While some companies use the same ledger to track all of their expenses and profits, others use a method – double-entry accounting – that provides a more holistic view of their finances. Double-entry accounting looks at more than just what is coming in and what is going out; it looks at the different areas that money is coming in and out of.
What is double-entry accounting?
Double-entry accounting is based on the principle that a financial transaction recorded in one place as a credit (cash earned by your company) must elsewhere be recorded as a debit (cash lost by your company). Think of it as Newton's third law but applied to accounting: All transactions have an equal and opposite transaction. You can also represent double-entry accounting with the following mathematical equation:
Assets = Liabilities + Equity
Double-entry accounting, despite not being a mandatory accounting method, is used by many small to midsize businesses. If the accountant you've hired for your company has included a credit and debit column in your general ledger, your company is likely already using double-entry accounting. You're also likely using double-entry accounting if cash isn't your company's only account and instead you have a chart of accounts that paints a complex, detailed picture of your company's finances.
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How does double-entry accounting work?
Double-entry accounting may sound needlessly complicated, but it's quite straightforward – in fact, it's the very basis of modern accounting. Under double-entry accounting, every time your company makes a transaction, the transaction is recorded in the left-hand credit column if its value is positive. Negative transaction values are recorded in the right-hand debit column.
Your cash account isn't your only business account that gets this treatment – all your accounts are structured as such. Since double-entry accounting means that a debit in one account is a credit in another account and vice versa, the total value of all your accounts during a given period – a sum known as your company's trial balance – should be zero. [In need of accounting software? Check out the options we recommend for small businesses.]
Examples of double-entry accounting
Let's say you own a company that sells phone cases for $30 per case. If your company sells two phone cases, your bookkeeper or accountant will record a credit of $60 ($30 x 2) in your cash account. Your bookkeeper or accountant will also record a $60 debit in your inventory account, because with two fewer phone cases in your inventory, your inventory's cash value has decreased by $60, the value of two phone cases. (Note that in this example, since both cash and inventory are assets, their equal but opposite values balance the double-entry accounting equation.)
Another example may make double-entry accounting even clearer. Let's say that each phone case in your inventory costs $25 to acquire, and you initially ordered 50 phone cases. That means you spent $1,250 on your inventory. However, since you used your business credit card to buy the cases, you have $1,250 in your loan account. In your assets, your $1,250 increase in inventory is recorded as a credit, and in your loans account, your $1,250 loan is recorded as a debit. As such, in the double-entry accounting equation, your $1,250 assets debit balances your $1,250 liabilities credit. When you repay this loan, you debit your loans account $1,250 and credit your cash account for the same amount.
For our final example, let's go back to the invoicing scenario posed earlier. When you send an invoice to a client, the value of the invoice is recorded as a credit in accounts receivable but a debit in your sales account. Once your client pays the invoice, you record its value as a credit in your cash account and a debit in your accounts receivable account. As such, you'll have the cash you need to pay your team – and when you pay these wages, they become a credit on your wages account and a debit on your cash account.
Types of accounts
In the above examples, you may have noticed several different transactions – cash from a customer to your company, cash value lost in inventory, and money borrowed from a creditor. In double-entry accounting, all transactions can be grouped into one of seven different types of accounts:
- Assets: What your company owns, including cash, accounts receivables and equipment
- Liabilities: What your company owes, including accounts payable and loans
- Equities: The amount of your company's value tied up in shareholder stocks
- Revenues: The amount of money your company earns from selling its products or services
- Expenses: What your company spends to cover its operations, including rent, utilities and employee wages
- Gains: what your company earns by selling an asset
- Losses: what your company loses by selling an asset
Benefits of double-entry accounting
There are myriad reasons why most businesses use double-entry accounting. Among the benefits that accompany double-entry accounting are:
- A thorough understanding of your finances. Since an amount recorded in one account is recorded in another account, double-entry accounting gives you a complete picture of your company's finances. If your cash flow is lacking, you'll see where your cash is tied up, be it accounts receivables or overspending on supplies.
- Fewer accounting errors. Since double-entry accounting by definition requires the total value of all your accounts to equal zero, you'll know you have accounting errors if your total value isn't zero. Granted, finding the sources of these errors may take work, but in double-entry accounting, errors are usually less frequent, given the clear credit and debit columns in each of your accounts. Plus, under double-entry accounting, you'll know to always pair a transaction with an equal and opposite transaction elsewhere.
- Easy conversion into financial statements. Through financial statements, you can quickly see your company's assets, liabilities, equity, cash flow, profit and many other metrics vital to your financial well-being. Double-entry accounting facilitates the creation of these statements, since the value of your company's accounts will always be apparent. And these statements are good for more than your own internal use: They are beneficial when you are seeking debt or equity financing.
- More transparent finances. The credit-debit columns and numerous account types fundamental to double-entry accounting give a comprehensive view of your company's spending and earning. As such, your company's finances will be clear to you, your accounting team and any funding sources who ask for your financial statements.
- The ability to hold yourself and your clients accountable. Double-entry accounting clearly indicates when your clients owe you money and when you owe money to employees or vendors. That means more accountable business practices for you and everyone you work with, since you'll know when to ask for money you're owed and pay other people.
- It's the common standard. Most businesses use double-entry accounting. Investors, banks and any parties you're working with toward a merger or acquisition may feel less inclined to work with your company if you use single-entry accounting.
What is the difference between single-entry and double-entry accounting?
Single-entry accounting ledgers represent check registers where each transaction gets one entry. Just as a check deposit or a withdrawal from your checking account is recorded once, in single-entry accounting, you don't record equal and opposite entries for a transaction. Instead, transactions are recorded as positive or negative values in one column.
Alternatively, in single-entry accounting, you can create two separate columns for revenue and costs. However, without recording equal and opposite values of all transactions in another company account, you're still using single-entry accounting despite having two columns.
Although double-entry accounting is far and wide the business standard, you can probably get away with single-entry accounting if you're an independent contractor or sole proprietor. That's because, as a one-person operation, you likely have fewer categories to separate expenses than a multiperson business. Additionally, as a one-person operation, you might not have the time to create a chart of accounts and add transactions to two accounts at once. You might thus prefer the simplicity of single-entry accounting.
However, if your work involves storing inventory, paying expenses that facilitate your work or waiting long periods for invoice fulfillment, double-entry accounting may still be better for you. As the above details show, there are numerous reasons double-entry accounting is the standard – in using it, your company could benefit substantially.