I was asked this question 2 times recently, so that means it’s time to blog about it!
I may not be the best person to answer this, but I will try to make it understandable especially since most solopreneurs I know (including myself) don’t relish doing their bookkeeping. When I worked for corporate, and one of my roles was to interpret numbers for operations people so I do enjoy making the complex into something useful. Disclaimer: this is not meant to take the place of advice from your legal or financial professional and should not be construed as advice. It’s also not meant to be an exhaustive, comprehensive explanation but more of something to think about.
First, why is it important to know what double-entry bookkeeping is? It’s something that describes the capability of any bookkeeping software you might use and this may impact how much work your accountant has to do to prepare taxes or financial statements. It also gives you the ability to get a wider variety of data from you bookkeeping records than a system that doesn’t follow this convention.
So what is it?
Double-entry bookkeeping is a way to keep the records of the company that supports the idea that a business has assets (one side of the double entry), and that two groups of people have claim to those assets (the other side of the double entry). The first group is creditors or people the business owes money to. The second is the owner or owners. Another way to look at is that the owners share in the business is what’s left over after debts are subtracted from assets. Many transactions effect both sides, but some will only effect one side.
For many solopreneurs, it’s fine to just measure financial health based on cash. Cash comes in and goes out, and you categorize it and get your data from there. For other businesses though, this would not present a full picture. Categorizing your cash in and out could be a simple form of double entry accounting.
For example, let’s say a business signs a 3-month contract to do tech support for a customer and gets a $3,000 check on the spot. When the business owner leaves the customer’s place of business and deposits the check into his or her bank account, the business’ cash has gone way up but they haven’t actually done anything to be entitled to the income represented by the contract. At the end of month one, they’ve earned $1,000, another $1,000 by the end of month 2 and the final $1,000 at the end of month 3. The advantage of looking at this transaction this way is that it lets you know when you’ve earned the income not when the cash came in, although cash flow is important too. Treating the contract this way also allows you to match the revenue more closely to the period of time over which you have expenses relating to earning that income.
What system of bookkeeping do you use? Tell me about it in the comments.
— AnOracleGuy ? There’s quite a bit of misunderstanding above about how manual accounting systems are run. As transactions occur, they are recorded in a journal, which is a list of transactions of some particular sort (i.e. sales). The journal will contain entries similar to your first account; each transaction will list two or more accounts that are affected by the transaction, and each transaction maintains the invariant that the sum of credits and the sum of debits are equal. Journals generally correspond to functions and not to accounts. At closing, the various journals are “closed”, and the transactions recorded therein are “posted” into the ledgers. A ledger is a list of all transactions on a particular account (or a set of accounts). Individual items in a ledger do not obey the double-entry invariant; however for each credit in a given ledger there is a corresponding debit in some other ledger (or combination thereof). Many outside the accounting/bookkeeping profession are unaware of the distinction between a “journal” and a “ledger”, and use the terms interchangeably; when they are most definitely not the same thing.
Thanks for the explanation! I think I see where some of the confusion can come from.