There are two systems of accounting: double-entry and single-entry. Many small business owners pick a system early on based on business factors. Which is the best method for your business? This article will get into why you should be using the double entry accounting system.
In this article:
- What is double-entry accounting?
- Double entry accounting definition
- The accounting equation
- Pros and cons of double entry system vs single entry
- Double entry accounting examples
What Is Double-entry Accounting?
Double-entry accounting is a system of accounting where every business transaction is represented by at least two entries. The entries track which account your money comes from and where it’s going. Entries are described as a “debit” or a “credit,” that increases or decreases the balance of the account.
Double Entry Accounting: a system of recording business transactions where each transaction affects at least two accounts and requires an equal debit and credit.
For example: A customer buys sunglasses from your eCommerce store, your sales account goes up, and your inventory account goes down. It is one transaction but it is recorded in two accounts.
The Accounting Equation
The accounting equation (Assets = Liabilities + Equity) is the foundation of double entry accounting. It is also known by these names:
- Basic accounting equation
- Balance sheet equation
The accounting equation represents accounts on the balance sheet. By balancing debits and credits, and entering each transaction into the corresponding asset, liability, or equity accounts, the equation remains in balance. If at any point this equation is out of balance, it calls out an error in double-entry bookkeeping and can easily be remedied.
Who Invented Double Entry Accounting?
The system was first documented in a book by Luca Pacioli in Venice in 1494. He is often credited as the father of double-entry accounting, though he merely described the system in a mathematical encyclopedia. Before merchants were trying to add and subtract roman numerals. When Arabic numbers weaved their way through society it provided a better way to visualize business and it evolved into double entry accounting.
Pros And Cons Of Double Entry Vs Single Entry Accounting
Each accounting system has advantages and disadvantages. See for yourself why we favor double-entry over the single-entry accounting system. Here are the pros and cons of each system:
Double Entry Accounting
More visibility into your finances
Tracks assets, liabilities, and equity accounts
Multiple ledger system
Prevents fraudulent activity
Can do progress comparisons month to month, year to year, etc.
Accepted by investors and creditors
There is a learning curve
Single Entry Accounting
Simple to understand
Better for freelancers or sole proprietors
Prone to errors
Can’t view financial performance
Doesn’t track assets and liabilities
Not good for modern business
Not ideal for inventory or loan tracking
Not very secure
Single ledger system
Why Double Entry Accounting?
The main reason for double entry accounting is financial visibility. You’re tracking your money so you can later interpret that information via financial statements. Each statement gives you insights into the profitability and health of your business. Helping you make more informed decisions about future investments.
Double-entry accounting also decreases bookkeeping errors. How? As stated earlier in the article credits and debits must balance out. If there was an error during transcription, it will be apparent when you are reconciling the ledger. All entries get summarized into a trial balance, the total of all account balances, and the sum of your total credits and total debits. If accounting was done correctly, your trial balance will show that the credit and debit summaries are equal.
How To Do Double Entry Accounting
Here is a quick guide on how to do double entry accounting. This can be used by any business and is especially encouraged for high volumes of transactions.
Debits and Credits
Debits and credits are at the heart of a double entry accounting. A debit is how you used your funds, what you received or purchased; a credit is the source of your funds, where the money came from, or what you gave. When inputting journal entries, debits are always recorded on the left, and credits on the right. Credits and debits should always match per transaction.
Credit and debits are made to all accounts on the balance sheet. Accounts on the balance sheet are called your chart of accounts which is like a map of business dealings. A chart of accounts is broken up into five types: assets, liabilities, equity, income, and expenses. Each of your business accounts will fall into one of these categories. Here are some examples:
Asset accounts: are associated with resources a business owns, such as the cash in a checking account or the price paid for inventory.
Liability accounts: show what a business owes, such as a building mortgage, equipment, loan, or credit card balances.
Equity: shows financing for the company, such as investor contributions, stock accounts, or retained earnings.
Income accounts: money that is received, such as sales revenue and interest income.
Expense accounts: money that is spent, including purchased goods for sale, payroll costs, rent, and advertising.
Debits and credits will perform differently depending on the type of account. Here is how debits and credits work under in each type of account in the double-entry system:
Debits: left side
- Increase an asset account
- Decrease a liability account
- Decrease an equity account
- Decrease revenue account
- Increase an expense account
Credits: right side
- Decrease an asset account
- Increase a liability account
- Increase an equity account
- Increase revenue account
- Decrease an expense account
Double Entry Accounting Examples
Remember under double-entry accounting, every debit always has an equal credit, to keep the accounting equation (Assets = Liabilities + Equity) in balance:
You are starting a SaaS company and you need to pay for software hosting. You pay a monthly premium of $300 for a hosting subscription.
In double-entry accounting, you make two entries, one in your utilities (liability) account and one in a cash (asset) account. Since you received hosting for your software, that is a debit; you paid for it from your cash account, that is a credit. Both accounts are decreasing, assets and liabilities are equal so the accounting equation remains in balance.
This example will have more than two entries. You just sold $1000 worth of wholesale products, on credit, to a customer. Your customer must pay the outstanding invoice in 2 weeks.
You make two entries, one in your sales (asset/income) account, and one in accounts receivable (asset). Since your customer hasn’t paid the invoice the sale isn’t finalized. You will receive income, but until then the $1000 sits in accounts receivable, that is a debit; to balance the debit it needs to be paid from your sales account, that is a credit. Accounts receivable increases while the sales account decreases. Both are asset accounts so the credit and debit balance the asset side of the accounting equation.
In 2 weeks when the customer pays their invoice, the sale is finalized. You make two more entries, one in your cash (asset) account, and one in accounts receivable (asset). This time you are receiving $1000 into your cash account, a debit; moving money from accounts receivable, is a credit. Accounts receivable decreases while the cash account increases. Once again the credit and debit balance the asset side of the accounting equation.
The Double Entry Accounting System Means Better Business
Business is way too complex to remain on a single scroll. Most accountants will strongly recommend using a double-entry accounting system. By organizing your transactions into accounts and keeping the accounting equation in balance, you won’t be in the dark about your performance. Double-entry provides clear financial reporting so you can anticipate loss and most importantly profits. We know it takes time to get the hang of this system of accounting so we are always open to answer any questions.