Double-entry bookkeeping balances all general ledger debits with credits for accurate financial statements. Invented by Luca Pacioli, it is the basis of the accounting equation and helps catch errors. However, it may not accurately represent cash flow and requires a statement of cash flows for a clearer picture.
Double-entry bookkeeping is an accounting system that balances all general ledger debits with general ledger credits. The most common use of double-entry bookkeeping is in the accrual accounting method, which records financial transactions as they occur during the accounting period. Accrual accounting creates a more accurate picture for financial statements; it basically smooths out the variances found in financial transactions by allowing accountants to accumulate future income and expenses to balance matching current income or expenses.
Luca Pacioli invented the double-entry bookkeeping system for Venetian merchants during the Italian Renaissance. His system used year-end entries and a trial balance to show that his ledger was balanced, which is a system still used in accounting offices today. Pacioli also wrote numerous documents on essential financial information and transactions found in common business transactions.
Pacioli’s double-entry bookkeeping system is the basis of today’s accounting equation: Assets = Liabilities + Owner’s Equity. This formula balances the general ledger accounts, the trial balance, and the financial statements. The benefits of double-entry bookkeeping include accurate calculation of profits and losses on the income statement and the ability to include assets and liabilities on the balance sheet. This system also makes it easy for accountants to catch errors, as out-of-balance accounts in the general ledger will be quickly reflected in the financial statements.
Financial transactions are recorded in two separate accounts in the double-entry bookkeeping system. Each journal entry includes a debit and credit that balance each entry as it is posted, keeping the general ledger balanced throughout the accounting period. This accounting system is also based on accounts receivable and accounts payable, which represent sales and collections made by extending credit from suppliers and customers.
While double-entry bookkeeping keeps all debits and credits balanced in the general ledger, it may not present an accurate representation of a business’s cash flow. If used in conjunction with the accrual accounting method, double-entry accounting distorts the company’s available cash account in the general ledger account. This occurs because transactions are recorded as they occur rather than when cash changes hands: the books may reflect accumulated cash that the company does not yet have, or accumulated expenses that the company has not yet paid.
To rectify a distorted picture of cash flow, companies must prepare a statement of cash flows, which takes certain accounting items and reverses their effect on the cash account. This statement then provides the company with a clearer picture of its current positive or negative cash flows. The cash flow statement has become important information for investors willing to invest their cash in the business. Investors may be less willing to invest in companies with consistent negative cash flow because the companies will need outside financing to continue operations.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
