Double Entry Bookkeeping

Double-Entry Bookkeeping, a step-by-step guide

Double-Entry Bookkeeping, a step-by-step guide

In the world of bookkeeping and accounting, there are many different rules, regulations, and processes that must be followed.

These, for the most part, are standardized and followed across the board.

There are, however, some extra nuances in bookkeeping and accounting that many businesses (especially small businesses) need to be aware of in order to properly balance their books and be clean in the eyes of the tax man.

We’re referring to the type of bookkeeping used by businesses.

Specifically, double-entry bookkeeping.

So, in this article we’re going to understand just what double-entry bookkeeping is, how it works, how it differs from single-entry accounting, the rules of double-entry bookkeeping, and a step-by-step process on how to carry out this style of bookkeeping.

What is bookkeeping?

First, however, we want to start with a simple definition of bookkeeping. Here’s what we’ve come up with.

Bookkeeping is the process of recording and organizing financial transactions of a business. It involves creating and maintaining accurate records of income and expenses, assets and liabilities, and financial transactions. Bookkeeping is essential for financial management, tax compliance, and decision-making in businesses and organizations.

In simpler terms, it’s how businesses track their money moving in and out of the business accurately and properly.

What are the types of accounting and bookkeeping?

Now that we know what bookkeeping is, let’s understand the different types and styles of accounting and bookkeeping.

For the purposes of this article, we’re going to focus on single- and double-entry bookkeeping – also called single- and double-entry accounting.

At a high level, here’s how they differ.

In single-entry bookkeeping, each financial transaction is recorded once, either as a debit or a credit. This method is typically used by small businesses with simple accounting needs.

In contrast, double-entry bookkeeping involves recording each financial transaction twice, as both a debit and a credit, to ensure accuracy and balance in the accounts.

Neither is necessarily incorrect or better than the other – but there are certain instances when one should be used over the other. We’re going to discuss double-entry accounting in this article.

Other methods of accounting include cash basis accounting, which records transactions when cash is received or paid out, and accrual basis accounting, which records transactions when they are earned or incurred, regardless of when cash is exchanged.

Additionally, there are industry-specific accounting methods, such as cost accounting, which tracks the costs of producing goods or services, and managerial accounting, which provides financial information for decision-making within a business.

However, like we mentioned, we’re going to really home in on double-entry bookkeeping, and how this systems works.

Understanding the double entry system

In this section, we want to provide a comprehensive understanding of the double-entry system, so we’re going to cover what it is, how it works, the difference between single and double entry, and the main ‘rules’ of the double entry system.

The double-entry system, defined

The double entry bookkeeping system is a method of recording financial transactions where each transaction is entered into at least two accounts: one account is debited, and another account is credited (more on that, below).

The system ensures that the accounting equation remains in balance, as each transaction affects both sides of the equation.

This system is widely used in accounting to provide accurate and reliable financial information, to prevent errors and to ensure accountability.

The double entry bookkeeping system is a cornerstone of modern accounting, providing the framework for financial analysis, decision-making, and reporting.

How does double entry bookkeeping work?

The double entry bookkeeping system is based on the principle that every financial transaction has two equal and opposite effects on the accounting equation, Assets = Liabilities + Equity. To record each transaction, the system uses debits and credits to reflect the changes in the accounts affected.

In the double entry system, each transaction is recorded in at least two accounts, one account being debited and another account being credited. The debit and credit amounts must be equal to ensure the accounting equation remains in balance.

For example, if a company purchases inventory for $500 on credit, the transaction would be recorded by debiting the Inventory account for $500 (an asset account), and crediting the Accounts Payable account for $500 (a liability account).

This entry shows that the company has increased its assets by acquiring inventory, while also increasing its liabilities by incurring a debt to the supplier.

See the example illustrated, below:

Account Debit (DR) Credit (CR)
Inventory $500
Accounts Payable $500

The double entry system also uses T-accounts, which represent each account in a ledger. Debits are recorded on the left side of the T-account, while credits are recorded on the right side.

The total debits and credits for each account are then calculated, and if the totals do not match, an error has occurred.

However, this upfront complexity often leads to much simpler recording of transactions down the road. All a company needs to do is tally up the total debits and total credits for each account (inventory, Accounts payable, cash, account receivables, etc.) and they have a clear picture of the state of each account at the end of a reporting period.

The double entry bookkeeping system provides several benefits, including accuracy and accountability, and the ability to detect errors or discrepancies in the accounts. It also provides the basis for financial analysis, decision-making, and reporting, as it allows businesses to understand their financial position and make informed decisions based on that information.

Double entry vs Single entry

Double entry bookkeeping and single entry bookkeeping are two different methods used to record financial transactions. The main differences between the two methods are:

  • Recording Transactions: In single entry bookkeeping, each financial transaction is recorded once as a single entry, either as a debit or credit. In contrast, in double entry bookkeeping, every transaction is recorded in at least two accounts, with both a debit and a credit. This ensures that the accounting equation remains in balance.
  • Complexity: Single entry bookkeeping is simpler and easier to use, making it ideal for small businesses with basic accounting needs. Double entry bookkeeping is more complex and requires more skill, making it more suitable for larger businesses and organizations with more complex financial transactions.
  • Accuracy: Double entry bookkeeping is more accurate as it requires each transaction to be recorded twice and creates a system of checks and balances to ensure accuracy. Single entry bookkeeping is more prone to errors, as it only records transactions once and does not have the same system of checks and balances.
  • Financial Reporting: Double entry bookkeeping provides more detailed and comprehensive financial reports, as it records each transaction in multiple accounts. Single entry bookkeeping can provide only limited information about the financial position and performance of a business.

Overall, while single entry bookkeeping may be simpler and easier to use, double entry bookkeeping is the preferred method for businesses looking for greater accuracy, more detailed financial reporting, and a better understanding of their financial position.

The “rules” of double entry

The main rules of double entry bookkeeping are:

  1. The accounting equation must always be in balance, which means that the total value of assets must equal the total value of liabilities and equity.
  2. Each transaction must be recorded in at least two accounts, with at least one debit and one credit. The total amount of debits must equal the total amount of credits.
  3. Debits must always equal credits in each transaction, as well as in the overall accounting system.
  4. Assets and expenses are increased with debits and decreased with credits, while liabilities, equity, and revenue are increased with credits and decreased with debits.
  5. Every account has a normal balance, which is either a debit or credit balance. For example, asset accounts have a debit balance, while liability and equity accounts have a credit balance.
  6. The date, description, and amount of each transaction must be recorded accurately and clearly in the appropriate accounts.

By following these rules, businesses can ensure the accuracy and reliability of their financial records and use the information to make informed decisions and report financial performance to stakeholders.

The double entry bookkeeping system provides a framework for recording financial transactions accurately and comprehensively, which is essential for effective financial management and decision-making.

Why double entry bookkeeping is important?

In this article, we’ve indirectly covered several of the benefits and the importance of the double-entry system. However, we want to include a short list of the key reasons why this system of accounting is so important:

  1. Accuracy

    The system ensures that each transaction is recorded accurately in at least two accounts, providing a system of checks and balances that reduces the risk of errors and omissions. This leads to more accurate financial records and reporting, which is essential for businesses to make informed decisions and meet regulatory requirements.

  2. Accountability

    Double entry bookkeeping provides a clear and comprehensive record of all financial transactions, making it easier to trace and audit transactions. This increases transparency and accountability, which is important for maintaining the trust of stakeholders such as investors, creditors, and regulatory bodies.

  3. Decision-making

    Accurate and reliable financial records provide businesses with the information they need to make informed decisions about their operations, investments, and financing. Double entry bookkeeping provides the detailed financial data required for effective financial analysis and forecasting.

  4. Legal and regulatory compliance

    Double entry bookkeeping is required by law in many jurisdictions and is a widely accepted standard for financial reporting. Using this system ensures that businesses comply with legal and regulatory requirements, reducing the risk of fines, penalties, and legal disputes.

  5. Comparability

    Double entry bookkeeping provides a standardized framework for recording financial transactions, making it easier to compare financial data across different time periods, businesses, and industries. This is essential for financial analysis and benchmarking.

In summary, the double entry bookkeeping system is important because it ensures accuracy, accountability, and compliance, and provides the financial data required for effective decision-making and analysis.

What businesses should use double entry bookkeeping?

The double entry bookkeeping system is suitable for all types of businesses, regardless of their size or industry.

However, it is especially important for businesses that have complex financial transactions, multiple accounts, or a large number of transactions. Such businesses include:

  1. Large corporations have complex financial transactions, multiple accounts, and high transaction volumes. The double entry bookkeeping system ensures accuracy and reliability in recording all these transactions.
  2. Medium-sized businesses may have multiple accounts, various sources of income and expenses, and a need for detailed financial reporting. Using the double entry bookkeeping system ensures accurate recording of transactions and comprehensive financial reporting.
  3. Professional services firms, such as law firms and accounting firms, bill clients for services rendered and may have multiple accounts for billing and expense tracking. The double entry bookkeeping system ensures accurate tracking of these transactions and proper invoicing of clients.
  4. Non-profit organizations have a unique accounting structure and require a reliable system to track donations, expenses, and grants. The double entry bookkeeping system is suitable for tracking these transactions and ensuring compliance with regulatory requirements.
  5. Manufacturing companies may have multiple accounts for tracking inventory, production costs, and sales. The double entry bookkeeping system ensures accurate recording of these transactions and provides detailed financial reports on inventory and cost of goods sold.

Really, any business that wants to maintain accurate and reliable financial records should use the double entry bookkeeping system, regardless of their size or industry.

A step-by-step process of double entry bookkeeping

The much-anticipated part of this article is how exactly small business owners and businesses carry out the double entry bookkeeping process. We’ve provided the 7 core steps on how to identify, record, and post transactions in the double entry process:

  1. Identify the transaction: The first step is to identify the transaction that needs to be recorded in the accounting system. This could be a sale, purchase, payment, receipt, or any other financial transaction.
  2. Analyze the transaction: Next, the transaction needs to be analyzed to determine which accounts it affects. Each transaction affects at least two accounts, with one account debited and the other credited.
  3. Determine the account type and amount: For each account affected, determine whether it is an asset, liability, equity, revenue, or expense account. Then, determine the amount of the transaction that should be recorded in each account.
  4. Record the transaction in the journal: The transaction is recorded in the journal, which is a chronological listing of all transactions. Each entry in the journal includes the date, a brief description of the transaction, the account debited, and the account credited, as well as the amounts recorded in each account.
  5. Post the transaction to the ledger: The transaction is then posted to the ledger, which is a group of accounts that summarizes the financial activity of the business. Each account in the ledger includes the balance, which is updated with each transaction that affects the account.
  6. Prepare the trial balance: The trial balance is a listing of all accounts in the ledger, along with their balances. The total debits should equal the total credits, ensuring that the accounting equation is in balance.
  7. Prepare financial statements: Financial statements, such as the income statement, balance sheet, and cash flow statement, are prepared using the information in the ledger. These statements provide a summary of the financial performance and position of the business.

By following these steps, businesses can maintain accurate and comprehensive financial records using the double entry bookkeeping system.

At Valley Business Centre – Bookkeeping & Payroll, we are local experts in using and implementing the double entry system. For over 30 years, Valley Business Centre – Bookkeeping & Payroll has been providing comprehensive bookkeeping, tax, and remote bookkeeping services to our clients in Whistler, Squamish, the Sea to Sky Corridor and metro Vancouver B.C. areas. Valley Business Centre provides reliable and effective services to all clients.

Disclaimer

This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulation may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions.

 

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