Double-entry accounting is an accounting technique that records debit and credit for all business transactions. It gives a financial picture of a business’s finances.
This technique is based on the accounting formula: Assets = Liabilities + Equity. Credits to one account must equal debits to another for the equation to be balanced. Accountants use debit and credit entries to record transactions to each account.
Double-entry accounting reduces errors and increases the likelihood that your books will balance. It also helps with financial reporting and fraud prevention.
Single vs Double-entry accounting
In single-entry accounting, the income and expenses for transactions are recorded in a cash register. Single-entry accounting systems track revenue and costs. Since they do not track assets, liabilities, or owners’ equity, you can’t generate financial statements.
The double-entry system begins with a journal, followed by a ledger and a trial balance, and then a financial statement.
There are various advantages to using a double-entry system over a single-entry system:
- Debits and credits must always be the same in double entry, otherwise an error occurs. This makes it easy to detect errors and ensures that they do not spread to other financial statements. With single entry, there is no way to detect or correct errors.
- A single-entry system’s data is insufficient for financial reporting or creating profit and loss statements. Larger firms rely on these reports to track their performance, therefore double-entry accounting is more suitable for them.
- An income statement enables you to examine your company’s development and effect, including financial expenditures and revenue. Sales and purchases are documented as ledger entries so you can easily monitor which sectors require investments and how expenses can be cut efficiently.
- The single-entry system is only suitable for small businesses, but the double-entry system can be used by all sizes of businesses.
Disadvantages of double-entry accounting
- A double-entry accounting system requires maintaining many books, which is inconvenient for small businesses.
- Using the double-entry system for bookkeeping requires extensive knowledge of accounting.
In double-entry accounting, businesses can use any combination of the five types of accounts – assets, liabilities, equity, revenue, expense, gains and losses. Each journal entry includes two sides: one for debits and one for credits. The type of account determines whether it has a normal debit or credit balance and whether they increase the balance.
- Assets: Assets owned by a business have potential economic value in the future.
- Liability accounts: Reflect what the company owes, such as a mortgage on a property, an equipment loan, or credit card balances.
- Equity: Amount of money invested in a business by its owner/s, plus all retained earnings from operations. Examples include paid-in equity (funds from investors), retained earnings, and common stock.
- Expenses: Show how much money was spent, including the cost of purchased goods for sale, payroll costs, rent, and advertising.
- Revenue: Money earned from any business activity, such as product sales, service fees, and interest income. Revenue has a normal credit balance and is increased through credits.