If you run a small business, you need to keep track of your finances accurately and efficiently. This involves recording every financial transaction that affects your business, such as sales, expenses, payments, and loans. To do this, you may need to use a bookkeeping system that can help you organize and report your financial data. One of the most common and reliable bookkeeping systems is double-entry bookkeeping.
Double-entry bookkeeping is a method of accounting that records every transaction in two accounts: a debit account and a credit account. The total amount of debits and credits must always be equal, which ensures that the accounting equation is balanced. The accounting equation is a formula that shows the relationship between the assets, liabilities, and equity of a business. It is expressed as:
Assets = Liabilities + Equity
In this blog, we will explain what double-entry bookkeeping is, how it works, why it is important, and how to use it for your small business.
What is Double-entry Bookkeeping?
Double-entry bookkeeping is a system of accounting that records every transaction in two accounts: a debit account and a credit account. A debit account is an account that increases when a transaction occurs, and a credit account is an account that decreases when a transaction occurs.
For example, if you buy a computer for your business for Rs. 1,000, you will debit your computer equipment account (an asset account) by Rs. 1,000, and credit your cash account (another asset account) by Rs. 1,000. This means that your total assets remain the same, but the composition of your assets changes.
The two accounts that are affected by a transaction are called a journal entry. A journal entry consists of the date, the accounts, the amounts, and a brief description of the transaction. For example, the journal entry for buying a computer would look something like this:
| Date | Account | Debit | Credit | Description |
|---|---|---|---|---|
| 01/01/2024 | Computer Equipment | $1,000 | Purchased computer | |
| 01/01/2024 | Cash | $1,000 | Paid cash |
The journal entries are recorded in a book called a journal, which is also known as the book of original entries. The journal is a chronological record of all the transactions that occur in a business. There are different types of journals, such as sales journals, purchase journals, cash receipts journals, and cash payments journals, depending on the nature and frequency of the transactions.
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The journal entries are then posted to a book called a ledger, which is also known as the book of final entries. The ledger is a collection of all the accounts that are used in a business, such as assets, liabilities, equity, revenue, and expenses.
Each account has a separate page or section in the ledger, where all the journal entries that affect that account are recorded. The ledger shows the balance of each account at any given time, which is the difference between the total debits and credits of that account. For example, the ledger page for the computer equipment account would look something like this:
| Computer Equipment | Debit | Credit | Balance |
|---|---|---|---|
| 01/01/2024 | $1,000 | $1,000 | |
| Total | $1,000 | $1,000 |
The ledger is used in compiling the financial reports of a company, including the income statement, balance sheet, and cash flow statement.
The financial statements summarize the financial performance and position of a business for a specific period, such as a month, a quarter, or a year. The financial statements are used to communicate the financial information of a business to the owners, managers, investors, creditors, and other stakeholders.
How Does Double-entry Bookkeeping Work?
Double-entry bookkeeping works by following a set of rules and principles that ensure the accuracy and consistency of the accounting records. The main rules and principles of double-entry bookkeeping are:
- Every transaction must affect at least two accounts: one debit account and one credit account.
- The total amount of debits and credits must always be equal for every transaction. This ensures that the accounting equation is always balanced.
- The accounts are classified into five categories: assets, liabilities, equity, revenue, and expenses. Each category has a normal balance, which is the expected balance of that account. Assets and expenses have a normal debit balance, meaning they increase with debits and decrease with credits. Liabilities, equity, and revenue have a normal credit balance, meaning they increase with credits and decrease with debits.
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- The accounts are further classified into subcategories, such as current assets, long-term assets, current liabilities, long-term liabilities, owner’s equity, retained earnings, sales revenue, cost of goods sold, operating expenses, and non-operating expenses. Each subcategory has a specific definition and purpose and may have different accounting rules and treatments.
- The accounts are assigned a unique number, called an account number, which is used to identify and locate the account in the ledger. The account number usually follows a standard format, such as the chart of accounts, which is a list of all the accounts and their numbers used in a business.
- The accounts are arranged in a specific order, called the trial balance, which is a list of all the accounts and their balances at the end of an accounting period. The trial balance is used to check the accuracy of the accounting records and to prepare the financial statements. The trial balance usually follows this order: assets, liabilities, equity, revenue, and expenses.
Why is Double-entry Bookkeeping Important?
Double-entry bookkeeping is important for several reasons, such as:
- It provides a complete and accurate record of all the financial transactions that occur in a business, which can help the business owners and managers monitor and control the business operations and performance.
- It ensures that the accounting equation is always balanced, which means that the assets, liabilities, and equity of a business are always in agreement. This can help the business owners and managers assess the financial position and solvency of the business.
- It allows for the detection and correction of errors and frauds, as any discrepancy between the debits and credits of a transaction will indicate a mistake or a manipulation. This can help business owners and managers maintain the integrity and reliability of the accounting records and the financial statements.
- It facilitates the preparation and analysis of the financial statements, as the ledger accounts provide the information and data needed to summarize and report the financial results and situation of a business. This can help the business owners and managers to communicate the financial information of the business to internal and external users, such as investors, creditors, regulators, and tax authorities.
How to Use Double-entry Bookkeeping for Your Small Business?
To use double-entry bookkeeping for your small business, you need to follow these steps:
- Identify the financial transactions that affect your business, such as sales, purchases, payments, receipts, loans, and investments. You can use source documents, such as invoices, receipts, bank statements, and contracts, to verify and record the transactions.
- Determine the accounts that are involved in each transaction, and classify them into the five categories: assets, liabilities, equity, revenue, and expenses. You can use the chart of accounts to find and assign the account numbers for each account.
- Decide which account is debited and which account is credited for each transaction, based on the normal balance and the effect of the transaction on the account. You can use the following table as a guide:
| Debit | Credit | |
|---|---|---|
| Asset | Increase | Decrease |
| Liability | Decrease | Increase |
| Equity | Decrease | Increase |
| Equity | Decrease | Increase |
| Revenue | Decrease | Increase |
| Expense | Increase | Decrease |
- Record the transaction as a journal entry in the journal, using the date, the accounts, the amounts, and a brief description of the transaction. Make sure that the total debits and credits are equal for each journal entry.
- Post the journal entry to the ledger, by transferring the debit and credit amounts to the corresponding ledger accounts. Update the balance of each ledger account after each posting.
- Prepare the trial balance at the end of the accounting period, by listing all the ledger accounts and their balances in the order of assets, liabilities, equity, revenue, and expenses. Check that the total debits and credits are equal to the trial balance.
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- Adjust the trial balance for any errors, omissions, or accruals, by making the necessary adjusting entries in the journal and the ledger. For example, you may need to record depreciation, prepaid expenses, accrued revenues, or accrued expenses.
- Prepare the financial statements from the adjusted trial balance, by using the ledger accounts to calculate and report the income statement, the balance sheet, and the cash flow statement. Make sure that the financial statements are consistent and comply with the accounting standards and principles.
- Close the temporary accounts, such as revenue and expense accounts, by transferring their balances to the permanent accounts, such as retained earnings or owner’s capital. This is done by making the closing entries in the journal and the ledger and preparing the post-closing trial balance.
Also Read: What Is Bookkeeping: Importance, Objectives, Modern Accounting Trends
The Bottom Line
Double-entry bookkeeping is a system of accounting that records every transaction in two accounts: a debit account and a credit account. The total amount of debits and credits must always be equal, which ensures that the accounting equation is balanced.
Double-entry bookkeeping is important for providing a complete and accurate record of financial transactions, ensuring the balance of assets, liabilities, and equity, detecting and correcting errors and fraud, and facilitating the preparation and analysis of financial statements.
To use double-entry bookkeeping for your small business, you need to identify the transactions, determine the accounts, decide on the debits and credits, record the journal entries, post the ledger accounts, prepare the trial balance, adjust the trial balance, prepare the financial statements, and close the temporary accounts.
