Double entry system definition

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What is the Double Entry System?

The double entry system mandates that every business transaction be recorded in at least two accounts. Furthermore, it requires that the total value of all debits entered in a transaction must batch the total value of all credits; otherwise, a journal entry is said to be out of balance. These rules are needed to ensure that a business always keeps its accounting equation properly balanced. For example, a debit of $1,000 to an asset account may be balanced by a credit of $1,000 to a liability account. The accounting equation is as follows:

Assets = Liabilities + Equity

Advantages of a Double Entry System

There are numerous advantages associated with operating a double entry system, including the following:

  • Can produce financial statements. A double entry system allows an organization to produce a full set of financial statements. In particular, it can create a balance sheet, which cannot be produced with just a single entry system. With complete financial statements, it is much easier for a business to convince investors to invest money in it.

  • Increased accuracy. By balancing debits and credits, the system inherently checks itself, thereby reducing the chances of errors.

  • Compliance with accounting standards. Double-entry systems comply with generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS), ensuring consistency and reliability. This compliance is often required by lenders, investors, and regulators.

  • Supports scalability. As businesses grow, the complexity of their financial transactions increases. Double-entry systems can handle this complexity and maintain accurate records.

  • Enhances business credibility. Well-maintained accounts are a sign of professionalism and good management. This can improve trust with stakeholders, such as investors, creditors, and customers.

Disadvantages of a Double Entry System

There are several disadvantages to using a double entry system. First, it is more complex to use, and so is generally avoided by smaller businesses that cannot afford to hire anyone with accounting expertise. Second, the need for accounting expertise means that a double entry system is more expensive to operate, which is a nonstarter for businesses that are already losing money. And third, it takes more time to close the books properly at the end of each reporting period, which can delay the production of financial statements.

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Example of the Double Entry System

The Grouch Electronics company sells a $5,000 home entertainment installation to a client on credit. This results in a debit of $5,000 of the company’s accounts receivable account and a credit of $5,000 to its sales account. Later, the customer pays the $5,000 invoice, at which point the company records a debit of $5,000 to its cash account and a credit of $5,000 to its accounts receivable account. The end result of these transactions is a sale of $5,000 and an increase in cash of $5,000.