Virtually all UK businesses rely on double-entry accounting, even if they don't realise it, and it’s the reason why we talk about ‘balancing the books.'
“Even accountants struggle to explain double-entry accounting and it can be confusing,” says Mahmood Reza, a business finance advisor and Founder of the I Hate Numbers consulting group. “Today most double-entry accounting is done automatically by accounting software, so it’s not something most of us will ever see or have to do.”
In this article, we’ll explain how double-entry accounting works, and the ways in which it can help you make better business decisions.
What is double-entry accounting?
Double-entry accounting is an approach to bookkeeping that records each transaction as two separate entries in the ledger. For example, a sale for £200 would be recorded as a transaction, as well as a 'reaction' to that transaction - a corresponding increase in cash of £200.
Another example could be where a company takes an investment of £1 million in exchange for a stake in their business. The £1 million would be credited to the company’s bank balance, but a corresponding debit would be recorded in the company’s equity account.
Most modern accounting software automatically applies double-entry accounting to your figures, says Reza, and will capture the reactions to all your transactions. “This is important because it helps to reduce the risk of errors in your accounts by ensuring the numbers all align, but it also provides you with better information about how your business is performing,” says Reza.
ROCK is a UK-based technology consulting firm that uses accounting software that applies double-entry accounting. This means that transactions are captured not just as sales or expenses, but in a way that shows the impact of each transaction on available capital, assets and liabilities, and other accounts, says Rob Dance, the company’s CEO.
“Having accurate and up-to-date financial information supports our operations by giving us data showing where expenses could be reduced, or revenue increased,” says Dance. “They’re also critical in planning budgets and forecasts and monitoring the business over time to see trends and ensure we remain compliant.”
Types of accounts
The most common types of accounts used in double-entry accounting are:
- Assets and liabilities.
- Equity.
- Revenue.
- Gains and losses.
Debits and credits
In a double-entry accounting system, the terms credit and debit have a specific meaning.
Depending on the sort of account being discussed, a debit can increase or decrease the balance of that account. For example, a liability account usually has a positive balance – this is a sum of money the business owes to other companies. The balance of a liabilities account is therefore increased by a credit and decreased by a debit. The opposite is true of an assets account.
Double-entry vs. single-entry accounting
Single-entry accounting is a list of transactions similar to what you might see on a bank statement or a cash register. However, the vast majority of UK businesses use accrual accounting when filing annually with Companies House and HMRC, which requires double-entry accounting to produce the necessary data.
Reza goes on to say that you might find a self-employed individual working as a freelancer or tradesperson, for example, who uses single-entry accounting, but "once you move onto the most basic online accounting package, you’ll be using double-entry accounting."
Example of double-entry bookkeeping
Company A has £1,500,000 in its bank account and spends £100,000 on new laptops for its workforce.
- First, the company records an outflow of cash as a ‘credit’ that reduces the asset (cash).
- There is also a corresponding increase in the asset owned by the company.
- The company hasn’t generated any new profit but the cash balance has reduced and been replaced by the new computers.
If, however, the company borrowed £100,000 to buy the new computers, the double-entry accounting would recognise the different impact this has on accounts:
- The company’s cash balance has not decreased.
- The company has acquired £100,000 in assets, but now also has £100,000 in debt.
“Business owners do not need to know the details of how this information is captured, but they do need to be aware that every time you buy something, sell something or borrow money, this has an impact on the overall financial health of the organisation and what the balance sheet looks like,” says Reza.
Why is double-entry accounting important?
Double-entry accounting reduces the risk of error, says Reza. Because each sale is balanced by a corresponding change in another of the company’s accounts, mistakes should be immediately obvious.
“As a business owner, you should expect your accountant to spot these mistakes, but double-entry accounting on your finance systems should alert you to any figures that don’t match up,” he says.
ROCK uses the double-entry approach to populate monthly management accounts that show key financial performance metrics, says Dance. “The monthly management accounts provide a summary of financial activities including revenue, expenses and profits, which means I can track performance month to month and identify areas for improvement,” he says.
Other reports generated using double-entry bookkeeping include annual P&L accounts, which summarise cost of goods sold, revenue and expenses over a year. This is produced at the same time as the balance sheet, which provides an overview of assets, liabilities and equity. Because double-entry accounts are generated in near real-time, ROCK can access these reports as often and quickly as needed, says Dance. “It helps me to know that we are on track to meet financial obligations, and manage cash flow,” he says.
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What are the rules for double-entry accounting?
When using the double-entry accounts system, the important rules to remember are that:
- For every transaction, there must be a reaction, and this means each transaction must result in at least two entries in the general ledger.
- One side of each transaction is called a debit, the other side is called a credit. These names terms are used differently depending on the type of account.
Credits are used to record:
- Sales and other income such as interest.
- Liabilities such as trade creditors, or long-term borrowing.
- Share capital.
- Profits and gains that form part of shareholder funds.
- Reduction in debt balance.
Debits are used to record:
- Expenses.
- Assets of any kind.
- Losses form part of shareholder funds.
- The reduction of credit balance.
“The software gives the illusion that the numbers are easy, but it can be quite complex, even following these rules,” says Reza.
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