Double-entry bookkeeping explained

Every transaction changes more than one thing. A sale on credit adds to what customers owe you and adds to your income. A new loan puts money in the bank and creates a debt to the lender. Double-entry bookkeeping records both changes, one as a debit and the other as a credit, for the same total.

business.gov.au's glossary defines both methods. Single entry, which it ties to cash accounting, captures one side of each transaction. Double entry captures both sides of every transaction.

Which side each type of account takes is a set of rules in its own right. This guide is about what the two-sided rule does for the books as a whole.

Double entry is built on one relationship: assets equal liabilities plus equity. Everything the business owns was paid for either with money it owes to someone else or with value that belongs to its owners.

business.gov.au works from the same relationship. Its glossary arrives at equity by taking liabilities away from assets, and its balance sheet template works out net assets as total assets less total liabilities. The glossary also gives owner's equity as another name for net assets.

Income and expenses enter the equation through equity. Income adds to what the owners have in the business and expenses take away from it, so a period's profit or loss shows up as a change in equity.

A balanced entry moves the two sides of the equation by the same amount, or moves value around within one side, so the equation is still true after every transaction. The table starts from a small business's opening position and records a run of everyday transactions.

On every row, assets equal liabilities plus equity. The loan changes both sides. The customer's payment changes neither total: it turns an amount owed into money in the bank. Equity finishes higher than it started by the period's profit, which is the sale less the advertising and the rent.

Each entry has equal debits and credits. Add up every entry ever posted and the debits in total must still equal the credits in total. A list of every account's balance, called a trial balance, should therefore have debit and credit columns that agree.

In accounting software, a transaction entered once, such as a supplier bill, is posted to both of its accounts automatically, and an entry with unequal sides is normally rejected. In handwritten books, the bookkeeper posts each side to the ledger separately, which is how one-sided errors get in.

Because each account has a type, the ledger divides cleanly between two of the financial statements. The income and expense accounts form the profit and loss statement, which business.gov.au describes as setting out sales and expenses. The asset, liability and equity accounts form the balance sheet, which lists what is owned and owed at one date and works out net assets.

Profit is what ties them together. Income less expenses gives the profit or loss, and because that result belongs to the owners it becomes part of equity. On the balance sheet, equity includes the profit or loss not yet moved into the equity accounts, usually the financial year to date, and with it added in, equity matches net assets and the balance sheet balances.

Double entry also gives amounts owed a place to sit. Under accrual accounting, which business.gov.au says records sales and expenses when they happen rather than on payment, an unpaid invoice waits in accounts receivable and an unpaid bill in accounts payable until each is settled. business.gov.au calls accrual the more complicated of the two methods, needing a good grasp of bookkeeping or a professional's help.

The check built into double entry is that both sides of each entry must match, so it catches entries whose debits and credits differ. Mistakes that keep the debits and credits equal pass straight through, so other checks, mostly against records from outside the business, are needed to find them.

The trial balance finds the first kind. The second kind usually comes to light when the books are compared with evidence from outside, such as statements from the bank, card providers and suppliers and what customers say they owe, or when someone reviews each account's balance and asks whether it makes sense. A bank reconciliation, in business.gov.au's glossary, checks the cash book against the bank statements, and the same approach works for any account that has an outside record.

The ATO makes a similar point about cash and EFTPOS sales in its tips on avoiding common record-keeping errors: check them regularly against outside records to confirm what you recorded.