Double Entry Accounting
is a form of recording financial transactions for businesses. In its most basic form double entry accounting is a system where all debits and credits must balance. In double entry accounting for every action there must be a reaction within the accounts.
The basic equation by which double entry accounting works is shown below:
Assets = Liabilities + Equity
Effectively for everything a company owns (Assets) there is a claim against it (Liabilities+Equity) whether it be due to owing the bank, or owing a shareholder who has paid money into the company. Liabilities come in the form of both long term (bank loans) and short term (overdraft, trade credit), equity is usually shown on the balance sheet under shareholders' capital and represents those that own the business.
A company makes a purchase of £1,000 worth of stock, the company takes out a loan for £1,000 to pay for this. The purchase of £1,000 of stock is a debit and therefore it needs to be countered with a credit, which in this case is the loan of £1,000.
This would result in two changes to a companies balance sheet.
- An increase would occur in the company's long term liabilities (a long term liability is any payment that is due after 1 year).
- The company would see an increase in stock, this is reflected on the balance sheet through an increase in current assets (a term given to items that can be turned into cash within a year).
Double entry accounting has therefore resulted in the action of purchasing stock having a reaction in the form of an increase in long term liabilities due to the loan.
Double entry accounting can also be seen when a change happens on either side of the balance sheet, for example instead of taking out a loan to purchase the £1,000 of stock the company uses cash (which would appear under current assets) to buy the stock. This would then result in an increase in stock and a decrease in cash, both changes occur within the current assets section of the balance sheet.
What is a single entry accounting system then?
The difference between a double entry and a single entry accounting system is basically that a single entry is just that, it does not have another entry to counter it. The total of all transactions are merely added up to give you a profit or loss.
The reasons why you would choose double entry over a single entry accounting system include:
- It is easier to prepare accurate and compliant accounts from a double entry accounting system.
- Any mistakes are easier to spot due to the fact that if something is wrong the accounts will not balance, or in other words debits will not be equal to credits.
- Double entry accounting systems allow you to have assets and liabilities recorded
Computers can do the hard work for you
If you are keeping records by hand then, for every purchase or sale, you would have to write down the other side of the transaction. If you are using double entry accounting software then for every transaction (entry) the software will calculate the other side automatically, making double entry accounting that little bit easier.