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What Is Double Entry Bookkeeping?
If you are familiarising yourself with bookkeeping-related terms, you might ask what exactly is bookkeeping?
Our bookkeeping for beginners guide is a good place to start. But dig a little deeper and another question that may come up is “What is double-entry bookkeeping?’ This is one of those bookkeeping terms that needs a little more explanation.
The short answer is that it is an accounting system for recording transactions that has existed for millennia.
As a core part of the bookkeeper duties checklist, it is the foundation of modern cloud-based bookkeeping, banking and reporting systems.
With double entry bookkeeping, a business can keep track of income and outgoings and gain an understanding of things like profitability and business growth.
You also have a basis for all the reporting and submission obligations a business can have.
Sounds complicated, right?
Well, the principles of double entry bookkeeping are actually quite simple.
Read on to learn how it works and find out just what is double entry bookkeeping used for.
What is Double Entry Bookkeeping?
The governing principle of double entry bookkeeping is that every financial transaction has equal and opposite effects in a minimum of two different accounts.
It works by recording transactions on the basis of credits and debits – when one account gets a debit, a credit is recorded in another.
When you add all the debits together, they must be equal to the sum of all credits – this is the defining standard for modern accounting and it enhances the accuracy of financial statements.
In the accounting world, a debit is an entry added to the left of the account ledger, and a credit lies to the right.
Balance is achieved by keeping the sum of credits and debits for every transaction equal.
The principle satisfies the following accounting equation:
Assets = Liabilities + Equity
On an income statement, the balances in both expense accounts and loss ones are increased by debits and decreased by credits.
With the balances on gains and revenue accounts, it’s the other way round.
Double entry bookkeeping came about in Europe during the mercantile period as a means of rationalising transactions in the commercial world and improving the efficiency of trade.
It also made it easier for bankers and merchants to understand their profits and costs, and may have been a fundamental concept in the creation of capitalism.
Double entry bookkeeping is used to create the balance sheet, which ensures all uses of capital are equal to its sources.
Any company maintaining accurate accounts will record every transaction in a minimum of two accounts.
For example, when a company takes out a bank loan, that borrowed money raises the companies assets, but its loan liabilities also increase by the same amount.
Similarly, if a company purchases raw material with cash, it will add to the inventory asset, but take away from the capital.
Thus, every transaction affects at least two accounts, so recording transactions in this way is called double entry bookkeeping.
Today, double entry bookkeeping is usually done by accounting software.
You could buy this software yourself to maintain your own books, but you would need to spend time familiarising yourself with the way the software works. There are also plenty of free bookkeeping templates out there, but again it can be time-consuming to take this on yourself.
It would also be useful to review our complete bookkeeping guide.
Double Entry Bookkeeping Examples
If you still think double entry bookkeeping sounds complicated, you may need to see it in action.
At its most basic, it really is quite a simple system, so let’s take a look at some real-world examples of double entry bookkeeping to help explain the concept:
1. A bakery uses credit to order some new refrigerated delivery trucks for a total price of $250,000.
In accounting for this purchase on credit, the relevant accounting ledgers must be added to.
The business has accumulated new assets, so a debit of $250,000 is added to the asset account.
At the same time, a credit of the $250,000 must be added to the notes payable ledger.
The increase on the asset account and the associated increase in notes payable liability makes it equal.
2. A new takeaway business needs to order a reliable mobile phone for when the driver is out on delivery.
Let’s say the phone costs $1,500 and is paid for in cash.
Once the transaction is complete, a debit entry of $1,500 is added to the asset account, and a corresponding credit entry for the same amount is recorded to assets because of the cash spent.
In the first example written above, you have a scenario where double entry bookkeeping applies to a purchase with credit.
The second one is based on a purchase made with existing capital.
In both cases, you can see how the transaction involves a debit and a credit entry at the same time.
You can find more bookkeeping tips from the experts at ZX here.
In more complex transactions, more than two accounts can be affected, and this is where the work of expert bookkeepers and sophisticated accounting software is extremely valuable.
Why is Double Entry Bookkeeping important?
New businesses that are very small in scale may be able to get by with single entry bookkeeping.
However, there are various advantages of the double entry system that should not be overlooked.
- You get a more complete financial picture: double entry bookkeeping is a better way to assess a company’s financial health and growth rate. It is essential when a company has multiple employees, or has to think about things like inventory and debts.
- It helps with financial decision-making: with better insights into profitability and financial strength, business owners can understand their companies better. It pays to see how money has been spent and how it is growing so that you can make better financial decisions.
- Bookkeeping errors are reduced: by creating a balance sheet through double entry bookkeeping, you must always ensure liabilities and equity equal assets. If they don’t, there must be an error in your books. It also helps with transparency, keeping businesses accountable.
- It is favoured by investors and banks: The transparency and comprehensive nature of the double entry system is attractive to investors and banks. The reports it produces provide an accurate, complete picture of how your business is performing financially.