What is double-entry accounting?
Sole traders can often make use of the simplest form of accounting, known as the cash accounting method, which does not need double-entries. However, double-entry accounting may be required as you expand or when you choose to register as a limited liability company. This form of accounting system is not always easy to get your head around but it can be beneficial for producing accurate balance sheets and financial statements.
Double-entry accounting is an accounting system that takes its name from the fact that each transaction entry made to one account needs a corresponding entry to be made into a different account. As such, the double-entry accounting method has two equal sides to it, referred to as debit and credit. By convention, the left side is for debit entries while the right side is for credit entries.
As an example, an entry that is recording a cash sale of £50 will require two entries in a double-entry accounting ledger. In this instance, an entry of £50 to a debit account named ‘Cash’ will be made. In addition, an entry for the credit of the same sum would need to be made to another account, usually named something like ‘Revenues’.
With the double-entry accounting method, an accounting equation is also used. Basically, this states that an organisation’s assets will equal the sum of its equity added to its liabilities. Therefore, by using double-entry accounting, it is easier to produce balance sheets that accurately demonstrate the financial position of a business. As a consequence, using the method will mean that financial statements generated from your double-entry accounting become more useful in management decision-making than simply looking at the bank balance you happen to have at any one time.
The history of double-entry accounting
The double-entry system for accounting is nothing new. It has been around since the early Renaissance in Italy where it was first described by the mathematician, Luca Pacioli (1447 to 1517). He wrote a book named ‘Summa de arithmetica, geometria, proportioni et proportionalità’, which dealt with geometry, ratios and accounting equations. Unlike single-entry accounting, which had been widely used before, the double-entry approach meant that incoming and outgoing money was accounted for in a minimum of two accounts for every transaction. Indeed, the use of any accounting equations at all was revolutionary at the time!
Before Pacioli, every credit entry and every debit entry would go into their own ledgers with no accounting equation to link the two. This meant that they were effectively two separate records. However, no way existed of referring to this form of mono-entry bookkeeping to verify one set of accounts from the other. This is the problem that double-entry bookkeeping resolved.
Double-entry bookkeeping was soon taken up widely among the banking and financing establishments of Europe. Soon, double-entry accounts became the norm for producing balance sheets that gave a true reflection of the financial position of all sorts of businesses. Double-entry accounting is still used to this day by businesses, charities and government agencies. It is also used by auditors who check on the accounting practices of other organisations.
The basics of bookkeeping using the double-entry system
Unlike a single-entry system where you can use cash accounts, double-entry accounting forces you to split every transaction into a debit and a credit in your general ledger. Receivable sums, known as revenue, will, therefore, add to your credit balance and these sorts of business transactions act as negative debits in your ledger accounts. Whereas the debit left side of an expense account will increase, the credit right side will decrease when you spend money and record the transaction properly. In many cases, T-accounts are created for each transaction in double-entry bookkeeping because a T-shape is formed when the left and right-hand sides of each entry is made.
In double-entry accounting, there is a total of five different accounts that are used. Four of these are asset accounts, liability accounts, expense accounts and capital accounts. The final one is the income account, which is also sometimes called the revenue account. Expense and asset accounts increase on the debit side when a transaction is made and correspondingly decrease on the credit side. On the other hand, capital, income and liability accounts accrue credit when a transaction is recorded. The debit side will go down when an accounting entry is made, however.
Whether a transaction is for income or for something payable, the double-entry method must be used every time. Bookkeeping for both creditors and debtors is recorded with the same system. If not, then each side of the accounting ledger will not balance. Unbalanced liability records will indicate that something has not been recorded properly. This is one of the chief advantages of double-entry bookkeeping. It highlights mistakes in the general ledger without having to examine each individual accounting entry. This means the accounting method will ensure your bookkeeping and balance sheets remain accurate. What’s more, it also helps to bring to light any potential fraudulent activity by making it harder to hide payable debits or liability transactions within an otherwise presentable income statement.
Accounting software for double-entry ledgers
You don’t need to write down every transaction in a ledger to see your equity, liabilities, debits and receivable sums in a double-entry system. There is plenty of accounting software that will help you to record your transactions twice without needing to manually subtract from one account to another every time. Essentially, many accounting software packages of this type will allow you to conduct your bookkeeping with many of the background processes being automated. They are, therefore, ideal for limited liability companies that have to use the accrual record keeping method.