Double-Entry Accounting Explained
Double-entry accounting is a method of recording financial transactions that maintains the balance of a company’s accounts and presents an accurate financial picture of the company. This method relies on the accounting equation which states that assets = liabilities + equity.
Maintaining Accurate Books
As a company’s activity expands, the likelihood of clerical errors increases. While double-entry accounting does not completely prevent errors, it minimizes their impact on the overall accounts. Thanks to the account structure, errors can be detected and alerted to accountants quickly, before the mistake leads to further errors that affect the accounts in a cascading manner. Additionally, the nature of the account structure makes it easy to trace entries and ascertain the source of the error.
Types of Accounts
When using double-entry accounting, you will need to use different types of accounts. Some key account types include:
- Asset Accounts: These reflect the money associated with items owned by the company, such as cash in checking accounts or the price paid for inventory.
- Liability Accounts: These show what the company owes, such as a construction loan or equipment loan, or credit card balance.
- Revenue Accounts: These represent amounts received, such as sales revenue and interest income.
- Expense Accounts: These display amounts spent, including purchases made for sale, payroll costs, rent fees, and advertising.
Using Accounting Software
Most accounting software for businesses employs double-entry accounting. Without this feature, an accountant would struggle to track information such as inventory, accounts receivable, and prepare financial and tax records. The double-entry system comes bundled with accounting software packages for businesses. When setting up the software, a company can configure its general ledger to reflect the actual accounts used by the company.
Examples of Double-Entry Accounting
As an example of double-entry accounting, if you were to record sales revenue of $500, you would need to make two entries: a debit of $500 to increase the general ledger account titled “cash” and a credit of $500 to increase the income statement account titled “revenue.”
Another example could be purchasing a new computer for $1,000. You would need to make a debit entry of $1,000 to increase the income statement account titled “technology” and a credit entry of $1,000 to decrease the asset account titled “cash.”
The opposite is also true: if your company borrows money from the bank, assets will increase, and liabilities will increase by the same amount. Double-entry accounting ensures accuracy, as after completing the entries, the total of the accounts with debit balances should exactly equal the total of the accounts with credit balances. This confirms that you have recorded every part of the transaction.
Frequently Asked Questions (FAQs)
What are debits and credits in double-entry accounting?
Debits add money to accounts, while credits subtract money from accounts. When you make a payment, it is considered a debit, and when you pay someone else, it is considered a credit.
Who invented double-entry accounting?
The French monk Luca Pacioli in the 15th century is considered one of the first to write about modern accounting methods such as double-entry accounting. However, he did not invent it; rather, he was the first to describe accounting methods that were already a common practice among merchants in Venice.
Source: https://www.thebalancemoney.com/what-is-double-entry-accounting-1293675
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