Double-entry accounting is more than 500 years old and serves as a foundational tool to our modern global economic system—to the point where it’s been called the “most influential work in the history of capitalism.”
To the uninitiated, though, double-entry accounting can feel like dark alchemy. With some practice, you can get the hang of it fairly fast. And even if you aren’t an accountant, it’s important for every small business owner to understand, as it serves as the basis for all accounting today.
What Is Meant by Double-Entry Accounting?
Double-entry accounting is maintained in a general ledger, where each financial transaction for a business is recorded. These financial transactions break down into credits and debits. Oftentimes, transactions are as simple as revenue and expenses, although it usually won’t break down quite as simply as this, depending on your business.
What Is Double-Entry Bookkeeping?
In double-entry bookkeeping—another term for double-entry accounting—each transaction is recorded twice, as the name of the system suggests. Every transaction is recorded as a credit and as a debit in different account columns.
“Double entry is a simple, yet powerful concept: each and every one of a company’s transactions will result in an amount recorded into at least 2 of the accounts in the accounting system,” explains CPA Harold Averkamp.
How Does Double-Entry Accounting Work?
Every double-entry system hinges on recording each financial transaction twice alongside the date the transaction occurred: as a credit in 1 account and a debit in another account.
This might seem a little confusing—but all you need to remember is that any transaction is both a credit and debit.
“Let’s say my startup has $2,000 in the bank,” explains Anvil. “I then spend $1,500 of that on a laptop. If I was just looking at the money in my bank account, I’d think that money just disappeared. But it didn’t disappear—it turned into a laptop!”
If you buy an asset, your cash account is debited the cost of the asset, while your asset accounts are credited by the cost of the asset—this is how the transaction is recorded twice. The balance always stays at 0.
To utilize double-entry accounting, you’ll want to create several distinct accounts that relate to your business. You can be as detailed as you want—and it’s best to be as detailed as possible. Some common account categories include assets, liabilities, accounts payable, accounts receivable, inventory, and property. Each of these categories can be broken down further if you wish.
If you buy a lot of inventory on credit, i.e. accounts payable, these are the 2 accounts you are debiting and crediting when recording the transaction. Your inventory, an asset, increases, but it’s recorded as a debit. Your accounts payable increases by the same amount, but it’s considered a credit in this account. Through this, the balance remains 0.
What Is the Golden Rule of Double Entry?
The so-called Golden Rule of double-entry accounting is:
Assets = Liabilities + Equity
Your company’s assets are the total worth of your company, like the cash in your bank account, property, equipment, and accounts receivable.
The Golden Rule claims that your assets are equal to your liabilities plus your equity, which is the difference between your assets and liabilities.
Put another way, your assets must always equal your liabilities. If you take out a $10,000 loan, for example, your assets increase by $10,000—and your liabilities simultaneously increase by $10,000. Even if you spend $5,000 from the loan on furniture, your assets and liabilities remain at $10,000, even as you record this transaction. Your assets would remain $10,000: $5,000 would now be in cash and $5,000 in furniture.
“The reason this rule is important is that when accounting professionals record a transaction, each side of this equation will always be affected, and both sides of this equation will always balance,” the Academy of Learning explains.
Double Entry vs. Single Entry
Single entry, as the name suggests, records every financial transaction as a single entry in a list. You start with the total amount, and every subsequent transaction either adds or subtracts from this total. Over time, single-entry accounting usually only works well for cash-based businesses—and even then, most accountants will suggest double-entry bookkeeping. This is because most businesses have multiple types of accounts, and their value is expressed in different ways, not just as cash in a bank account.
Software Can Help
Fortunately, this centuries-old system becomes a lot easier today due to software like Sunrise. Instead of ensuring that you’re meticulously recording every transaction twice, apps and software can automate this whole process. The best options can even turn this double-entry system into income statements and balance sheets with a few clicks.