Double entry bookkeeping is the concept that every accounting transaction impacts a company’s finances in two ways. The general ledger is the record of the two sides of each transaction.
- Double-entry bookkeeping says each accounting transaction has two sides.
- The general ledger is a record of the two sides of the transaction—a debit and a credit.
If a company sells a product, its revenue increases and its cash increases by an equal amount. When a company borrows funds from a creditor, the cash balance increases, but the balance of the company’s debt increases by the same amount.
The double entry system creates a balance sheet made up of assets, liabilities and equity. The sheet is balanced because a company’s assets will always equal its liabilities plus equity. Assets include all of the items that a company owns, such as inventory, cash, machinery, buildings and even intangible items such as patents. Liabilities represent everything the company owes to someone else, such as short-term accounts payable owned to suppliers or long-term notes payable owed to a bank. Equity represents the owners’ stake in the company. Equity may include any contributions the owners have made to the company, plus the company’s profits or minus the company’s losses.
Each entry has a “debit” side and a “credit” side, recorded in the general ledger. Asset accounts increase when debited and decrease when credited. Conversely, liabilities and equity increase when credited and decrease when debited. If an asset increases with a debit, then the credit side of the entry will either affect another asset by decreasing it, or affect a liability or equity account, increasing it, in order to keep the assets = liabilities + equity equation in balance.
A sub-ledger may be kept for each individual account, which will only represent one half of the entry. The general ledger, however, has the record for both halves of the entry. When Lucie purchases the shelving, the Equipment sub-ledger would only show half of the entry, which is the debit to Equipment for $5,000. The Credit Card Due sub-ledger would include a record of the other half of the entry, a credit for $5,000. The general ledger would have two lines added to it, showing both the debit and credit for $5,000 each.
Accountants today do not typically use a physical general ledger book; however, modern accounting software uses the same underlying concept of posting two entries to the general ledger for every transaction.
Debit entries are entries recorded for payments made or dues owed. In general, Debit signifies
- Decrease in liability
- Decrease in income
- Decrease in equity
- Increase in assets
- Increase in expense
Credit entries which are the exact opposite of debit entries, are entries recorded for payments received. In general, Credit signifies
- Decrease in expense
- Decrease in assets
- Increase in income
- Increase in equity
- Increase in liability
Every transaction in a Double-entry system is recorded as a credit as well as debit. The credit entry is used for recording those transactions that bring in revenue into the account. On the other hand, the debit entry is used to record every payment transaction from the account. The idea is to have both these entries balance out the accounts.
If there is a Double-entry system, what happened to the Single-entry system? This bookkeeping system deserves mention in this section before we understand what the Double entry system brought to the table.
The Single entry system records financial transactions in a single ledger. Transactions are shown to affect only a single account. In such a system, only one account’s value will increase or decrease. The most significant disadvantage that this system suffers from is the inability to generate proper financial reports or statements.
Let’s look at some important differences other than the number of entries.
- Single-entry bookkeeping does not show the current state of wealth
- With the single-entry bookkeeping system, generating financial statements, cash-flow statements, and balance sheets wasn’t easy.
Advantages of Double Entry system
There are several benefits that the double-entry system of accounting brings to the table. Most of them are listed below.
- The double-entry system allows for trial balance, ensuring accuracy in accounting.
Trial balance is usually prepared periodically or at the end of the financial year, assuring arithmetic accuracy by ensuring that there is an equal and corresponding credit for every debit.
- The double-entry system allows for recording details so that the overall profit and loss scenario is clear.
The Trading and Profit & Loss A/c gives a clear picture of overall profit or loss for any given financial year.
- Financial facts are much clearer for taking crucial financial decisions.
Whether for expansion or a round of investment, keeping a clean book with up-to-date transactional facts is necessary. The Double entry system of bookkeeping keeps the system transparent and clean, thus keeping investor confidence high.
- The Double entry system allows easy identification of dues owed.
The double-entry system makes it easy for the business to identify dues owed to lenders, suppliers, and service providers.
- The Double entry system facilitates easy tax liability identification.
It becomes easier for businesses and tax authorities to calculate comprehensive income and levy appropriate and accurate taxes.
- Frauds can be detected quite easily with the double entry system.
With the double-entry system improving the transparency of the accounting system, frauds are also picked up early.
With trial balances and profit & loss statements becoming easy with a double entry system, deeper analysis like year-on-year financial performance analysis is readily available.