Journal entries are the building blocks of every company’s accounting system. Bookkeepers record financial transactions as journal entries that increase or decrease the amount of money in different accounts, depending on the type of transaction.
With double-entry accounting, each journal entry updates at least two accounts in the company’s general ledger, using an equal balance of debits and credits to those accounts. Because each journal entry uses both debits and credits, it is said to have two sides — hence the term “double-entry accounting.”
What Is Double-Entry Accounting (or Bookkeeping)?
Double-entry accounting is a bookkeeping system in which each transaction affects at least two accounts and maintains a balance between debits and credits. This approach reduces the likelihood of accounting errors. Companies of all sizes use double-entry accounting to run their businesses.
Double-entry accounting is required for all public companies, and it’s generally a necessity for businesses that rely on outside financing.
The accounting equation is a framework that underpins many aspects of business accounting, especially double-entry bookkeeping. The accounting equation is:
Assets = Liabilities + Equity
This equation must remain in balance. Double-entry accounting maintains this balance by recording each transaction as a journal entry that balances an equal number of debits and credits.
A company’s balance sheet is the embodiment of the accounting equation: It reports the value of assets, in balance with its liabilities and equity, at a certain point in time. The income statement reflects the changes in a company’s assets, liabilities and equity from its operations over a given period.
Who Uses Double-Entry Accounting?
Companies of all sizes, across all industries, use double-entry accounting. One key reason is that it is the only bookkeeping method that complies with U.S. Generally Accepted Accounting Principles (GAAP). All U.S. public companies must be GAAP compliant for financial reporting purposes. Additionally, most lenders require GAAP-compliant financial statements when evaluating loan applications from any private or public company.
Double-entry accounting is also the foundation for accrual-basis accounting. Most companies adhere to this accounting method because it provides a more accurate picture of their financial health.
- Double-entry accounting means that each journal entry affects at least two accounts and maintains a balance between debits and credits.
- Double-entry accounting maintains the accounting equation that assets must equal liabilities plus equity.
- Double-entry accounting is the default system for most businesses because it reduces errors, enables accrual-basis accounting and is GAAP-compliant.
Double-Entry Accounting Explained
With double-entry accounting, bookkeepers record each financial event with a journal entry that updates at least two accounts. Bookkeepers choose the appropriate accounts for these entries from a list of the company’s accounts, called the chart of accounts. The chart of accounts includes account names and general ledger codes for all classes of accounts on the balance sheet and income statement. Standard types of accounts include assets, liabilities, equity, revenue and expenses.
Once bookkeepers have selected the right accounts, they create a journal entry, recording the dollar value of the event with a debit or credit in each account. These amounts must be equal and opposite: For example, in a transaction that involves two accounts, the debit to one account must equal the credit to the other account.
In accounting, the terms “debit” and “credit” have a specific meaning that differs from the colloquial use of the words (as in “debit cards” or “bank credits”). The way that debits and credits work depends on the type of account. In accounting, each type of account has a normal or natural balance, which refers to the kind of balance the account is expected to have and dictates whether debits or credits increase the value in the account. For example, asset accounts have a debit balance, so debits increase them and credits decrease them. Conversely, liabilities have a credit balance; they are increased by credits and decreased by debits. Each journal entry is shown in two columns in an accounting system, with the debits on the left and the credits on the right.
The journal entries are posted to the general ledger and periodically “closed” to create a trial balance. The closing process includes accumulating all the debits and credits within an account and offsetting them against each other. The trial balance lists the resulting net debit or credit value for all the accounts. Like the underlying journal entries, the trial balance is shown in two columns: debits on the left, credits on the right. The two columns should be equal.
After checking the trial balance and making any necessary adjustments, the company creates a final adjusted balance used to generate the line items in the company’s principal financial statements: the income statement, balance sheet and statement of cash flows.
Double-Entry vs. Single-Entry Accounting
Single-entry accounting is the alternative method to double-entry accounting for recording financial activities. Single-entry accounting resembles a list of transactions in a check register or bank statement. Single-entry accounting and double-entry accounting closely map to whether companies use cash-basis accounting vs. accrual accounting. As the name suggests, with cash-basis accounting, each entry consists of a debit or credit to a single account.
While single-entry accounting is simpler to implement, it has significant shortcomings compared with double-entry accounting. It is more prone to errors, especially omissions and duplications, because it lacks the double-entry accounting control method of balancing accounts.
Additionally, single-entry doesn’t create a complete financial picture of the business because it only records cash inflows and outflows, reflecting when cash is in hand versus when it is actually earned. It also doesn’t reflect things like sales made on credit. Finally, it requires extra work in the closing process to yield balanced financial statements. Public companies can’t use single-entry accounting because it’s not accepted under GAAP.
Rules of Double-Entry Accounting
There are two important rules that govern the ways companies use double-entry accounting. These rules ensure that the accounting equation is balanced and reduce the likelihood of errors:
- Every transaction must be recorded in two or more accounts.
- For each transaction, the total amount debited must equal the total amount credited.
While every transaction must be recorded in at least two accounts, the number of accounts on the left (debit) side of the journal entry does not need to be the same as the number of accounts on the right (credit) side. Journal entries with three or more accounts are called “compound entries.” For example, when a loan payment is made, the compound entry debits two accounts: loans payable and interest expense. But it credits only one account: cash.
Additionally, although the debits must equal credits in each transaction, a journal entry may not result in an increase to one account and a matching decrease to another because of the way natural balances work. If one account has a natural debit balance, a debit will increase the total amount in the account. If the other account updated in the transaction has a natural credit balance, the corresponding credit will increase that account, too. A single journal entry can increase both accounts at the same time, decrease both or a combination.
And finally, it’s important to dispel any misconceptions that debits are good and credits are bad, or vice versa. It depends on the account and the specific situation. Debits increase asset accounts, such as the company’s cash account. In most cases, this is considered a positive. However, debits also increase expenses, which may be viewed as a negative.
How Double-Entry Accounting Works
The process of setting up and using a double-entry accounting system can be divided into four key steps. It begins with setting up the accounts in which bookkeepers will record transactions and ends with using the account information to generate financial statements. The stages are:
- Create a chart of accounts, which is a complete listing of all the general ledger accounts a company can use to record transactions. It includes all the accounts for each of the five types: assets, liabilities, equity, revenue and expense. Most accounting software includes pre-made charts of accounts with room for customization, while other accounting solutions allow for customized charts of accounts.
- Use debits and credits for all transactions in equal amounts to reflect the substance of a transaction. Debits and credits can be in any monetary unit.
- Make sure every transaction has two components (debits and credits, in balance) in accordance with the accounting equation. Accounting software often facilitates this.
- Run financial statements straight out of the double-entry accounting system. When closing the books at the end of each accounting period, the net account totals in the double-entry accounting system are used to create the company’s trial and final balance. The final adjusted balances flow into financial statement line items. Accounting software can automate the integration and process flow necessary to do this.
History of Double-Entry Bookkeeping
Double-entry bookkeeping has an interesting history. Some historians credit the Italian mathematician Luca Pacioli, known as the father of accounting, with inventing the double-entry system in the 1400s. Others suggest that double-entry accounting was being used in Korea centuries earlier or point to the ancient Romans who used a similar system.
Regardless of which version of history is most accurate, double-entry accounting has been around for a long time and is the bedrock on which accounting rests.
Types of Accounts
In double-entry accounting, businesses can use any combination of the five types of accounts — assets, liabilities, equity, revenue, expense, gains and losses — when recording transactions. Each journal entry has two sides, with debits on the left and credits on the right. The type of account dictates whether it has a normal debit balance or a normal credit balance, and therefore whether debits or credits increase the balance.
The five types of accounts are:
- Assets: Resources owned by a company that represent future economic value. Examples of asset accounts include cash, accounts receivable and equipment. Assets have a normal debit balance and are increased via debits.
- Liabilities: Amounts owed or committed by a company. Examples include accounts payable, loans and accrued expenses. Liabilities have a normal credit balance and are increased via credits.
- Equity: Amount of funds invested in a business by its owners plus all retained income from operations. Examples include paid-in equity (funds from investors), retained earnings and common stock. Equity has a normal credit balance and is increased via credits.
- Revenue: Money generated from any operating activities. Examples include product sales, service fees and interest income. Revenue has a normal credit balance and is increased via credits.
- Expenses: Costs incurred in running a business. Examples of expenses include inventory purchases, salaries and depreciation. Expenses have a normal debit balance and are increased via debits.
The following chart summarizes the impact of debits and credits for each of the five types of accounts.
Double-Entry Accounting System
In practice, using a double-entry accounting system quickly becomes second nature. Bookkeepers become fluent in the language very quickly and begin to think in terms of T- accounts, which are visual representations of accounts listing debits on the left and credits on the right. The graphic above is set up to resemble a T-account.
Like idioms in language, certain account pairings are ingrained in the double-entry accounting system. For example, transactions often debit accounts receivable and credit sales, or they debit cash and credit accounts receivable.
Double-Entry Accounting Examples
Let’s explore some real-world examples of double-entry accounting for common business transactions. Each scenario uses a typical journal entry style that lists the account names, debits on the left, credits on the right and a memo below.
This journal entry puts the tractor on the books, increasing the balance in the asset account with a debit representing its value and reducing the balance in the cash account with a credit.
This entry increases the inventory asset account with a debit and establishes a liability for the amount owed on credit with a credit. When the company pays the bill from Checkers Sugar Supply, the bookkeeper will reduce accounts payable with a debit and reduce cash with a credit.
This entry puts an account receivable on the books by debiting the asset and records revenue earned with a credit. Both sides of the entry increase the respective accounts.
How to Use Double-Entry Accounting
As the example above shows, double-entry accounting needs to be well-organized in order to accurately record the full impact of the company’s transactions and reflect that impact in its financial statements. As the volume of transactions increases, this becomes more difficult.
As a result, few companies today use manual recording methods for double-entry bookkeeping. At a minimum, modern bookkeeping relies on spreadsheets that can automate some calculations. Most often, companies use accounting software to simplify and automate the process and prevent errors that lead to inaccurate financial statements and other issues.
How to Decide Whether Double-Entry Is Right for My Business
Double-entry accounting is the default approach for most businesses because of the need to generate GAAP-compliant financial statements for owners and lenders. Public companies are required to use double-entry accounting to meet GAAP requirements. But some owners of relatively simple private businesses may have to decide whether to use double-entry or single-entry accounting. Questions that can help owners decide include:
- Does the business own or hold inventory?
- Does the business have multiple employees?
- Does the business have a robust chart of accounts?
- Does the business owe money to people outside the company or plan to apply for loans?
- Does the company plan to use an automated accounting system?
If the answer is yes to any of the above, double-entry accounting is likely the best approach for your business. Double-entry accounting most appropriately handles balance sheet accounts that are typically required for activities like holding inventory, paying employees and complying with loan agreements. Well-designed user interfaces can simplify double-entry accounting for companies that have a long list of general ledger accounts.
Double-Entry and Accounting Software
Gone are the days of leather-bound ledgers kept in a safe. Businesses of every size maintain their books using accounting software designed for double-entry accounting. Even small businesses can benefit from the time savings and accuracy that leading accounting solutions bring, especially as they grow. Some systems simplify data entry by tracking digital receipts and allowing users to upload photos of physical ones, a much better alternative to keeping shoeboxes full of paper documentation. Accounting software can also typically integrate with bank and credit card accounts to automatically pull in information from those sources. And for business owners who use tax professionals, uploading data to tax systems when it comes time to file tax returns is much easier and less time-consuming than manual methods for both parties.
Larger businesses have taken advantage of double-entry accounting software for decades. It is a necessity given the complexity and volume of their business. When choosing accounting software, companies should look for features such as real-time data access, advanced analytics tools and accelerated closing processes.
Double-entry accounting is the foundation of financial management at most businesses. It helps growing businesses track increasingly complex operations, and it’s essential for public companies and for private ones that rely on outside financing. Software can automate and greatly simplify the process of establishing and maintaining a double-entry accounting method and using it to generate financial statements.
Double-Entry Accounting FAQs
What is meant by double-entry accounting?
Double-entry accounting is a method for booking journal entries to reflect financial activity by updating two or more accounts with equal and opposite debits and credits.
What are the two rules of double-entry accounting?
The two rules of this type of accounting are every transaction must be recorded in two or more accounts, and the total amount debited needs to equal the total amount credited. These rules keep the accounting equation in balance.
What is the double-entry system with an example?
Below is an example of double-entry accounting for buying a piece of equipment in cash. The journal entry puts the van on the books by increasing the balance in the asset account. It reduces the balance in the cash account with a credit for the same amount.
Is double-entry accounting necessary?
It depends on the business, but many require double-entry accounting. This system is necessary for any business that needs to generate GAAP-compliant financial statements for owners or lenders, which includes public companies. Smaller businesses that operate using cash-basis accounting may find single-entry bookkeeping is simpler and adequate for their needs.