amount of money you hold, known as the Balance
We should also use an example to explain single-entry accounting. Let us say you have a $10,000 cash balance starting in October. That amount will be your first entry.
You paid for rent the next day, which was $1,000. It is an expense, so you subtract the amount from your cash balance. As a result, you have $9,000 remaining.
Later, your customer paid an invoice for $500, which counts as income. In turn, you record a $500 debit and increase your account balance to $9.500.
Next, you bought office supplies worth $1,500. As a result, you reduce that amount from the existing balance. Also, your remaining weekly balance is $8,000.
Single-entry vs. double-entry system
There is no one-size-fits-all solution for accounting. Single-entry and double-entry bookkeeping have their pros and cons. First, let us discuss the single-entry system.
It suits small businesses and startups because it is simple and affordable. You can use it even if you have little to no accounting experience. As a result, you do not have to pay for an accountant.
The single-entry accounting is also great for service-based businesses and remote workers. They do not need to handle inventory, so a simple system is enough.
Note that the IRS has rules regarding single-entry bookkeeping. For example, it prohibits businesses with annual gross sales of over $5 million from using this system.
Also, it is prone to errors if you have more than one employee. Single-entry accounting will lump every transaction into one book, making it difficult to understand.
Double-entry accounting shines in this scenario. Businesses can use it to track their financial standing and their current growth. In other words, you get a complete picture of every financial transaction.
As mentioned earlier, double-entry bookkeeping can help reduce errors. Do you remember the accounting equation from earlier? You match each debit amount with a corresponding credit amount.
If one side reflects the wrong amount, that may count as an error. Perhaps it could be a sign of fraud or other irregularities. However, it can get complicated.
You would need to hire an accountant with double-entry accounting experience. Otherwise, your staff member may become confused with monitoring a minimum of five books.
Your accountant will also take more time to crunch numbers due to the increased information. Moreover, you will have to store more books in the office.
As a result, you would likely spend more money on a double-entry system. Still, it is worth it to have a growing business because it could significantly reduce the chances of error.
Double-entry accounting software
You can make double-entry accounting more manageable with the right digital tools. For example, PDF invoice generators can facilitate financial transactions.
They can track your invoices based on their deadlines and other key metrics. Also, you can create an invoice design that suits your business and automate sending and receiving invoices.
You can also make the double-entry system a breeze with business accounting software like Quickbooks and FreshBooks. It reduces calculation errors and facilitates recording.
Moreover, keeping electronic records can save you huge amounts of space. Some of these tools also have dashboards that provide overviews of key metrics.
Note that you should still hire an accountant with double-entry accounting experience even if you have these tools. Computer programs can still make errors, and professionals can check for them.
Conclusion
Double-entry accounting works well for growing businesses. They provide a comprehensive overview of their financial situation and growth progress.
Small businesses and startups may start with single-entry bookkeeping. They could switch to the double-entry system as they grow and increase their income.
Digital tools can facilitate both methods and reduce their costs. Follow Inquirer USA for updates on the latest tech trends and business and other topics.
