Double-Entry Accounting: What It Is and Why It Matters
It’s impossible to find investors or get a loan without accurate financial statements, and it’s impossible to produce accurate financial statements without using double-entry accounting. Once your chart of accounts is set up and you have a basic understanding of debits and credits, you can start entering your transactions. To understand how double-entry bookkeeping works, let’s go over a simple example to solidify our understanding. Assume that Alpha Company buys $5,000 worth of furniture for its office and pays immediately in cash.
- There are two columns in each account, with debit entries on the left and credit entries on the right.
- The likelihood of administrative errors increases when a company expands, and its business transactions become increasingly complex.
- The asset account “Equipment” increases by $1,000 (the cost of the new equipment), while the liability account “Accounts Payable” decreases by $1,000 (the amount owed to the supplier).
- In fact, a double-entry bookkeeping system is essential to any company with more than one employee or that has inventory, debts, or several accounts.
- Alongside your income statement and cash flow statement, it gives you, your accountant, and your financial investors a well-rounded snapshot of your business’s financial health.
- Or, FreshBooks has a simple accounting solution for small business owners with no accounting background.
Businesses that meet any of these criteria need the complete financial picture double-entry bookkeeping delivers. This is because double-entry accounting can generate a variety of crucial financial reports like a balance sheet and income statement. Due to the complexity of the double-entry system, there is an increased chance of making errors while recording transactions. Mistakes can occur in identifying the accounts affected, determining whether to debit or credit an account and calculating the amounts, among other possibilities. These errors can ironically make this “safer” system more inaccurate than the single-entry alternative. Let’s go back to our previous example, where you spend $1,000 on supplies using cash.
How double-entry accounting works
In order to understand how important double-entry accounting is, you first need to understand single-entry accounting. Benedetto Cotrugli, an Italian merchant, invented the double-entry accounting system in 1458. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.
- Public companies must use the double-entry bookkeeping system and follow any rules and methods outlined by GAAP or IFRS (the differences between the two standards are outlined in this article).
- It’s impossible to find investors or get a loan without accurate financial statements, and it’s impossible to produce accurate financial statements without using double-entry accounting.
- If you sell a bolt of cloth, you’ve increased your revenue, but you’ve decreased your inventory.
- A journal entry refers to the record you’ll make in your general ledger (GL) for every financial transaction.
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.
Single-entry accounting vs. double-entry accounting
Your accountant or bookkeeper can talk you through it and handle the trickiest details themselves, or you can use accounting software that makes balancing your books as painless as possible. Obviously, single-entry accounting is much simpler than double-entry, but it’s also much less accurate. And since it doesn’t break down your cash flow into categories like expenses, assets, and equity, single-entry bookkeeping can’t give you any real insight into your business’s performance. Per our example above, selling your fabric increases your revenue and decreases your inventory amount. So to record the sale, you would enter the amount as a debit under an asset account and a credit under an expense account.
Double-Entry Accounting: What It Is and Why It Matters
Therefore the total debit amount must equal the total credit amount for every transaction made. To see double-entry accounting in practice, let’s look at two double-entry accounting examples. Accurate bookkeeping is central to every small business’s success—including yours. Knowing exactly where you stand financially helps you make smart business choices to improve profits while trimming costs.
Step 2: Use debits and credits for all transactions
Meanwhile, the single-entry system is an easier pick for folks craving simplicity. But it makes life much easier for smaller entities needing a quick and hassle-free way to balance the books. The primary difference between single-entry and double-entry accounting is the number of https://personal-accounting.org/double-entry-accounting-definition/ accounts each transaction affects. In single-entry accounting, each transaction involves only one account. But in double-entry accounting, each transaction affects two accounts out of multiple. If you’re using the wrong credit or debit card, it could be costing you serious money.
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Alongside your income statement and cash flow statement, it gives you, your accountant, and your financial investors a well-rounded snapshot of your business’s financial health. You always list an increase in assets in the debit (left) column and a decrease in assets in the credit (right) column. If the total amount in your debit columns matches the total amount in your credit columns, your books are balanced. If the amounts don’t balance, there’s an accounting error somewhere in your records. You can dive in and find it before the issue blossoms into a financial crisis. The chart of accounts is a different category group for the financial transactions in your business and is used to generate financial statements.
Account Information
You can also connect your business bank account to make recording transactions easier. Double-entry accounting is a system of recording transactions in two parts, debits and credits. This method of recording business transactions allows users to avoid errors and omissions. Credits increase revenue, liabilities and equity accounts, whereas debits increase asset and expense accounts. Debits are recorded on the left side of the general ledger and credits are recorded on the right.