What Is Double-Entry Accounting?
In use for hundreds of years, double-entry is an accounting system that operates on the principle that every financial transaction impacts at least two accounts, either as a debit or as a credit. The main premise of double-entry accounting is that a company's financial health is sufficient if its debits and credits remain balanced at all times.
If you're the owner of a small business and you wish to apply for a loan, you will need to show an accurate picture of the financial health of your business. Because double-entry accounting is the standard way to record finances in business, it’s important to understand the principles behind it.
The three rules of double-entry accounting
There are three rules for double-entry accounting:
- Every transaction is recorded in at least two accounts.
- The debit recorded in one account must be equal to the credit recorded in another account.
- Total assets must always equal total liabilities plus total equity. (assets = liabilities + equity)
When entries are made into a company's general ledger using double-entry accounting, debits are recorded on the left and credits on the right. All of the entries are then summarized in a trial balance. If the numbers have been entered properly, the total credits of the business will equal the total debits.
This system provides accountants, loan officers and investors with the ability to see the information presented in a number of different types of financial statements, including income statements, balance sheets, statements of retained earnings and cash flows.
Using double-entry accounting also has benefits for a business. For example, it’s possible to itemize the profits in each account to help determine which products and services are doing well, and make better informed financial decisions.
Double-entry accounting can impact different accounts
There are five accounts used in double-entry accounting systems. These are known as the chart of accounts:
- Asset accounts. These assign a monetary value to company-owned resources with current or future business benefit. If a company owns real estate or intellectual property, for example, the value of these will be recorded in an asset account.
- Liability accounts. These include expenses that have not yet been paid. This account includes outstanding debts and pending payments.
- Equity. This provides information about ownership of the business and includes common stock, treasury stock and retained earnings. This is where ownership of a business is recorded.
- Income accounts. These track the income generated by the business, such as sales revenue, interest income and asset-generated income.
- Expense accounts. These provide information about the company's costs, such as utilities, payroll, or rent.
The payments that are made into and from these accounts as a result of a transaction can be recorded as either a debit or a credit.
- An increase to an asset account, such as the purchase of new equipment, is considered a debit, while a decrease to that account is considered a credit.
- An increase to a liability account, such as taking on a loan, is considered a credit, while a decrease to that account, such as paying off a debt, is considered a debit.
- Increases to equity accounts are recorded as credits, while decreases to these accounts as a result of expenses are considered debits.
It is important to note that a double entry can impact two accounts of the same type. For example, purchasing a piece of office equipment can impact an asset account by taking cash away from the business, and it can simultaneously increase an asset account by adding the additional equipment to the company's assets.
Who uses double-entry accounting?
Double-entry accounting is the accounting system used by most businesses, with the exception of those that are very new or very small. Some of the advantages provided by this accounting method include:
- Preventing fraud and embezzlement by producing a record of every transaction.
- Providing a complete picture of the financial health of the company, including tracking employee expenditures, inventory, debts and assets spread out over multiple accounts.
- Maintaining up-to-date financial information. This is needed when a company applies for a new loan, for example, or wants to attract new investors.
- Reducing accounting errors and making those that do occur easy to spot and fix. With double-entry accounting, errors are easily spotted, because if liability and equity don't equal assets, then the books are wrong.
What are the advantages of single-entry accounting?
There is a simpler system of accounting: single-entry accounting. However, it’s generally not used by established businesses.
The main benefit of a single-entry accounting system is ease of use. The most common type of single-entry system is a checkbook where income and expenses are added or deducted from a running cash balance.
While you can generate an income statement from this type of system, you will be severely limited in your ability to track liabilities and assets. It’s also harder to spot and correct errors.
Examples of double-entry accounting
Practically any business transaction that is recorded by your accountant or by accounting software uses the double-entry accounting system. Here is a look at three examples of how it works.
You purchased a new office printer for $1,000. When recording the transaction, it is recorded as a debit that increases your asset account, while appearing as a credit that decreases your cash account.
You deposited $300 in revenue for your business. The transaction is recorded as a credit (loss) to your revenue account, while also being recorded as a debit (gain) to your cash account.
You took out a business loan of $100,000. The loan will appear as a debit (increase) to your assets as well as a credit (increase) to your liabilities.
What is double-entry accounting software?
Most popular brands of accounting software use involve double-entry accounting. These software applications make double-entry accounting easy to use. You can simply enter a transaction in the form of a check, invoice or bill, and the impact of the transaction is automatically entered on a second account.
One way to determine whether the software you're considering is capable of double-entry accounting is to see if it can produce a balance sheet. If a balance sheet is available and does not require you to add any information beyond the date of the report, the software is using a double-entry accounting system.