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Double-entry bookkeeping explained

Bookkeeping can be complicated businesses of any size, and double-entry bookkeeping, all the more so. Here's a closer look at this financial process and how understanding double-entry bookkeeping can help your organisation.

Double-entry bookkeeping definition

Double-entry bookkeeping is an accounting system that rules that for every entry into one account, an equal entry must be made in another account. Said to date back to the 11th century, double-entry bookkeeping maintains that there must be an equal debit for every credit a company records in its accounting system. These transactions are recorded in a company's general ledger, in individual nominal codes. From the general ledger, you can derive a trial balance that is made up of the sum of all the nominal accounts. The trial balance has both a debit and credit side that are equal to each other.

What the double-entry bookkeeping system looks like

There are some key features of a double-entry bookkeeping entry to look out for, depending on what sort of expense or income you are recording:

  • Debits are always on the left-hand side. Debits will increase an asset account or decrease a liability account. Debits also decrease revenue.

  • Credits are always on the right-hand side. Credits will increase a liability account but decrease an asset account. Credits increase revenue.

Following this format, it should be easy for you to understand the books when data is recorded as double-entry, making it simple to see discrepancies or find errors if revenue or account balances seem off.

Understanding double-entry bookkeeping

The purpose of double-entry bookkeeping is to create a set of financial statements (the profit and loss statement and balance sheet) based on the trial balance. The profit and loss statement shows the revenue, costs, and profit/loss for a certain period. The balance sheet shows the assets, liabilities, and equity of a company for all time.

The double-entry bookkeeping system is based on the following formula:

Assets = Liabilities + Equity

This is known as the accounting equation. The equity portion of a balance sheet includes the profit or loss made for all time, including the current period.

What comprises a double-entry bookkeeping balance sheet?

  • Assets

  • Liabilities

  • Equity

What comprises the profit and loss statement?

  • Revenue.

  • Costs

  • Profit/loss

To understand how double-entry bookkeeping works, look at the example below. In this case, we'll focus on a company that sells apples.

First, we need to invest in the business. We invest $100,000 – the double-entry bookkeeping example for this is below

Account

Debit

Credit

Cash

$100,000

-

Equity

 

$100,000

Now, we need to buy a shop front to sell the apples from. The shop's value is $500,000, so let's assume we take out a loan for the full amount.

Account

Debit

Credit

Property

$500,000

-

Liability (Mortgage)

$500,000

We need to buy some actual apples to sell. Let's buy $10,000 worth of inventory – this is a cost.

Account

Debit

Credit

Inventory

$10,000

-

Cash

$10,000

Time to sell. We sold all the apples for $12,000.

Account

Debit

Credit

Cash

$12,000

-

Revenue

$12,000

Putting all this double-entry bookkeeping data together will form a trial balance and the financial statements.

Double-entry bookkeeping trial balance

Account

Debit ($’000)

Credit ($’000)

Property

500,000

-

Inventory

-

Cash

102,000

Liabilities

500,000

Equity

100,000

Revenue

12,000

Costs

10,000

Total

612,000

612,000

Notice how there is no inventory left, as everything bought was sold. Also, notice how cash has changed. We initially started with 100,000, spent 10,000 to buy apples (90,000 remaining). However, we made 12,000 by selling those same apples. So, 100 – 10 + 12 = 102.

Because of the accuracy of double-entry bookkeeping, we can now form other financial statements with correctly balanced data.

Perfect Apples Ltd - Profit and Loss Account

Revenue

12,000

Costs

(10,000)

Profit

2,000

Perfect Apples Ltd - Balance Sheet

Assets

Property

500,000

Cash

102,000

Total Assets

602,000

Liabilities

Mortgage

500,000

Net Assets (assets - liabilities)

102,000

Equity

Shareholder Investment

100,000

Profit

2,000

Total Equity

102,000

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Why use a double-entry bookkeeping system?

By logging both credit and debits in a double-entry bookkeeping system, you can accurately record your financial information. A business must keep as close an eye on its income as it does on its expenses, which is why every business needs to use double-entry bookkeeping. By having all this information to hand, companies are also better able to forecast future spending.

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