For many freelancers, contractors, and solopreneurs, keeping track of business expenses is a simple matter of creating a laundry list of pluses and minuses, better known as single-entry accounting. But once an individual or a small company decides to bump up their operations to the next level – maybe by applying for a business credit card, opening a line of credit, bringing on investors, or even going public – that basic accounting system quickly proves inefficient.
At that pivotal point, when you’re shouldering more responsibility, growing your business, and dealing with more transactions every month, it’s time to switch from single-entry to double-entry accounting.
What is double-entry accounting? It’s a more sophisticated method of bookkeeping that allows you to depict the financial position of a company more accurately by recording transactions according to “debits” and “credits,” which fills two sides of a ledger instead of one. Double-entry accounting follows this accounting equation: Assets = Liabilities + Equity, which gives you a real read on gains, losses, and cash flow.
Let’s take a more in-depth look at double-entry accounting and some of its benefits.
Double-Entry Accounting Definition: A Beginner’s Guide
Double-entry accounting is used by small and large companies across all industry sectors. In essence, the definition of double-entry accounting is a bookkeeping method that keeps a company’s accounts in balance, revealing the true state of its finances.
What’s the purpose of double-entry accounting? To gain a clearer picture as to where and how your business is spending, earning, or even frittering away money. Double-entry accounting can help hold your business more accountable for its spending, give you the leeway to scale as your operations grow, and illuminate its profitability. And in the eyes of banks and potential investors and buyers, using double-entry accounting elevates your company to the level of a bona fide business.
The double-entry accounting system records transactions between business parties (such as customers and businesses, or vendors and businesses) as debits and credits. Every financial transaction is recorded as a journal entry, which impacts at least two accounts. When a debit is marked in one account, it counterbalances a credit in another account, so the tally of debits equals that of the credits. The accounts must be equal for the system to be balanced.
A more sophisticated method of bookkeeping than single-entry accounting, double-entry accounting allows businesses to record financial transactions using debits and credits.
Double-entry accounting is also the basis for accrual accounting, a method that lets a business record revenue and expenses when they are earned and incurred, rather than when payment for those goods and services is made. It’s also considered more accurate than cash-basis accounting, a different method used for single-entry accounting. Cash-basis accounting records expense and payment transactions only when cash payment has been received or paid.
Publicly traded companies and others that release financial statements to the public are required to use double-entry accounting. In doing so, they must adhere to U.S. Generally Accepted Accounting Principles (GAAP), which serve as the foundation of approved standards used in business and corporate accounting. These principles are established and maintained by the Financial Accounting Standards Board (FASB), a private nonprofit organization. If your company is in the throes of applying for a business loan, note that most lenders require GAAP-compliant financial statements when reviewing applications, regardless of whether your company is private or public.
Setting Up the Double-Entry Accounting System
A journal entry in double-entry accounting impacts at least two accounts, with debits entered in the left-hand column and credits in the right-hand column. Setting up a double-entry accounting system typically entails implementing accounting software, and following these four basic steps:
1. Draw up a chart of accounts.
This will help ensure that your bookkeeper can record economic events and categorize journal entries correctly. Accounts usually fall under five classifications, with the type of account determining if it has a normal (or natural) debit or credit balance, or the kind of balance that’s normally expected of that account. The five accounts include:
- Assets: A company’s holdings, including cash, inventory, equipment, property, business vehicles, office furniture, and accounts receivable.
- Liabilities: The amount of money a company owes or is expected to owe down the line, including loans, mortgages, taxes, accounts payable, and accrued expenses.
- Equity: The amount of funds owners contribute to a business, including money from investors, preferred stock, common stock, and retained earnings from business operations and treasury stock.
- Revenue: Money your business earns from its operations, including service fees, merchandise sales, and interest income.
- Expenses: What it costs to (literally) keep the lights on in your business, including the purchase of goods (inventory), rent, utilities, insurance, payroll, and depreciation.
2. Categorize financial events as debits and credits.
Whatever the transaction or monetary unit, debits and credits are used to reflect the financial event. A debit entry will increase the balance of asset and expense accounts. It’s deducted from revenue, and from liability or equity accounts. A credit entry raises the balance of revenue and liability or equity accounts. It’s deducted from expense or asset accounts.
3. Always use two components for every transaction.
Those components, debits and credits, should always be in balance, following the accounting equation (Assets = Liabilities + Equity). If the sum of liabilities and equity falls short or exceeds your assets, then you need to double-check your bookkeeping.
4. Run financial statements.
Businesses can get a clear financial picture by using accounting software to produce accurate financial statements. Typically, at the end of each accounting period, bookkeepers close the books to get a grasp on events, using the net account totals to create a final balance. That adjusted final balance is integrated into the financial statement line items, ensuring that a business is always in balance.
Double-Entry Accounting Examples
To see double-entry accounting in practice, let’s look at two double-entry accounting examples.
Suppose that you own an art framing business and need to replenish your inventory of frames. In March, you spend $2,000 on readymade picture frames purchased from ABC Frames. You record a journal entry in the lefthand column, increasing the “inventory asset account” with a debit. A credit in the righthand column adds a $2,000 liability to the “accounts payable account,” owed to ABC Frames. When your company pays ABC, the bookkeeper reduces the amount in the accounts payable account with a debit and reduces the cash account with a credit.
Another example: Say you spend $1,000 on expenses related to a business trip. If you were still using single-entry accounting, you’d simply lop the sum off your bank account balance. By using double-entry accounting in the manner just described, and establishing separate accounts in your chart of accounts for transportation, business meals, and lodging, you’ll be able to see how much you’ve laid out for those individual aspects of the trip. That information may prove helpful for planning future out-of-town trips.
The Takeaway
A more sophisticated method of bookkeeping than single-entry accounting, double-entry accounting allows businesses to record financial transactions using debits and credits. Each journal entry fills two sides of a ledger, instead of one, and follows the accounting equation: Assets = Liabilities + Equity. Bookkeepers enter journal transactions into many individual accounts, which are classified as one of the following: assets, liabilities, equity, revenue, or expenses. Using accounting software, they can use these journal entries to produce accurate financial statements, with a concrete understanding of a business’' gains, losses, and cash flow.
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