The double entry accounting system has roots over 500 years old—and for good reason. It’s a simple yet powerful concept, which helps explains why it’s still used today in both manual systems and sophisticated accounting software for the modern business world. But what is double entry accounting? And why should your business switch to this system of bookkeeping?
Keep reading to learn more. Click on a question and jump straight to your answer or read end-to-end for a comprehensive overview.
- What is double entry accounting?
- How do you make double entries?
- What are the rules of double entry accounting?
- What is the difference between single and double entry accounting?
- What are the advantages of the double entry accounting system?
- Is double entry accounting necessary?
What is double entry accounting?
In its simplest sense, the double entry accounting system tracks where your money came from and where it’s going. Double entry defined by Investopedia explains how, according to this concept, “every financial transaction has equal and opposite effects in at least two different accounts”.
Here are a few example transactions to illustrate how the double entry accounting system works:
|Transaction||Account #1||Account #2|
|● Company pays rent||Cash||Rent expense|
|● Sale of merchandise on credit||Accounts receivable||Sales|
|● Receives money from customer who purchased merchandise on credit||Cash||Accounts receivable|
|● Sale of merchandise in cash||Cash||Sales|
|● Company purchases goods on credit||Inventory||Accounts payable|
Essentially, in this form of bookkeeping, every transaction is transferred from one source (or “account”) to another. Before diving into the details and advantages of the double entry accounting system, let’s establish some accounting basics so you can understand the key terms.
Double Entry Accounting: Terminology
Here are some accounting terms you’ll need to know in order to understand how the double entry accounting system works.
- Debit: This refers to a transaction in which money is transferred into an account.
- Example: Susan debited $500 into the business checking account.
- Credit: This transaction transfers money away from an account.
- Example: Bryan credited $1,500 to an account payable for his monthly retail lease.
- T-Account: In a double entry system, credits are offset by debts using a visual representation of all accounts in a chart that resembles a “T”. Debits are always recorded on the left; credits are always recorded on the right.
- Accounting equation: Businesses use double entry bookkeeping to satisfy the accounting equation, which states that…
Assets = Liabilities + Equity
- Assets: Within the accounting equation, assets (sometimes referred to as capital) include cash, accounts receivable, inventory, property, equipment, machinery, and other liquid assets. Debits increase an asset account; credits decrease an asset account. Examples of assets include:
- Accounts receivable (money owed to the business)
- Inventory (goods that the business has in their possession for the purpose of resale)
- Fixed property (equipment, machinery, vehicles, furniture)
- Other liquid assets
- Liabilities: These accounts refer to obligations a company must pay to stay in business, including monies owed to:
- Accounts payable (money the business owes)
- Lines of credit
- Long-term debt
- Equity: This number represents a company’s total assets minus its liabilities. Equity is created through:
- Retained earnings (net income)
Pro Tip: Most people rely on bank statements to make sense of their financial position, but keep in mind that these are written from the bank’s perspective—which is exactly opposite to your system of double entry accounting.
When you deposit a check in the bank, you give them money they promise to pay back some day; your money is technically a loan, or a source of funds for the bank, so they show a credit to your bank account when you deposit money. Remembering this difference is essential for avoiding confusion within the double entry system!
How do you make double entries?
To make a double entry, record each debit and credit transaction as two separate lines.
Using the above terminology, let’s take a deeper look at how this method works and why so many businesses bookkeeping experts follow its concept. Here are a few examples of the double entry accounting system in action.
Double Entry Accounting in Action
In our first example, Matt is launching a startup company called MobileMover and needs to record his first business transaction. A team of investors has given him a sum of $15,000 in exchange for five shares of MobileMover’s stock. In this case, he will record a double entry with a debit transaction into the cash asset account and a credit transaction to the common stock equity account.
Assets = Liabilities + Equity
($15,000) = $0 + ($15,000)
$15,000 = $15,000
Note: In this example, Matt didn’t actually provide any moving services. He received no earnings and therefore has no revenue to report. There are also no expenses reported in this transaction.
Now that Matt has some funding, he can afford to buy a moving truck to get his business up and running. He uses his asset account to purchase a truck for $12,500, then soon after, Matt completes his first moving job and earns $250 for his service. Using the double entry accounting system, this would require four separate entries.
So far, Matt’s books are balanced and each side of the accounting equation shows the same value. That’s good! But what would it look like if, instead of purchasing a used moving truck, Matt decided to invest in a new $25,000 vehicle with a $5,000 down payment?
He would be crediting the cash account $5,000 and debiting the fixed asset account $25,000. The effect of these debit and credit entries is a net asset change of $20,000. The liability (the amount of the loan) is also $20,000, meaning the transaction is balanced.
Assets = Liabilities + Equity
(-$5,000) = $0 + $0
(+$25,000) = $0 + $0
(-$5,000 + $25,000) = (+$20,000) + $0
$20,000 = $20,000
Fast-forward a couple months. MobileMover business is booming and Matt had to hire help to keep up with the demand. He enlists a payroll processing service to make his life easier and decides he needs to purchase a laptop that can handle his increased workload. The service costs $90/month and he purchased the laptop with a business credit card for $1,500. Here’s what his bookkeeping looks like.
Did you catch his mistake? The first two entries are correct; payroll is an asset that is balanced with a credit entry under accounts payable. But remember, Matt bought his laptop with credit—not cash. This error will throw his ledger out of balance by failing to report an outstanding expense (i.e. his credit card bill).
Matt should have broken the transaction into credit and debit entries in order to have a clearer picture of where his money is coming and going, as well as an overview of his outstanding debts.
Pro Tip: To avoid accounting errors in the double entry system, it’s imperative to clearly label every account by its associated asset, liability, equity, revenue, expense, gain, or loss. Take a look at the chart below for an idea of the different accounts your business may have.
Use these examples to set up your own chart of accounts and establish a strong financial foundation for your business transactions.
What are the rules of double entry accounting?
There are several rules of double entry you’ll need to follow. Use these principles as a guide:
- Every transaction posts to two different accounts; an equal amount of money is transferred from one account (or group of accounts) to another account (or group of accounts).
- In a double entry system, transactions are recorded in terms of debit (DR) entries and credit (CR) entries; debit and credit describes whether money is going to or from an account.
- Debits are entered on the left side of the T-account; credits are entered on the right side of the T-account.
- The total amounts entered into the account(s) on the left, must be identical in value to the amount entered into the account(s) on the right.
- A debit increases one account while decreasing another (Example: debits increase an asset account but decrease a liability/equity account).
- Within the double entry system, the first stage of the transaction is recorded in a book labeled “journal” then posted a second time within a “ledger”.
Above all else, the most important rule of the double entry system: For every transaction, the total amount of debits (left column entries) must equal the total amount of credits (right column entries). Every transaction must be in balance to satisfy the accounting equation.
What is the difference between single and double entry accounting?
Single entry accounting records every business transaction as either a debit or a credit, but not both. It’s very similar to a check register that individuals use to keep track of their personal checking accounts, displaying the date, amount, and name of each transaction.
You can add more columns to show different categories of revenues and expenses, but as you can see, the single entry system is a much simpler way to track income and expenses.
Alternatively, within the double entry accounting system, income is recorded as an increase to assets (by either increasing the cash account or the accounts receivable). Expenses are not captured directly within the accounting equation, but instead have an indirect effect on stockholder equity.
What are the advantages of the double entry accounting system?
It takes a bit more bookkeeping work, but there are a number of advantages to the double entry system that make the added time well worth your while.
- Single entry accounting is only as insightful as a checkbook ledger.
- With two separate entries in the double entry system, manual errors are easier to avoid and detect before costly mistakes are made.
- By carefully labeling all classes of financial accounts, you can keep detailed records of where money is moving to and from.
- The double entry system accounts for not only income and expenses, but also takes liabilities and equity into consideration for a clearer picture of your financial position.
- Because all aspects of the transaction are recorded, it is therefore possible to verify the arithmetical accuracy of books through trial balance, but this is not possible in the single entry system.
- Single entry systems do not account for a business’s liabilities, but by using the double entry method, you can compare the financial position of a business with a balance sheet.
- Unlike single entry accounting, the double entry system is based on a scientific method.
- Double entries make it easier to prepare financial statements during forecasting and quarterly reporting.
In light of the many advantages of the double entry accounting system, your business should seriously consider adopting this form of bookkeeping.
Is double entry accounting necessary?
Sometimes. Freelancers, small startups, and sole proprietorships might be able to make single entry accounting work for their business purposes, but doing so will create a very narrow view of the financial health of their business. For larger enterprises and publicly traded companies, an accounting equation that factors in stockholder equity is a must.
If double-the-entry sounds like double-the-boredom, enlist small business accounting services that can apply the benefits of this bookkeeping system—which stretches back to the mercantile period of Europe—to your modern business. Community Tax pairs you with a professional who will…
- Personally learn the ins and outs of your business accounting
- Keep track of your debit and credit transactions
- Solidify your bookkeeping workflow
You can sit back and enjoy managing your business with perfectly accurate financials and a balanced double entry system while our accountants run the numbers and take care of the tedious work. More time on your hands means more time spent on driving business growth and stretching profit margins—and less time wasted on complicated bookkeeping software.
Best of all? Your first month is always free. Give us a call to see how we can assist with your double entry accounting system and set your business up for financial success.