Double entry accounting

What Is Double-Entry Accounting?

Double-entry accounting is a bookkeeping system in which each transaction affects at least two accounts and maintains a balance between debits and credits. This approach reduces the likelihood of accounting errors. Companies of all sizes use double-entry accounting to run their businesses.

Double-entry accounting is required for all public companies, and it’s generally a necessity for businesses that rely on outside financing.

Double-Entry Accounting Explained

With double-entry accounting, bookkeepers record each financial event with a journal entry that updates at least two accounts. Bookkeepers choose the appropriate accounts for these entries from a list of the company’s accounts, called the chart of accounts. The chart of accounts includes account names and general ledger codes for all classes of accounts on the balance sheet and income statement. Standard types of accounts include assets, liabilities, equity, revenue and expenses.

Once bookkeepers have selected the right accounts, they create a journal entry, recording the dollar value of the event with a debit or credit in each account. These amounts must be equal and opposite: For example, in a transaction that involves two accounts, the debit to one account must equal the credit to the other account.

In accounting, the terms “debit” and “credit” have a specific meaning that differs from the colloquial use of the words (as in “debit cards” or “bank credits”). The way that debits and credits work depends on the type of account. In accounting, each type of account has a normal or natural balance, which refers to the kind of balance the account is expected to have and dictates whether debits or credits increase the value in the account. For example, asset accounts have a debit balance, so debits increase them and credits decrease them. Conversely, liabilities have a credit balance; they are increased by credits and decreased by debits. Each journal entry is shown in two columns in an accounting system, with the debits on the left and the credits on the right.

The journal entries are posted to the general ledger and periodically “closed” to create a trial balance. The closing process includes accumulating all the debits and credits within an account and offsetting them against each other. The trial balance lists the resulting net debit or credit value for all the accounts. Like the underlying journal entries, the trial balance is shown in two columns: debits on the left, credits on the right. The two columns should be equal.

After checking the trial balance and making any necessary adjustments, the company creates a final adjusted balance used to generate the line items in the company’s principal financial statements: the income statement, balance sheet and statement of cash flows.

How Double-Entry Accounting Works

The process of setting up and using a double-entry accounting system can be divided into four key steps. It begins with setting up the accounts in which bookkeepers will record transactions and ends with using the account information to generate financial statements. The stages are:

Create a chart of accounts, which is a complete listing of all the general ledger accounts a company can use to record transactions. It includes all the accounts for each of the five types: assets, liabilities, equity, revenue and expense. Most accounting software includes pre-made charts of accounts with room for customization, while other accounting solutions allow for customized charts of accounts.

Use debits and credits for all transactions in equal amounts to reflect the substance of a transaction. Debits and credits can be in any monetary unit.

Make sure every transaction has two components (debits and credits, in balance) in accordance with the accounting equation. Accounting software often facilitates this.

Run financial statements straight out of the double-entry accounting system. When closing the books at the end of each accounting period, the net account totals in the double-entry accounting system are used to create the company’s trial and final balance. The final adjusted balances flow into financial statement line items. Accounting software can automate the integration and process flow necessary to do this.

Types of Accounts

In double-entry accounting, businesses can use any combination of the five types of accounts — assets, liabilities, equity, revenue, expense, gains and losses — when recording transactions. Each journal entry has two sides, with debits on the left and credits on the right. The type of account dictates whether it has a normal debit balance or a normal credit balance, and therefore whether debits or credits increase the balance.

The five types of accounts are:

Assets: Resources owned by a company that represent future economic value. Examples of asset accounts include cash, accounts receivable and equipment. Assets have a normal debit balance and are increased via debits.
Liabilities: Amounts owed or committed by a company. Examples include accounts payable, loans and accrued expenses. Liabilities have a normal credit balance and are increased via credits.
Equity: Amount of funds invested in a business by its owners plus all retained income from operations. Examples include paid-in equity (funds from investors), retained earnings and common stock. Equity has a normal credit balance and is increased via credits.
Revenue: Money generated from any operating activities. Examples include product sales, service fees and interest income. Revenue has a normal credit balance and is increased via credits.
Expenses: Costs incurred in running a business. Examples of expenses include inventory purchases, salaries and depreciation. Expenses have a normal debit balance and are increased via debits.

Double-Entry and Accounting Software

Gone are the days of leather-bound ledgers kept in a safe. Businesses of every size maintain their books using accounting software designed for double-entry accounting. Even small businesses can benefit from the time savings and accuracy that leading accounting solutions bring, especially as they grow. Some systems simplify data entry by tracking digital receipts and allowing users to upload photos of physical ones, a much better alternative to keeping shoeboxes full of paper documentation. Accounting software can also typically integrate with bank and credit card accounts to automatically pull in information from those sources. And for business owners who use tax professionals, uploading data to tax systems when it comes time to file tax returns is much easier and less time-consuming than manual methods for both parties.

Larger businesses have taken advantage of double-entry accounting software for decades. It is a necessity given the complexity and volume of their business. When choosing accounting software, companies should look for features such as real-time data access, advanced analytics tools and accelerated closing processes.

Double-entry accounting is the foundation of financial management at most businesses. It helps growing businesses track increasingly complex operations, and it’s essential for public companies and for private ones that rely on outside financing. Software can automate and greatly simplify the process of establishing and maintaining a double-entry accounting method and using it to generate financial statements.

Example:

Double-entry accounting

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