What is Double Entry Accounting?
Double entry accounting, also known as double entry bookkeeping, is a method of recording financial transactions where each transaction is recorded twice. These records, known as bookkeeping entries, are made in two columns: debits and credits.
The debits column represents the source of money for each transaction, while the credits column shows where the money goes. The fundamental principle of double entry accounting is that for every debit entry, there must be a corresponding credit entry, ensuring that all aspects of a business’s finances are properly documented.
The crucial aspect of double entry accounting is balance. This means that the total debits must equal the total credits in each transaction. By adhering to this principle, businesses can accurately track the flow of money into and out of their operations.
Regular reviews, such as trial balances, are conducted to ensure that the accounts are accurate and balanced.
Example
An example of double entry accounting is: a business purchases $2,000 worth of supplies using cash, this transaction would affect both the cash and supplies accounts. The supplies account would be debited by $2,000 to reflect the increase in assets, while the cash account would be credited by $2,000 to account for the decrease in available funds.
How Does Double Entry Accounting Work?
Double entry accounting operates in alignment with a foundational concept in finance known as the accounting equation:
Assets = Liabilities + Equity
This equation summarises the essence of a business’s balance sheet, one of the three key financial statements alongside the income statement and cash flow statement.
The balance sheet earns its name because it illustrates that a business’s assets must equate, or balance, the debt and liabilities utilised to fund them. Ideally, assets exceed debt and liabilities, and the disparity constitutes the owners or shareholders equity. Equity signifies the monetary value of an ownership interest, irrespective of whether the entity is a sole proprietorship or a large corporation with numerous shareholders.
In double entry accounting, the entries on the left side are termed debits, while those on the right side are credits. These entries are documented in a ledger, either physically or within software. This meticulous recording ensures that each transaction maintains the balance between debits and credits, preserving the equilibrium dictated by the accounting equation.
Key Steps To Set Up a Double Entry Accounting System
Setting up a double entry accounting system involves several steps to ensure accurate and systematic financial record keeping:
Establish a Chart of Accounts
To begin, the entity creates a chart of accounts, which categorises various types of transactions. These categories include assets (like cash and inventory), liabilities (such as loans and accounts payable), equity (representing owner contributions and retained earnings), income (including sales and interest), and expenses (like production costs and advertising).
Setup a General Journal & Special Journals
The General Journal and Special Journals are the central record of all transactions, documented in chronological order along with supporting documents like receipts and invoices. Transactions recorded here are then transferred to the ledger for further processing.
Create a Ledger
The ledger serves as the backbone of the accounting system, organising and summarising transactions from the journal. Each account has its own section in the ledger, with entries reflecting both debits and credits associated with each transaction. While accounting software can automate much of this process, understanding the principles of double entry accounting remains crucial for accuracy.
Perform a Trial Balance
Regularly, the entity conducts a trial balance of the ledger. This review ensures that the total debits equal the total credits, highlighting any discrepancies or errors that need correction before financial statements are prepared. Typically conducted monthly, the trial balance safeguards the accuracy and reliability of the entity’s financial records.
The Purpose of Double Entry Accounting System
The purpose of a double entry accounting system is to provide a more comprehensive and reliable method of recording financial transactions compared to a single entry system. In a single entry system, transactions are recorded simply as increases or decreases in a single business account. However, a double entry system offers greater accuracy and detail by recording each transaction twice, as both a debit and a credit.
With double entry accounting, entities can create multiple accounts to track various aspects of their finances, such as accounts receivable, accounts payable, and inventory. This allows for a more detailed and organised record keeping process.
Double entry accounting is particularly crucial for businesses that need to prepare financial statements, including the balance sheet, income statement, and cash flow statement. It also facilitates accrual accounting, where revenue and expenses are recorded when they are incurred, rather than when cash is exchanged. This enables entities to have a more accurate representation of their financial position and performance over time.
Furthermore, double entry accounting is often required by lenders and investors when evaluating a business’s financial condition before providing a loan or making an equity investment.
Financial statements based on double entry accounting provide a clearer picture of the entity’s financial health and help stakeholders make informed decisions about providing financial support.
Advantages of Double Entry Accounting
The advantages of double entry accounting are manifold and contribute significantly to efficient financial management:
Analyse Cash Flows
With a multitude of accounts beyond simple income and expense categories, double entry accounting enables thorough analysis of how money moves through the entity. This enhanced visibility into cash flows allows for more informed decision making regarding financial management and resource allocation.
Determine Profitability
Double entry accounting simplifies the calculation of the entity’s profitability by providing a clear framework for tracking revenues, expenses, and various income streams. This facilitates the identification of profitable and unprofitable aspects of the business, aiding in strategic planning and optimisation efforts.
Detect Errors and Theft
The structured nature of double entry accounting makes it easier to identify and rectify accounting errors. Additionally, the comprehensive record keeping can serve as a deterrent against fraud or embezzlement, as discrepancies are more readily noticeable.
Facilitate Outside Reviews
Banks, investors, and other stakeholders can gain a dependable understanding of the entity’s financial health through double entry accounting. The detailed and accurate records serve as valuable evidence of the entity’s condition, supporting loan approvals and equity investments while instilling confidence in external parties.
Limitations of Double Entry Accounting
Despite its benefits, double entry accounting also comes with some drawbacks:
Complexity
Double entry accounting is inherently more complex than single entry accounting because it involves managing balance sheet accounts and adhering to various accounting principles, such as accrual of income and expenses. This complexity can pose challenges for entities, especially those with limited financial expertise or resources.
Time Consuming
Maintaining a ledger and reviewing account balances in a double entry system can be more time consuming compared to single entry accounting. The need for meticulous recording of transactions and periodic reconciliation requires a significant investment of time and effort.
Costly
For very small entities, the cost associated with double entry accounting can be prohibitive. Hiring a bookkeeper or accountant to manage the accounting tasks or investing in accounting software programmes can strain the entity’s financial resources. These costs may be challenging to absorb, particularly for entities operating on tight budgets.
Difference between Single Entry and Double Entry Accounting
Single entry and double entry accounting are two methods employed by entities to document their financial transactions. Single entry accounting involves recording each transaction with only one entry, impacting one account without ensuring the balance of debits and credits. This method primarily focuses on monitoring revenue and expenses, neglecting to delve into equity, assets, and liabilities as thoroughly as double entry accounting.
Here are the main distinctions between single entry and double entry accounting:
Single Entry Accounting
- Tracks revenue and expenses.
- Utilises only one entry per transaction.
- Prone to errors due to its straightforwardness.
- Can be manually recorded or maintained via spreadsheets.
- Offers limited insights beyond basic profit and loss statements.
- Most suitable for sole proprietors, freelancers, and service oriented businesses with minimal assets, inventory, or liabilities.
Double Entry Accounting
- Tracks assets, liabilities, equity, revenue, and expenses.
- Demands two entries per transaction to ensure the balance of debits and credits.
- Reduces accounting errors through its systematic approach.
- Ideally employed with specialised accounting software for enhanced efficiency.
- Provides valuable insights into the overall financial health of an entity.
- Appropriate for all small businesses with significant assets, liabilities, or inventory.
Thus, while single entry accounting may suffice for uncomplicated business structures with fewer financial intricacies, double entry accounting delivers a more comprehensive and precise depiction of an entity‘s financial status and is better suited for businesses with more extensive operations and financial dealings.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.