If you’re a freelancer, sole entrepreneur, or independent contractor, you have to decide your business’s accounting system: double-entry or single-entry? You might have been using single-entry accounting, especially if you aren’t using accounting software. While this may have been sufficient initially, you should probably move to use accounting software and double-entry accounting if you plan to grow your business.
In this article, we’ll walk you through double-entry accounting as simply as possible. We’ll explain how it differs from single-entry, and help you decide which accounting system suits your business best.
What is double-entry accounting?
Double-entry accounting is a bookkeeping method that maintains the balance of a company’s accounts. This method shows the most accurate picture of the company’s finances. At its core, this method relies on the accounting equation Assets = Liabilities + Equity.
This accounting system was invented by Benedetto Cotrugli, an Italian merchant, in 1458. This system was later shared by the Italian mathematician and Franciscan friar Luca Pacioli, the author of The Collected Knowledge of Arithmetic, Geometry, Proportion, and Proportionality, which included a detailed description of the double-entry accounting system.
Using double-entry accounting is the only way to make sure all of your transactions follow the accounting equation rules. Unlike single-entry accounting which only requires that you post a transaction into a ledger, double-entry tracks both sides (debit and credit) of each transaction you enter. Using the double-entry accounting system reduces errors and makes it easier to produce accurate financial statements. Later in the article, we will take a look at a real-world example to help make these concepts even more clear.
See more: A Small Business Guide To General Ledgers.
Types of accounts
When you employ double-entry accounting, you will need to use several types of accounts. Some key account types include:
- Assets: Assets are resources owned by a company, which represent future economic value. Some examples of asset accounts are accounts receivable, cash, and equipment.
- Liabilities: Liabilities are amounts owed or committed by a company, such as accounts payable, loans, and accrued expenses.
- Equity: Equity is the amount of funds invested in a business by its owners plus all retained income from operations. Common examples of equity are paid-in equity (funds from investors), retained earnings, and common stock.
- Revenue: Revenue is the money generated from any operating activities, like product sales, service fees, and interest income.
- Expenses: Expenses are all costs incurred in running a business, such as inventory purchases, employee wages, and depreciation.
What are debits and credits?
Debits and credits are fundamental to the double-entry system. In accounting, a debit entry appears on the left side of an account ledger, while a credit entry appears on the right side. A transaction’s total debits and credits must be equal to be in balance. Credits don’t necessarily imply increasing, and debits don’t always imply decreasing.
A debit may increase one account while decreasing another. For example, a debit increases asset accounts but decreases liability and equity accounts, supporting the general accounting equation of Assets = Liabilities + Equity.
Debits increase the balances in expense and loss accounts on the income statement, while credits decrease their balances. Debits decrease revenue and gain account balances, while credits increase their balances.
To make things a bit easier, we’ve made this table to show you how debits and credits work under the double-entry bookkeeping system:
|– Are always recorded on the left side|
– Increase an asset account, or decrease a liability account or equity account (such as owner’s equity).
– Increase an expense account.
– Decrease revenue
|– Are always recorded on the right side|
– Increase a liability or equity account, or decrease an asset account.
– Decrease an expense account.
– Increase revenue
How double-entry accounting works
Setting up and operating a double-entry accounting system includes four key steps. It starts with setting up the accounts in which bookkeepers will record transactions and ends with using account information to generate financial statements. The steps are:
- Stage 1: Create a chart of accounts for posting your financial transactions. This chart is a complete listing of all the general ledger accounts that a company can use to record transactions. It contains all the accounts for each of the five types: assets, liabilities, equity, revenue, and expense. Nowadays, most accounting software comes with pre-made charts of accounts available for customization, while other accounting solutions offer customized charts of accounts.
- Stage 2: Enter all transactions with equal amounts of debits and credits to reflect the elements of a transaction. Debits and credits can be recorded in any monetary unit, but the currency should be consistent throughout the accounting process.
- Stage 3: Ensure each entry has two components; debit and credit. And, ensure that they are in balance with the accounting equation. Using accounting software can help you with this.
- Stage 4: Check and ensure that financial statements balance and reflect the accounting equation. The net account totals in the double-entry accounting system are fundamental to creating the company’s working and final balance when closing the books at the end of each accounting period. The final adjusted balances flow into financial statement line items. Nowadays, accounting software can automate the integration and process flow necessary to do this.
An example of double-entry accounting
Let’s explore a realistic example of double-entry accounting for a common business transaction. If you buy a new $1000 laptop for your freelance startup and you would like to record the expense, here’s how you’d do it:
First, you need to enter a $1,000 debit to increase your asset statement “Laptop” expense account and a $1,000 credit to decrease your balance sheet “Cash” account.
In double-entry accounting, you still record the $1,000 in your cash account, but you also record that $1,000 as an expense.
Should I use double-entry or single-entry accounting?
Single-entry might be enough for your accounting needs if your business is very simple, has only one employee, doesn’t have any inventory or debts, and doesn’t have many accounts to keep track of.
Otherwise, if your business is any more complex than that, most accountants will strongly recommend switching to double-entry accounting.
Why? Though single-entry accounting is simpler to implement, it has significant drawbacks compared with double-entry accounting. Single-entry accounting is more prone to errors, especially omissions and duplications, because it lacks the control method of balancing accounts.
Furthermore, single-entry accounting can’t create a complete financial picture of the business. It only records cash inflows and outflows, indicating when cash is in hand versus when it is actually earned. It also doesn’t indicate items like sales made on credit. Moreover, single-entry accounting requires extra work in the closing process to yield balanced financial statements. Lastly, single-entry accounting is unsuitable for public companies because it’s not accepted under GAAP (Generally Accepted Accounting Principles.)
Double-entry accounting provides you with a more complete, three-dimensional view of your finances than the single-entry method ever could. Since you’re recording where your money is coming from and where it’s going, you can then collate that information into financial statements. This gives you comprehensive insights into the profitability and health of various parts of your business. That’s a win because accurate financial statements can help you make better decisions about spending money in the future.
Double-entry accounting also reduces the risk of bookkeeping errors, improves financial transparency, and provides a layer of accountability to your business that single-entry accounting cannot.
If you want your business to be taken seriously by investors, banks, and potential buyers, you should be using double-entry.
The bottom line
Accounting entries are the foundation of every company’s accounting system. Taking good care of those documents means better control over your expenses.
Shoeboxed can help you with that! Shoeboxed is a receipt scanning and expense management solution that helps businesses digitize piles of paper receipts in just a few clicks. After scanning your receipts, the app will automatically extract the key data and categorize them in proper order. You can then create clear and comprehensive expense reports, export, share or print all of the information you need for easy tax preparation or reimbursement.
What’s more, Shoeboxed ensures that all your digitized receipts are human-verified and accepted by both the Internal Revenue Service and the Canada Revenue Service in the event of an audit.
Using Shoeboxed saves you time and hustle collecting and keeping those paper receipts for report-making, especially when it comes to tax preparation. Sign up for free and go paperless with Shoeboxed!