Double-Entry Bookkeeping Explained

This is why single-entry accounting isn’t sufficient for most businesses. That’s a win because financial statements can help you make better decisions about what to spend money on in the future. Increase a liability or equity account, or decrease an asset account. It’s impossible to find investors or get a loan without accurate financial statements, and it’s impossible to produce accurate financial statements without using double-entry accounting. To enter that transaction properly, you would need to debit your cash account, and credit your utilities expense account.

Sole proprietors, freelancers and service-based businesses with very little assets, inventory or liabilities. The system might sound like double the work, but it paints a more complete picture of how money is moving through your business.

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Payments made to the business by customers for the goods and/or services provided by the business. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. In bookkeeping for small business order to understand how important double-entry accounting is, you first need to understand single-entry accounting. Benedetto Cotrugli, an Italian merchant, invented the double-entry accounting system in 1458.

• In our next scenario, our company purchases $50,000 in inventory — however, the purchase was completed using credit rather than cash.
• Double-entry accounting is a system that requires two book entries — one debit and one credit — for every transaction within a business.
• Debit to Asset → If the impact on an asset account’s balance is positive, you would debit the asset account, i.e. the left side of the accounting ledger.
• He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses.
• Debits are increases to an account, and credits are decreases to an account.
• The system might sound like double the work, but it paints a more complete picture of how money is moving through your business.

Lastly, each account in the Chart of Accounts is classified as one of five account types. To fully understand how to post transactions and read financial reports, these five different account types must be fully understood.

What Are the Rules of Double-Entry Bookkeeping?

The General Ledger is so named because a paper ledger previously held this data. When an Accounting period was over, the accountant prepared the General Ledger reports. The two most important reports are the Balance Sheet and Income Statement. The Chart of Accounts is flexible in that new accounts can be easily added.

• When you make the payment, your account payable decreases by $780, and your cash decreases by $780.
• This helps explain why a single business transaction affects two accounts as opposed to just one.
• A debit entry will increase the balance of both asset and expense accounts, while a credit entry will increase the balance of liabilities, revenue, and equity accounts.
• Here are a few transactions for which Journal Entries are to be recorded.
• Bookkeeping can be complicated businesses of any size, and double-entry bookkeeping, all the more so.
• The key feature of this system is that the debits and credits should always match for error-free transactions.

They are the Traditional Approach and the Accounting Equation Approach. Irrespective of the approach used, the effect on the books of accounts remains the same, with two aspects in each of the transactions. The General Ledger consists of the Chart of Accounts, individual transactions, account balances, and the financial reports for a given accounting period.

Who invented double-entry accounting?

Double-entry bookkeeping is designed to reflect the greatest truism of business – you don’t get anything for nothing. If something comes into your business, it’s because you gave something up.

Because of the accuracy of double-entry bookkeeping, we can now form other financial statements with correctly balanced data. A trained bookkeeper can quickly see how a transaction affects the five big accounts, but it doesn’t come naturally to most of us. It’s a handy link between daily business activities and the five accounting buckets. Since the purchase represents a “use” of cash, the cash account is credited $250,000, with the offsetting entry consisting of a $250,000 debit to the equipment account. The chart below summarizes the differences between single entry and double entry accounting.

Double-entry bookkeeping explained

This principle is useful for identifying errors in the transaction recording process. Contra liability accounts and contra expense accounts—like their contra asset counterparts—also reverse the debit/credit “rules” from the table in the previous section. An addition to a liability account, for instance, is usually a credit, but to a contra liability account, the increase is a debit. For this reason, the balance in a contra liability account is a debit balance. You always list an increase in assets in the debit column and a decrease in assets in the credit column. If the total amount in your debit columns matches the total amount in your credit columns, your books are balanced. If the amounts don’t balance, there’s an accounting error somewhere in your records.

The software lets a business create custom accounts, like a “technology expense” account to record purchases of computers, printers, cell phones, etc. You can also connect your business bank account to make recording transactions easier. For instance, if a business takes a loan from a financial entity like a bank, the borrowed money will raise the company’s assets and the loan liability will also rise by an equivalent amount.

Step 2: Use debits and credits for all transactions

“It was just a whole revolution in the way of thinking about business and trade,” writes Jane Gleeson-White of the popularization of double-entry accounting in her book Double Entry. Recording transactions this way provides you with a detailed, comprehensive view of your financials—one that you couldn’t get using simpler systems like single-entry.

In this case, assets (+$10,000 in inventory) and liabilities (+$10,000) are both affected. Both sides of the equation increase by $10,000, and the equation remains balanced. Accountants call this the accounting equation, and it’s the foundation of double-entry accounting. If at any point this equation is out of balance, that means the bookkeeper has made a mistake somewhere along the way. While you can certainly create a chart of accounts manually, accounting software applications typically do this for you. Once you have your chart of accounts in place, you can start using double-entry accounting.