The fact is, double-entry accounting is a must-have for all but the smallest, simplest businesses. It's a concept underlying the most dominant form of bookkeeping for the past five hundred years.
Experts even say that double-entry accounting created finance as we know it today.
One of the few downsides of double-entry accounting, though, is its apparent complexity. So to clear things up, in this post, we'll review what double-entry accounting is, how it works, as well as its pros and cons.
Double-Entry Accounting Definition:
To get started, let's answer the first question, what is double-entry accounting?
Double-entry accounting is a bookkeeping system in which each account entry corresponds with an opposite entry to a different account. Conceptually, this means that every financial transaction has equal and opposite effects in at least two different accounts.
In practice, this means that when you record a transaction in one account, you have to record that transaction in another account too. These two entries are classified either as a debit or a credit.
Putting it all together, for each transaction, at least one account gets debited and another gets credited.
How Double-Entry Accounting Works
Imagine you have an outstanding invoice for $1000, and your customer pays that invoice on-time. The entry for this payment transaction would be a $1000 credit to the Revenue account and a $1000 debit to the Cash account.
Which account is debited or credited and when depends on the transaction and the type of account. Accountants typically categorize transactions into five different types of accounts:
A debit to some of these accounts, such as Expenses and Assets, indicates an increase. From that, you can deduce that a credit to Expenses or Assets indicates a decrease. If that seems like a lot to remember, you can use the chart in the next section as an easy reference.
The Accounting Equation and How Debits and Credits Affect Accounts
The chart below shows how debits and credits affect different accounts.
When transactions are recorded this way, it enables accountants to use the Accounting Equation as an error check. This equation looks like this:
Assets = Liabilities + Equity
The reason this equation works as an error check is because of the double-entry accounting method. Every entry in an asset account is balanced by an entry in a liability or equity account. Thus, if assets don’t equal liabilities plus equity, you know you have a problem.
Pros of Double-Entry Accounting
1. Accounting equation acts as an error check
Despite its simplicity, single-entry accounting is far more prone to error than double-entry. This is thanks to the Accounting Equation, which we described in the previous section. As mentioned, if the equation doesn’t balance, it means there's an error in your reporting
. This makes it easy to prevent accounting mistakes from going undetected.
2. Provides an audit trail
Double-entry accounting requires that each debit and credit associated with a transaction include the same data and ID code. This creates an audit trail. An audit trail is useful because it enables you or your accountant to fix mistakes by tracing entries back to their original source.
Without an audit trail, there is no repeatable process for finding and fixing errors.
3. Transparent reporting
With built-in audit trail and error-checking features, double-entry accounting provides a more reliable view of your business's finances. This, along with controls for how transactions are categorized, makes double-entry accounting very transparent.
This is one of the main reasons double-entry accounting is considered the standard. If you’re trying to do business with others, such as a lender, partner, investor, or buyer, you’ll need double-entry accounting.
Cons of Double-Entry Accounting
1. It’s more complicated than single-entry accounting
Compared to single-entry bookkeeping, double-entry is at least two times more complicated. For the vast majority of business owners, you’ll need to retain a professional
to help you set up double-entry accounting. For single-entry bookkeeping, all you need is a physical or digital notebook.
2. There are a large number of accounts to keep track of
With single-entry, you record all your transactions in a single ledger
. If you can avoid errors, only having one account to keep track of is significantly less work. Of course, if there are any errors that go undetected, you could easily wipe out the time you gain from using single-entry.
Conclusion: Implement Double-Entry Accounting
Poor accounting is among the top ten reasons small businesses fail, according to the New York Times
. Due to this, it's imperative that you create an accurate accounting process that works for your business.
While double-entry accounting won’t solve all your accounting woes, it’s a key foundation. If you’re on the fence about making the switch to this type of accounting, it’s time to go forward. Whether you’re trying to get a loan, doing taxes, or even selling your business, double-entry bookkeeping is a prerequisite.