Why Your Business Needs Double-Entry Accounting
As a business owner, you’ll have to decide whether you’ll use double-entry accounting or single-entry accounting when setting up your bookkeeping.
Fortunately, this decision isn’t too complicated because almost any business will need to use double-entry accounting. It shows you that your business’s accounts are balanced and gives you the true financial picture of your business’s finances.
In this way, you’ll always know how profitable your business is and how it’s been performing. In turn, this helps you make better business decisions.
But what exactly is double-entry accounting and why is it so important? In this post, we’ll look at these questions in more detail.
What Is Double-Entry Accounting?
In simple terms, double-entry accounting is a standard accounting method where every transaction is recorded in at least two accounts. So, in typical accounting speak, a single transaction can result in a debit to some accounts while also resulting in a credit to other accounts. The underlying principle is that every transaction should balance out.
In contrast, single-entry bookkeeping is when you make one entry for every transaction. So, for example, entries in one column will be positive and entries in another column will be negative. This type of bookkeeping, however, is not suitable for large and complex companies.
For one, you can’t track different accounts like accounts payable or accounts receivable. So, while you can calculate your net income with single-entry accounting, it’s not possible to use it to prepare your business’s balance sheet or track your assets and liabilities.
How Double-Entry Accounting Works?
Considering the above, double-entry accounting relies on three major concepts. These are:
- Every transaction must be recorded in at least two accounts in your books.
- For every transaction, the total debits must equal the total credits.
- Your total assets must always equal your total liabilities plus equity. In this way, your books will balance.
With that in mind, let’s look at a few examples of double-entry accounting in action.
For the first example, let’s say you worked on a project for a customer. If you then send an invoice to the client after the completion of the project, the transaction will be reflected in your books as a debit in your Accounts Receivable and a credit in your Revenue accounts. When you receive payment for the project, you’ll then credit your Accounts Receivable account and debit your Cash account.
Another example is when you buy construction materials from a supplier. In this case, on receipt of the invoice, you’ll credit your Accounts Payable account and debit your Inventory account with the amount of the invoice. Once you pay this invoice, your Accounts Payable account will be debited, and your cash account will be credited.
Why Is Double-Entry Accounting Important?
Although many businesses may be able to use single-entry accounting, double-entry accounting offers many advantages over it. So, now that you’ve seen what double-entry accounting is and how it works, we’ll look at why your business needs double-entry accounting.
Gives You the Complete Picture
Simply put, double-entry accounting is a better way for you to monitor the financial health of your business and the rate at which it’s growing. This is simply because it gives you a complete picture of your business’s finances. This is in contrast to single-entry accounting which can show you your cash flow or net income but doesn’t give you much insight into the overall financial health of your business.
With double-entry accounting, you’re able to generate a variety of crucial financial reports, like a balance sheet or income statement from your business’s books. Then, by looking at these, you’ll be able to see all your business’s financial information at a glance and track year-on-year business growth.
For this reason, for businesses with more than one employee, with debts, inventory, and several accounts, double-entry accounting is essential.
Helps You Make Better Decisions
Because double-entry accounting shows you how profitable your business is, what your business’s expenses are, and how strong different parts of your business are performing, you’ll be able to see how your business is doing, how you spend your money, and how you generate revenue.
With this information available, you’ll then be able to make better financial decisions when it comes to your business.
Reduces Errors
As we’ve said before, your business’s total assets must always equal its total liabilities plus equity. And if you do your double-entry accounting right, this will always be the case. In simple terms, your books will balance. If they don’t, you know your books are wrong and that you’ve made a mistake somewhere.
In this way, double-entry accounting helps you to reduce errors in your business’s books. But it goes further than this. Because every transaction must be recorded in at least two accounts as debits and credits, it’s generally a more transparent way to keep your books and keep up to date with your business’s finances.
Preferred in the Business World
Because of the transparency and completeness it provides, double-entry accounting is favored in the business world compared to single-entry accounting.
So, for example, if you need to apply for a loan, your business’s books will give the bank a complete picture of its finances, and, based on that, they’ll then be able to decide whether to lend you money or not.
Likewise, if you need investors in your business or there are potential buyers interested in buying your business, they can get an accurate picture of your business’s financial health and how it has grown over the years. This will enable them to judge whether it’s a sound investment.
The Bottom Line
For your business, proper accounting is vital to ensure that you always know how profitable your business is, what its expenses are and whether it’s growing. And here, double-entry accounting gives you the bigger picture, especially when you have debts and several accounts.
That’s why at Simplypay, our platform is built around double-entry accounting to help you reduce the risk of accounting errors, increase the transparency of your business, and add a layer of accountability to your business.
Hopefully, this post helped illustrate how double-entry accounting achieves this. If it has, go ahead and share this article with your friends.
