What is double-entry accounting, really? It may sound complicated, but it doesn’t have to be.
If you’ve spent time reading on small business accounting, you’ve probably heard the term “balance your books.” But what does that really mean?
Simply put, balancing the books is the process of closing your accounts at the end of an accounting period (typically a year, but it could be a month or a quarter) to determine the profit or loss made during that period. But it’s not just a matter of looking at the bottom line. It involves making sure your debits and credits agree in a double-entry accounting system.
If that all sounds like a Greek language, don’t worry yet! In this article, we’ll cover the definition of debits and credits, what double entry accounting is and why it matters for your business.
Single Entry vs. Double Entry Accounting
Single entry accounting is a lot like keeping your cheque register. You simply record the income that comes in and the expenses that go out. This works well for small companies with few transactions and no inventory or fixed assets. But as your company grows in complexity, you might need something more.
That’s where double-entry accounting comes in.
In double-entry accounting, two entries (at least) are made for every transaction: a debit is made to one account, and a credit is made to another. The key is knowing which account should be debited and which account should be credited.
Whether you realize it or not, your business has a chart of accounts. A typical chart of accounts is organized as follows:
BALANCE SHEET ACCOUNTS
- Assets. Resources a company owns. This might include cash, accounts receivable, inventory and equipment
- Liabilities. Obligations or amounts owed. This might include payables, loans, and lines of credit
- Owner’s Equity. Assets minus liabilities, the book value of the company
INCOME STATEMENT ACCOUNTS
- Revenues. Fees earned from providing services or selling products
- Expenses. The cost of running your business
Expenses and assets are increased with a debit. Revenues, liabilities and Owner’s Equity are increased with a credit.
- Purchase office supplies for your business. When you pay for the supplies, your cash decreases (credit) and your expenses increase (debit)
- Sell a product for cash. When you deposit the cash, your cash increases (debit) and your revenue increases (credit)
- Collect an account receivable.When you collect the money, your cash increases (debit) and your receivables decrease (credit)
- Send a client an invoice for a service you performed. When you send the invoice, your receivables increase (debit) and your revenues increase (credit)
- Make a payment on a line of credit. When you make the payment, your cash decreases (credit) and your loan balance decreases (debit).
Benefits of Double-Entry Accounting
You might be wondering, why bother? Why not just stick with single-entry accounting and track the cash coming in and out of your business? There’s a reason double-entry accounting has been around for more than 500 years!
There are two primary advantages of double-entry accounting.
BENEFIT #1. A MORE COMPLETE PICTURE OF YOUR FINANCIAL TRANSACTIONS
Many transactions that occur in a business don’t affect cash at all—or at least initially. For example, if you sell a product on credit, your receivables increase, and your inventory decreases. If you finance the purchase of a piece of equipment, your loans payable increases and you fixed assets increase.
If the only thing you’re tracking is the balance in your bank account, you’re missing a big piece of the picture.
BENEFIT #2: MORE ACCURATE FINANCIAL RECORDS
Because double-entry accounting has two equal and opposite entries for every transaction, your debits and credits should always be equal or in balance. At the end of the year, if there is a difference between your debits and credits, you know right away that there’s an error in your books.
For example, say you’re using single-entry accounting in your business, simply tracking the cash in and out. You also keep a schedule of Fixed Assets on a spreadsheet. In July, you bought a #100,000 piece of equipment for your business. You recorded the money coming out of your checking account but forgot to add the equipment to your Fixed Asset Schedule.
At the end of the year, you send your Profit & Loss Statement and your Fixed Asset Schedule to your tax preparer. You could have claimed a big tax deduction for depreciating that piece of equipment, but your tax preparer has no idea that your fixed asset schedule is wrong, so you miss out on the deduction and overpay your taxes.
With double-entry accounting, you and your tax preparer would have known something was wrong with just a glance at your Trial Balance. Your debits and credits would be out of balance by #100,000. You would do a little investigating to find out the error and get to take advantage of that valuable tax deduction.
Is Double-Entry Accounting More Complicated?
With all of this talk of debits and credits and two entries for every transaction, it might sound like making the switch from single-entry to double-entry accounting is difficult and complex. In fact, if you use cloud-based accounting software, all of this is handled for you.
You’ll simply record a transaction, such as purchasing supplies, sending an invoice, or recording a cash deposit once, and the software takes care of the necessary debit and credit entries.
Still, it’s a good idea to know the basics behind double-entry accounting. That way, when you enter transactions into your software, you have an understanding of what’s going on behind the scenes and are better able to correct errors when something goes wrong.
Single-entry accounting is a simple system for freelancers without inventory, who don’t owe anyone money or have employees and get paid in a straight-forward manner. But as your business grows and becomes more complex, you’ll want to get more insight into your business and keep a better reign on your finances. The first step in doing that is to embrace the power and value of double-entry accounting.