Accountants today do not typically use a physical general ledger book; however, modern accounting software uses the same underlying concept of posting two entries to the general ledger for every transaction. For example, if Lucie opens a new grocery store, she may start the business by contributing some of her own savings of $100,000 to the company. The first entry to the general ledger would be a debit to Cash, increasing the assets of the company, and a credit to Equity, increasing Lucie’s ownership stake in the company. Double-entry bookkeeping is the concept that every accounting transaction impacts a company’s finances in two ways. There are several different types of accounts that are used widely in accounting – the most common ones being asset, liability, capital, expense, and income accounts.
If the accounts are imbalanced, then there is a problem in the spreadsheet. Thus, the asset account is increased with a debit and the liabilities account is equally increased with a credit. After the transaction is completed, both sides of the equation are in balance because an equal debit and credit were recorded.
Preventing Errors Through Double-Entry Bookkeeping
For this method to work, you will have to record these entries in the proper financial statements, including your balance sheet and income statement. The two rules of double-entry accounting refer to the systematic recording of transactions using debits and credits. For every transaction completed in your business, you must debit one account and credit another for the same amount.
Under this approach, assets and liabilities are not formally tracked, which means that no balance sheet can be constructed. This approach can work well for a small business that cannot afford a full-time bookkeeper. For instance, if a business takes a loan from a financial entity like a bank, the borrowed money will raise the company’s assets and the loan liability will also rise by an equivalent amount. If a business buys raw materials by paying cash, it will lead to an increase in the inventory (asset) while reducing cash capital (another asset).
Step 2: Use debits and credits for all transactions
When entering business transactions into books, accountants need to ensure they link and source the entry. Linking each accounting entry to a source document is essential because the process the true cost of employees helps the business owner justify each transaction. Double-entry bookkeeping is an important concept that drives every accounting transaction in a company’s financial reporting.
If you’re considering purchasing new equipment or taking out a line of credit, for example, your accountant can help you determine the financial ramifications your decision can have. Accounting also involves reporting these findings to tax collectors and regulators. It’s a process that tells the financial story of your business, including if your business is profitable or if you’re suffering a loss. To illustrate how single-entry accounting works, say you pay $1,500 to attend a conference. When you send an invoice to a client after finishing a project, you would “debit” accounts receivable and “credit” the sales account. Noting these flaws, a group of accountants—in 12th century Genoa, 13th century Venice, or 11th century Korea, depending on who you ask—came up with a new kind of system called double-entry accounting.
Assets, Expenses, and Drawings accounts (on the left side of the equation) have a normal balance of debit. Liability, Revenue, and Capital accounts (on the right side of the equation) have a normal balance of credit. On a general ledger, debits are recorded on the left side and credits on the right side for each account. Since the accounts must always balance, for each transaction there will be a debit made to one or several accounts and a credit made to one or several accounts. The sum of all debits made in each day’s transactions must equal the sum of all credits in those transactions.
If done correctly, your trial balance should show that the credit balance is the same as the debit balance. When using the double-entry accounting system, two things must always be balanced. The general ledger, which tracks debit and credit accounts, must always be balanced. Additionally, the balance sheet, where assets minus liabilities equals equity, must also be balanced. This is always the case except for when a business transaction only affects one side of the accounting equation.
How to record a journal entry
This system is a more accurate and complete way to keep track of the company’s financial health and how fast it’s growing. It can take some time to wrap your head around debits, credits, and how each kind of business transaction affects each account and financial statement. To make things a bit easier, here’s a cheat sheet for how debits and credits work under the double-entry bookkeeping system.
An example of double-entry accounting would be if a business took out a $10,000 loan and the loan was recorded in both the debit account and the credit account. The cash (asset) account would be debited by $10,000 and the debt (liability) account is credited by $10,000. Under the double-entry system, both the debit and credit accounts will equal each other. The primary disadvantage of the double-entry accounting system is that it is more complex. It also requires that mathematically, debits and credits always equal each other. This complexity can be time-consuming as well as more costly; however, in the long run, it is more beneficial to a company than single-entry accounting.
Additionally, the IRS can be unforgiving when it comes to mistakes — for instance, filing your payroll taxes just one day past the deadline incurs a 2% penalty. To make matters worse, these penalties can add up to a hefty 15% of the initial amount owed. The concept of double entry accounting is the basis for recording business transaction and journal entries.
- The first entry to the general ledger would be a debit to Cash, increasing the assets of the company, and a credit to Equity, increasing Lucie’s ownership stake in the company.
- When you receive the money, your cash increases by $9,500, and your loan liability increases by $9,500.
- A bookkeeper keeps track of day-to-day business finances, like recording transactions and managing general ledgers.
- After a series of transactions, therefore, the sum of all the accounts with a debit balance will equal the sum of all the accounts with a credit balance.
- A transaction that increases your assets, for example, would be recorded as a debit to that particular assets account.