As a fundamental accounting concept, double-entry bookkeeping reflects the fact that every financial action your business takes results in an equal, consequential reaction.
When you do something that brings cash into your business, for example (like sell a product or take on an investor), it means your business also gave something up (like inventory or equity).
Using double-entry bookkeeping to track where your money is coming from and going to:
- Increases the transparency and reliability of your financial data
- Decreases the risk of bookkeeping errors
- Helps you make better business decisions
To do double-entry bookkeeping correctly, however, you’ll first need to understand how business accounts are organized—and how debits and credits affect them.
What is double-entry bookkeeping?
Double-entry bookkeeping is an accounting system that uses debits and credits to record business transactions as journal entries in a general ledger (or master accounting document).
Every transaction is recorded in at least two accounts in your ledger: as a debit to one account and a credit to another. For more complex transactions, there may be more than two entries recorded.
Selling a product, for example, may:
- Increase your revenue account
- Decrease your inventory account
- Create a tax liability around the sales tax collected
To figure out which accounts to debit or credit, let’s start by looking at how general ledger accounts are set up.
Breaking down the general ledger
A general ledger is usually divided into five main account categories:
1. Assets (what your business owns) include things like cash, inventory, and accounts receivable
2. Liabilities (what your business owes) include things like loans, taxes, and accounts payable
3. Equity (Assets minus Liabilities) reflects things like retained earnings and owner’s equity
4. Revenue (money flowing into your business) includes things like sales and investment interest
5. Expenses (money flowing out of your business) include things like rent, insurance, advertising, and payroll
By breaking these main accounts into their corresponding subaccounts (also known as your company’s chart of accounts), you can:
- Record and organize all your business transactions
- Produce meaningful financial reports
- Use your data to evaluate business performance and make more informed financial decisions
For example, by breaking out what you own (asset accounts)—and subtracting what you owe (liability accounts)—your balance sheet reflects the value of your business.
Your income statement, meanwhile, reflects your business’s profitability by breaking out and subtracting your expenses (expense accounts) from your income (revenue accounts).
How does double-entry bookkeeping work?
As you’ll recall, with double-entry bookkeeping you must make at least two journal entries to record a business transaction. So, if your transaction involves trading one asset (cash) for another asset (equipment), you’d adjust both your cash and equipment accounts.
To make those adjustments correctly, however, you need to follow certain rules governing debits and credits.
- Increase asset accounts
- Decrease liability or equity accounts
- Decrease revenue accounts
- Increase expense accounts
- Decrease asset accounts
- Increase liability or equity accounts
- Increase revenue accounts
- Decrease expense accounts
When recording transactions as journal entries in your general ledger, debit entries are always recorded on the left side, while credit entries are recorded on the right.
These entries can be summarized (and checked) in a trial balance worksheet, which shows the debit or credit balances of each business account, along with the total credits and debits.
Here’s a simplified example to show how debits and credits are used to make journal entries:
You recently paid $3000 for a new business laptop. This represents an increase in equipment and a decrease in cash. To record this transaction in your books, you’d debit your equipment account by $3000 (because the equipment is an asset that’s increasing in value) and credit your cash account by $3000 (because cash is an asset that’s decreasing in value).
The key point to remember for ensuring all your accounts balance is that every business transaction must be recorded as a debit and credit in at least two accounts in your books.
This will also keep the following accounting equation in balance:
Assets = Liabilities + Equity
This equation is clearly represented on your balance sheet, where asset accounts are laid out and totaled down the left side, and liability and equity accounts are laid out and totaled down the right side.
If this equation is ever out of balance, it means a journal entry mistake has been made somewhere along the way.
Using accounting software
Accounting software (like QuickBooks, for example) makes it easy to do double-entry bookkeeping.
With such software, you can quickly:
- Customize your chart of accounts
- Record your transactions by coding them to specific accounts
- See when a journal entry is out of balance
You can even connect your bank feed to your accounting software to avoid manually importing bank and credit card transactions.
Single-entry vs. double-entry bookkeeping
Single-entry bookkeeping is another accounting system that can be used to keep track of business finances. With this method, however, there’s only one journal entry per transaction—and most entries record either incoming or outgoing funds.
Although the single-entry bookkeeping method is easier to use than double-entry (because all transactions are recorded in a single ledger), it does not track asset, liability, equity amounts and is more prone to mistakes.
Why is double-entry bookkeeping so important?
Unlike the single-entry method, double-entry bookkeeping provides a complete, three-dimensional view of your finances. This makes it a far more insightful way to monitor your company’s financial health.
The double-entry system also gives accountants the information they need to create all the major financial statements:
- Income statements
- Balance sheets
- Cash flow statements
- Statements of retained earnings
While public companies are legally required to use the double-entry bookkeeping system as part of Generally Accepted Accounting Principles (GAAP), small businesses with more than one employee should also use the double-entry method—especially if you’re looking to apply for a loan.
Not only is double-entry bookkeeping the more accurate accounting method, it’s the only way to see how quickly your business is growing. Plus, as the more complete and transparent system, it’s the preferred method of investors, buyers, and banks. Anyone considering investing or lending your business money, in fact, will be a lot more likely to do so if you use double-entry bookkeeping.
Need a hand understanding, setting up, or managing your business’s double-entry bookkeeping system? Enkel can help.