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Given the complicated system of transactions that occur every second of every day, remaining on top of everything is a huge challenge that all businesses face.
Fortunately, they can make use of a powerful tool known as double-entry bookkeeping to monitor their transactions and make prudent financial decisions.
But what exactly is this system, and how is it still useful today even as it’s several centuries old?
In this article, I’ll take you on a journey that explores one of the most fundamental financial foundations that underpin businesses in the modern age.
- Double-entry bookkeeping records each transaction as debits or credits in at least two accounts, keeping everything balanced
- Double-entry bookkeeping relies on this system of debits and credits to paint a complete picture of your business’s financial health and minimize the risk of fraud and errors
- This system is incredibly complex and powerful and is capable of providing valuable insights that inform a company’s decisions about its finances
- Almost everyone around the world uses double-entry bookkeeping as the accounting standard, and it even complies with the principles set by the US government.
Understanding Double-Entry Bookkeeping: Definition and How It Works
At a glance, it’s quite obvious what double-entry bookkeeping entails: every business transaction must be recorded in at least two entries (in at least two accounts) – one for debit, and another for credit (more on these two later).
A key feature of the double-entry system is that the debits and credits are always equal and opposite so that the financial record remains balanced (if you’ve heard of the term “balancing the books”, this is exactly what it’s referring to!).
This fact also means that the sum total of all debits and all credits are always equal to each other.
The double-entry bookkeeping system is incredibly helpful for understanding how healthy a company’s finances are, spotting and correcting errors, and avoiding fraud.
That’s because its system of rules makes it pretty straightforward to achieve all of these outcomes!
But how exactly does it work?
Well, it all boils down to the basic accounting equation, where: ASSETS = LIABILITY + EQUITY.
Each side of the equation must be equal to the other, such that an increase in one account is accompanied by a decrease in another.
History of the Double-Entry Bookkeeping Accounting System
The history of the double-entry bookkeeping system is an exciting tale of how simple ideas can revolutionize the world!
Although there have been isolated reports of European merchants using the double-entry system for their transactions, it only really started taking off when the Italian mathematician Luca Pacioli wrote about it in a book in 1494.
Pacioli was aided by his close friend Leonardo da Vinci, and together, they discussed the system in great detail.
The book contained all manner of accounting tools such as journals and trial balances that we still use to this day, cementing its place as a timeless masterpiece.
Thanks to double-entry bookkeeping, trade in Europe boomed and gave rise to today’s capitalist system.
Who uses the double-entry system?
Virtually everyone! The double-entry system is the dominant method for recording business transactions around the world.
Because of how organized it is, any person that’s familiar with the system can easily figure out the information they need from a transaction.
And because the double-entry system complies with the U.S. Generally Accepted Accounting Principles (GAAP), it’s used by all public companies in the US.
However, due to its complexity, it may not be too practical for smaller businesses and individuals.
What are the rules of double-entry bookkeeping?
As I’ve mentioned earlier, double-entry bookkeeping works exceptionally well because it follows a set of rules.
These are actually fairly easy to grasp and should give you a better understanding of how the system works:
Debit is written to the left, credit on the right. Unlike single-entry bookkeeping, you’ll quickly notice that double-entry bookkeeping contains two entries.
Any transaction that debits an account is written to the left, and on the right side, an equal but opposite amount is credited to another account
Every debit must have a corresponding credit. This is the most fundamental principle of the system!
Whenever you debit an account, you must also credit an equal but opposite amount to another account. Of course, this implies that a transaction is always recorded in at least two accounts.
Debit receives the benefits, and credit gives the benefits. We’ll talk more about this below, but it’s a good idea to think of the debited account as the one receiving the benefits, while the credited account provides them.
I’ll explore a few examples to help clarify this later on.
Types of Accounts
We’ve talked about how a transaction should be recorded as debits or credits in more than one account, but what exactly is an account?
I find it helpful to think about accounts as categories of transactions. In accounting, there are five major types of accounts:
1. Asset accounts
These are all the things you own that make your company more valuable! The simplest type of asset account to imagine is cash, but there are also plenty of other assets you may have such as your inventory, accounts receivable (money you stand to receive), and even long-term assets such as copyrights
2. Liability accounts
If assets are what adds value to your account, your liabilities are what you owe to others. Liabilities include your debt, the amount you have to pay to suppliers, and other accrued expenses.
A key characteristic of liabilities is that they represent all the expenses that you haven’t paid yet
These accounts represent all your investments into your business, including the value of the common stock and retained income.
Your equity rises alongside your assets and plummets whenever you have increased liabilities
4. Income accounts
Stated simply, these represent all the money you’ve earned to date! These cover anything you’ve sold, interest you’ve gained, and other sources of income
5. Expense accounts
It takes money to run a business, and that amount is reflected in your expense accounts. From your employees’ salaries to your rent and utilities, your expenses increase the more you spend on your business.
What are debits and credits?
All business transactions in the double-entry bookkeeping system rest on debits and credits.
Take a look at the following table to see how debits and credits work with each account:
|Increases what accounts?
|Assets and expenses
|Liabilities, equity, and income
|Decreases what accounts?
|Liabilities, equity, and income
|Assets and expenses
The above table shows that when you purchase $500 worth of items from your supplier, you will debit (increase) that value to your inventory asset account and credit (increase) the same value to your accounts payable liabilities.
Once you’ve settled the amount, you will debit (decrease) $500 to your liabilities as payment to the supplier and credit (decrease) an equivalent value from your cash assets.
Single-Entry vs. Double-Entry: What’s the Difference?
Now that we understand the basics of the double-entry bookkeeping system, let’s compare it to the simpler and less complicated single-entry system:
|Simple transactions involving only income and expenses
|Monitoring balance on multiple accounts, such as income, assets, and expenses
|Double entries — debiting one account and crediting another
|Vulnerable to accounting mistakes
|Helps reduce potential errors
|Value and quality of insights
|Limited and unable to provide meaningful insights
|Holistic; provides valuable insights about overall financial health
|Simple and can be done manually
|Complex and requires the use of accounting software
|Individuals and small businesses
|Companies of all sizes, particularly those with sizable assets or liabilities
As you can see, while the double-entry bookkeeping system is much more powerful, it can be overkill for certain users (such as individuals and smaller companies without that many assets or liabilities).
Double-Entry Bookkeeping Examples
I know the double-entry bookkeeping system is a bit complicated, so here are a couple of realistic examples to help you understand the process!
One of the situations where double-entry bookkeeping truly shines is when a company acquires a loan.
Let’s say that a company borrows $15,000 from the local bank. You will then report it as a debit to the assets account and a credit to the liabilities account.
|Outstanding loans (liabilities)
In another scenario: if you spend $4,500 to purchase new computer systems for your business, you’ll credit your assets account and debit the equivalent amount to your expenses:
Key Benefits of Bookkeeping
Here are a few more key advantages of double-entry bookkeeping:
When you note both sides of a transaction, you’ll have a more complete picture of how your business is performing.
It also doesn’t leave much room for error or potential fraud, and makes it incredibly easy to track down any inconsistencies in your records
Because double-entry bookkeeping requires that you have complete records, it creates a much more streamlined and organized chain of financial records — from your journals, down to your financial statements
Simplifies tax filing
Although it’s complex, double-entry bookkeeping is a superstar when it comes to your taxes.
This system reduces the likelihood of committing errors in your records and keeps everything organized, so you’ll have an easier time meeting your tax obligations
Cash flow management
I like to think of this system as something that keeps an eagle eye on a business’s cash flow.
When you’re getting the full picture of how much money enters and leaves your business, it’s much easier to make crucial decisions when seeking loans or increasing sales
Unlike single-entry systems that will force you to comb through entries upon entries of unorganized transactions, the double-entry bookkeeping system will save you precious time as each transaction is inherently linked to another one.
As a plus, it ensures that all your records are balanced as well!
In the US, double-entry bookkeeping is the gold standard that meets government specifications. Because of this, you’ll have a much easier time ensuring that your business is above board.
Double-entry bookkeeping is a powerful method of recording your business transactions, and it does so in the form of debits and credits across neat categories of accounts.
Thanks to its powerful ability to provide valuable insights into your financial health, it has become the standard for easier financial reporting and crucial decision-making!
What is the disadvantage of using the double-entry accounting system?
Double-entry bookkeeping is incredibly complex, and it’s very difficult to perform this manually.
As such, it requires special software and even dedicated professionals to make sure everything is going smoothly – making it rather costly.
Why is double-entry bookkeeping important?
Accuracy is the biggest hallmark of double-entry bookkeeping. It helps you avoid fraud, detect errors, and make the best decisions when it comes to allocating your resources.