In our advisory practice, we’ve navigated various financial recording methods with businesses of all sizes. Among these, double-entry bookkeeping consistently emerges as the gold standard for capturing a business’s true financial picture. So, what’s double-entry bookkeeping, and why should you, as a business owner, consider integrating it into your financial toolkit?
Let me unpack this tried-and-true accounting system for you, illuminating its undeniable advantages and the transformative effect it can bestow upon your business operations.
What is double-entry bookkeeping?
Double-entry bookkeeping is the accountant’s version of Newton’s third law: for every action, there is an equal and opposite reaction. Simply defined, it’s an accounting method used to balance debits (assets) and credits (liabilities). To do that, you need to record your financial transactions with equal and opposite entries in two different accounts. This method helps ensure accuracy and minimize errors in accounting records and provides you with a solid picture of the true value of your business.
The Balance Sheet implications when using the double-entry method
When you pay for something upfront, even if it’s a partial payment, but haven’t yet received the value (finished product or service) for that payment, you’d show that as an asset, or debit, on your Balance Sheet, indicating you have some value coming your way. An example of this would be when you pay an attorney a retainer for legal work for your business. You paid the cash, but they still owe you the work.
On the flip side, some money isn’t earned yet because you still owe products or services for the payment you received, so it’s more accurate accounting to show it as a liability, or credit, instead of income on your Balance Sheet. It reflects that you still owe something for that payment. An example of this is if you are the attorney.
According to the IRS, public companies and businesses with inventory are required to use double-entry bookkeeping.
At HireEffect, we use this method for all our clients because it provides a more accurate picture of when cash flows in and out of their business. It’s the basis for the accrual method of accounting.
How do single-entry and double-entry accounting methods differ?
Single-entry bookkeeping does account for cash flowing in and out of your business, but only at the time the actual cash transaction takes place. It’s a simple recording of financial transactions designed to give you a clear view of cash on hand. It’s great for businesses that have no assets or inventory.
But single-entry bookkeeping doesn’t take equity, assets, or liabilities into account at all. That means no valuable insights into your company’s true financial health. In fact, you won’t get much insight beyond a profit and loss statement.
Double-entry accounting gives you a more accurate picture of the value of your business. And you can still get a good picture of cash inflows and outflows with an understanding of the Cash Flow Statement.
How double-entry accounting boosted our client’s sales: A business example
Let’s explore. We have a client who collects money from their customers for ad placements on their website. Some customers pay for a full year upfront. Others pay month-to-month. They wanted to know which months generated the most revenue, and with single-entry bookkeeping, we couldn’t help them answer that question.
When we started to track their transactions using the double-entry/accrual method, we were able to give them the data they needed to make better decisions on when to focus their sales efforts. They increased profitable sales as a result because we were able to identify the profitable and unprofitable aspects of those sales.
What are the benefits and difficulties of using the double-entry system?
In addition to double-entry bookkeeping providing a more accurate picture of the value of your business at a single point in time, it also helps you reduce errors and significantly increases the chance that your books are balanced. With the double-entry method, you can see data entry errors right away because the debits need to match the credits.
And it can be challenging to execute. Double-entry bookkeeping is a formal accounting system that often requires training to use correctly. It’s also tedious and time-consuming, especially if you’re not familiar with the concept.
Why double-entry accounting matters: Tracking owed money beyond bank balances
Let’s face it, understanding debits and credits isn’t why you started your business.
But why should you care?
Double-entry bookkeeping is especially important for business owners who don’t only want to track the cash in their bank account but also want to know who owes them money and who they owe money to.
If you received money for a service that you haven’t yet completed, you haven’t really earned that money yet. So, to assume it increased the value of your business when you received the payment is misleading. You still owe something for that, and if you don’t provide the service, technically, you owe a refund.
The same is true for the cash you may have laid out. If you never receive the product or service for which you paid, you are owed a refund.
That is money – real cash – either not coming in – or not going out of your business. Either way, you need to know.
Bank statements vs business logs: The common discrepancy
It’s not uncommon for business owners to review their monthly bank statements and check them against sales and expenses, however they may have tracked them. Unfortunately, it’s also not uncommon that those logs and the bank statements don’t match. Sometimes the bank says you have more money than your records show, sometimes less.
This is why we suggest that all businesses use double-entry bookkeeping. It allows you to keep track of more than just income and expenses. You can also track inventory, assets, liabilities, and equity. Each of these components plays a distinct role in understanding your business’s operations, financial stability, and growth potential.
Inventory management: A case for ecommerce business
As an example, our ecommerce clients deal with physical products that need to be bought, stored, and sold. Efficient inventory management ensures that they have the right number of products on hand to meet their customer demand while also avoiding overstocking, which directly impacts their customer satisfaction, operational efficiency, and cash flow. By tracking inventory, they can optimize stock.
The importance of tracking liabilities
Double-entry bookkeeping also enables us to review liabilities. Tracking liabilities is essential for managing cash flow, understanding financial obligations, and maintaining a healthy debt-to-equity ratio. Failure to manage liabilities can lead to financial strain, affecting your ability to invest, expand, or meet day-to-day expenses.
Compliance and tax implications: A simple perspective
Maybe none of this resonates. So, how about this: accurate financial records are often required for tax purposes and regulatory compliance. Double-entry bookkeeping ensures that you can determine your profit and stay compliant by paying the appropriate amount of tax.
Changing your accounting method: How to transition from single-entry to double-entry system?
Transitioning to double-entry bookkeeping may require some time and effort, but it can significantly improve the accuracy and reliability of your financial records, ultimately leading to better decision-making for your ecommerce business.
Changing from single-entry to double-entry bookkeeping shouldn’t be too difficult unless you have some clean-up to do. You should familiarize yourself with the principles and concepts of double-entry bookkeeping, identify any discrepancies or gaps in your current single-entry accounting records, create a new chart of accounts for double-entry bookkeeping, and decide on a plan for transitioning from the single-entry system to the new double-entry system.
(Too overwhelming? HireEffect can help you accurately transition from single-entry to double-entry bookkeeping.)
Closing thoughts: Sustainable bookkeeping and beyond
Double-entry bookkeeping offers businesses a holistic view of their financial health. From tracking inventory and liabilities to ensuring regulatory compliance and enhancing decision-making capabilities, the merits of this system are undeniable.
From the years of business experience, we’ve witnessed firsthand the transformative power of double-entry bookkeeping on businesses, both big and small. Understanding where your money goes, who owes you, and who you owe is fundamental to successful financial management.
But the double-entry method takes you beyond the books into an array of practical implications that help you scale, gain insights, and maintain a solid financial foundation. While the initial transition may seem complex, the long-term benefits far outweigh the initial learning curve.