It’s a common bookkeeping problem for small-business owners: You review your monthly bank statements and check them against a handwritten log of sales and expenses. The log and bank statements don’t always match, however. Sometimes the bank says you have more money than your records show, sometimes less.
There is a better way to keep track of your business’s finances. It starts with double-entry bookkeeping.
What is double-entry bookkeeping?
Double-entry bookkeeping, also called double-entry accounting, is a system of recording each business transaction twice. These are known as bookkeeping entries, and they appear in equal but opposite amounts. One entry shows the source of money of each transaction, and the other entry shows the money’s destination. The double-entry system displays two columns for these entries, called debits and credits.
The key feature of double-entry is that the two columns must balance. This allows you to track money coming into your business and going out of it. Through periodic reviews called a trial balance, you ensure accounts are accurate.
What’s the purpose of a double-entry accounting system?
A double-entry accounting system is more reliable than a single-entry accounting system, in which purchases and payments are recorded simply as additions or subtractions to a single business account. Double-entry allows you to create other accounts to track money not yet received (accounts receivable) or paid (accounts payable), and goods held for sale (inventory).
Publicly traded companies and many privately owned companies use double-entry bookkeeping. It’s essential for preparing financial statements, such as the balance sheet, income statement, and cash-flow statement, as well as for accrual accounting—recording revenue and costs as they occur but that are not yet received or paid. Lenders and investors require financial statements based on double-entry to verify a business's financial condition before they consider a loan or an equity investment.
How double-entry accounting works
Double-entry bookkeeping and balancing a business’s books—ensuring that debits equal credits—is linked to a fundamental concept of finance called the accounting equation. It looks like this:
Assets = Liabilities + Equity
This equation sums up a business’s balance sheet, one of three essential financial statements along with the income statement and cash-flow statement. It’s called a balance sheet because the business’s assets must equal, or balance, the debt and liabilities used to finance them.
Ideally, assets are greater than debt and liabilities, and this difference makes up the owners’ or shareholders’ equity. Equity represents the dollar value of an ownership stake, whether the business is a sole proprietorship or a huge corporation with thousands of shareholders.
In double-entry bookkeeping, the left-side entries are called debits and the right-side entries are credits. The document (or software) where these entries are recorded is called a ledger.
What are the benefits of double-entry bookkeeping?
Double-entry can help your small business in several ways, including:
- Analyzing cash flows. Having more accounts than simple income and expense accounts allows you to comprehensively analyze how money flows through your business.
- Determining profitability. Double-entry makes it easier to calculate your business’s profit, including what parts of your business are most or least profitable.
- Detecting errors and theft. It makes detecting and correcting any accounting errors easier. It also can help identify fraud or embezzlement.
- Facilitating outside reviews. Banks and investors can get a reliable picture of your business’s condition before they consider lending money or making equity investments.
What are the limitations of double-entry bookkeeping?
At the same time, double-entry has some drawbacks, including:
- It’s complicated. It’s more complicated than single-entry bookkeeping because it deals with balance-sheet accounts and different accounting principles, such as accrual of income and expenses.
- It’s time-consuming. It’s more time-consuming to maintain a ledger and review account balances.
- It’s costly. Very small businesses have a harder time absorbing the cost of either hiring a bookkeeper or an accountant, or buying an accounting software program.
What’s the difference between double-entry and single-entry bookkeeping?
A quick rundown of the differences include:
- Once versus twice. Single-entry bookkeeping records a transaction once. Double-entry records the transaction twice, in equal and offsetting amounts.
- Size. Single-entry may be sufficient for very small businesses such as sole proprietors, freelancers, or others with a minimal number of transactions. Bigger businesses with more employees and frequent transactions usually use double-entry.
- Account types. Single-entry uses only personal and business cash accounts, such as a checking account, to track income and expenses, checks, and withdrawals. Double-entry uses nominal accounts (such as those appearing on an income statement) to track revenue and expenses, and real accounts (like a balance sheet) to track assets, liabilities, and equity.
- Complexity. Single-entry is simpler but incomplete, because recording transactions just once makes financial statements difficult to prepare. Double-entry is more complex, but by showing both sides of transactions through debits and credits, it’s easier for a business to generate financial statements.
- Information. It’s more difficult to know a business’s financial condition based on a single entry because it doesn’t maintain a ledger of debits and credits and doesn’t perform trial balances. Because double-entry accounting provides more information about the business, it’s easier to ascertain its financial condition.
- Tax preparation. Filing your taxes may be more difficult when using single-entry bookkeeping. A tax accountant must work from less information about your business’s transactions to determine its tax liability. Double-entry allows an accountant to examine the various accounts in your business to ensure proper tax treatment of transactions.
How to begin double-entry bookkeeping
Using an accounting software program is one of the easiest ways to start double-entry bookkeeping. Your small business has a wealth of options to choose from. After the initial setup of a double-entry system, most software providers charge a monthly subscription fee.
If your business accounts need to be straightened out first, you may also need to hire a bookkeeper or accountant before investing in a software program.
4 steps to set up a double-entry system
Starting a double-entry system isn’t necessarily easy, but the following four steps can simplify the process:
- Set up a chart of accounts
- Set up a business journal
- Create a ledger
- Conduct a trial balance of the ledger
1. Set up a chart of accounts
Double-entry requires the following five accounts for entering debits and credits. The first three relate to the business’s balance sheet, and the latter two to the income statement:
- Asset account. Assets include cash, property, factories, equipment, inventory, and accounts receivable.
- Liability account. Liabilities include loans, accounts payable, and customer credits.
- Equity account. This includes contributions from owners, money raised from selling stock, and retained earnings.
- Income account. Income includes sales, royalties, interest, and rents received.
- Expense account. Expenses include production costs, selling, general and administrative (SG&A) costs, and other expenses.
2. Set up a business journal
This is the place to record all transactions, in chronological order, with documentation, such as receipts, bills, and invoices. Journal transactions are then transferred and entered twice in the ledger as offsetting debits and credits. Software programs for business accounting typically are set up with formats for a journal and ledger.
3. Create a ledger
Even with a software setup, understanding the double-entry system can be challenging if you have little or no accounting experience. First, you must match transactions to the appropriate accounts for debit and credit entries. Second, the terms “debit” and “credit” are not always as simple as “add” and “subtract” in single-entry bookkeeping, and they may even seem counterintuitive. In some cases, a debit increases an account while a credit decreases it.
The important point is that debits, on the left side of the ledger, must be balanced by equal credits on the right side, to properly track the source of money for each transaction, and the destination for the money. Accounting software does much of this for you.
To keep them straight, below is a chart of the five key accounts and how they are debited or credited in double-entry bookkeeping:
|HOW IT INCREASES
|HOW IT DECREASES
Here are a few examples of double-entry bookkeeping:
Let’s say your business, an online seller of cookware and kitchen utensils, secures a $20,000 bank loan. A double-entry record of the loan transaction would look like this:
|Loan payable (liability)
Now, using part of the loan proceeds, let’s say you buy $10,000 worth of cookware at wholesale for your inventory. Here’s how this would look in double-entry:
Finally, you buy advertising for $2,500. You would record the costs as a double-entry this way:
4. Conduct a trial balance of the ledger
The trial balance is a review of the ledger to ensure that debits and credits match. This is the time to find and correct any errors so that the ledger can be used to prepare the business’s financial statements. You typically perform this review monthly.
Double-entry bookkeeping FAQ
Who created double-entry bookkeeping?
Some historians cite evidence of people using the double-entry method almost 2,000 years ago in the Middle East, but it became more widely used during the Italian Renaissance. Credit is often given to Luca Pacioli, a 15th-century Venetian friar and mathematician who wrote a treatise on the subject. He is sometimes called the father of modern accounting.
Is it possible to use single-entry and double-entry bookkeeping simultaneously?
You could, though it would be a waste of time. Double-entry bookkeeping incorporates all aspects of single-entry bookkeeping, so there is no need to do them simultaneously.
Does double-entry bookkeeping require extensive knowledge of accounting?
Some basic knowledge of accounting is helpful, because the double-entry system of debits, credits, and multiple accounts might seem daunting to a newcomer. Many small-business software programs are available and easy to set up.