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For small-business owners, keeping track of business expenses could mean adding up money coming in and going out, a method known as single-entry accounting. But if you're interested in taking operations to another level, you may want to incorporate a double-entry bookkeeping system.
What is double-entry bookkeeping? It’s a method of bookkeeping that allows you to depict the financial position of a company potentially more accurately by recording transactions according to “debits” and “credits,” which fills two sides of a ledger instead of one. If your company brings on investors or goes public, you may want to consider using double-entry accounting.
Understanding Double-Entry Accounting
Double-entry accounting is a method of tracking financial transactions. Under this system, transactions are recorded in two corresponding parts, as an asset or a liability. You’re either making money (a sale) or spending money (a debit, or perhaps a loan).
There are five categories you may track with double-entry accounting:
- Assets: A company’s holdings, including cash, inventory, equipment, property, business vehicles, office furniture, and accounts receivable.
- Liabilities: The amount of money a company owes or is expected to owe, including loans, mortgages, accounts payable, and accrued expenses.
- Equity: The amount of funds owners contribute to a business, including money from investors, preferred stock, common stock, and retained earnings from business operations and treasury stock.
- Revenue: Money your business earns, including service fees, merchandise sales, and interest income.
- Expenses: What it costs to keep the lights on, including the purchase of goods (inventory), rent, utilities, insurance, payroll, and depreciation.
Double-entry accounting may provide a more complete financial picture, according to Ella Rivkin, the CEO of E.R.S.P. Group, an accounting, tax and business strategy firm in Brooklyn, New York.
She says many of her clients who aren't using double-entry accounting might think they have sufficient funds in their bank account but still not have a clear picture of whether their business is actually doing well.
"The balance in the bank account doesn’t tell the whole story," Rivkin says. "You could owe [...] vendor payments, loan payments, or be holding customer deposits that don’t actually belong to you. Your bank account only shows how much cash you have today. What it doesn’t show you is how healthy your business really is.”
Double vs. Single Entry Accounting
Single-entry accounting may be an effective form of accounting, depending on the type and stage of your business.
“Single-entry accounting may work best when it is a small company with limited transactions,” says Matt Twiford, a managing partner with Pegacorn Group LLC, a finance, accounting and human resources company aimed at venture-backed startups in Boston, Massachusetts.
In that case, Twiford says, “The data is being generated primarily from a bank statement or credit card statement. There's no need to track accounts payable or accounts receivable.”
By contrast, double-entry accounting may be helpful when you want to track more information and produce complete financial statements, Twiford says.
He says the benefits of double-entry accounting go beyond being financially organized.
“It’s especially useful when dealing with larger volumes of receivables and payables, when you need to follow the rules of accrual accounting, when audited financial statements are required, or when you need to apply for a bank loan, as lenders may want to see more advanced financial reporting,” Twiford says.
Double-Entry Accounting Definition: A Beginner’s Guide
When you track your credits and debits, each journal entry may fill two sides of a ledger, instead of one, and follow the accounting equation: Assets = Liabilities + Equity.
Consider entering transactions as one of the following:
- Assets
- Liabilities
- Equity
- Revenue
- Expenses
Using accounting software, you may use these entries to produce potentially more accurate financial statements, with a clearer understanding of a business’s gains, losses, and cash flow.
“Once a business starts growing, hires employees, manages inventory, or needs better insight into profitability and cash flow, double-entry accounting becomes much more valuable," says Colleen Sullivan, director of account services at Third Road Management.
Double-entry accounting is meant to cover a range of financial transactions: money you have, expenses you’re making, debt you owe, and day-to-day operating costs such as utilities, rent and maintenance.
There are a lot of reasons to consider using double-entry accounting, Sullivan says. You could be more confident that your bookkeeping is accurate, but "it also means the books are in much better shape if a lender, investor, or auditor ever needs to review them."
A Basic Rule of Double Entry Accounting
Financial actions may have two effects on your company’s worth — the transaction either adds value or takes it away.
Keeping track of financial transactions might seem like a lot of work, but Rivkin says, “The real value of double-entry accounting is that it gives business owners clarity and control.”
Rivkin says that it may help answer important financial questions, such as:
- Where am I making money?
- Where am I losing money?
- Where is my cash really going?
- Am I building wealth or just staying busy?
Setting Up the Double-Entry Accounting System
The table below explains how a business may design a double-entry accounting system:
1. Draw up a chart of accounts. |
Organize your financial categories so you may track your income, expenses, assets and liabilities. |
2. Categorize financial events as debits and credits. |
This may help you to "balance the books" by listing what's being spent and/or borrowed, along with revenue being generated. |
3. Use at least two components for every transaction. |
When money moves, you both win and lose something, and you need to record those gains and losses. If you take out a loan for $5,000, that’s a debt, but if you use the money to buy inventory, you have an asset. |
4. Run financial statements. |
The more detailed your financial statements, the the more informed business decisions you may make. |
Double-Entry Accounting Example
For a loan, double-entry accounting could show the broader picture, according to Rivkin. If you purchase a piece of equipment for $100,000 using a line of credit, you now own a $100,000 asset, but you also have a $100,000 liability. "The real question now," Rivkin says, "is whether the equipment pays for the debt it created.”
Understanding the Limitations of Double Entry Accounting
Double-entry accounting could be considered one of the pillars for a successful business plan. It may also be necessary for a business that engages in accrual basis accounting, which means that your business’s income or expenses are tracked when you owe or are owed payments.
But double-entry accounting may have certain limitations — it may not identify every error and could be more costly to run as a business practice. What's more, it may not account for other factors — such as developing a quality product or service, creating a strong supply chain, and recruiting top talent — that might further position your business for success.
Photo: Getty Images
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