Why double entry bookkeeping is a crucial part of your financial statement
Understanding financial statements can be a daunting process for many. But that doesn’t have to be the case. Over the next two weeks, we’ll be giving a masterclass in financial statements in advance of the launch of our Financial Statements for Dummies guide. We’ll be breaking down the whole process from start to finish, beginning today with double entry bookkeeping, which forms the backbone of all financial statements.
The history of double entry bookkeeping
Finance and accounting today may be a very different beast from the time of the pharaohs, but keeping accounting records is arguably as old as civilisation itself. Financial statements can be traced as far back as the ancient Egyptians, who wrote their accounts on papyrus scrolls, while the Babylonians preferred to carve their figures onto tablets made of clay.
However, we need to travel to Italy, the birthplace of banking, to find the very first double entry bookkeeping system. It was in the glory days of the Renaissance in the 15th century when Luca Pacioli, a mathematician often referred to as the grandfather of accounting, invented this simple yet ingenious process.
What is double entry bookkeeping?
As its name suggests, double entry bookkeeping is when every figure entered into an account needs a corresponding and opposite entry. The idea is that by entering an amount into a debit column as well as one into a credit column, any mistakes are certain to be detected. The balance of the two columns should always be zero.
For example, if you’re selling a product for £500, then this should be inputted into the debit column. Then, when your customer pays the £500 that he owes, this will be entered into the credit column. If the customer hasn’t paid, then the balance won’t come to £0 and you’ll quite easily be able to tell that there’s a problem.
Double entry bookkeeping is also useful in providing business owners with an up-to-date record of assets and liabilities.
Remember that double entry bookkeeping is completely different from the illegal practice of keeping two sets of books, when companies keep two accounting records in order to hoodwink the tax authorities.
Where the general ledger comes in
There are two types of general ledger accounts, both of which will be explored further in a later blog:
- The balance sheet, which records the assets, liabilities and equity capital
- The profit and loss account.
The general ledger will be booked with what are known as “journal entries”. These journal entries will show which general ledger accounts must be debited and credited. Each journal entry must be balanced by making sure that the credit and debit columns are always equal.
So, in other words, all bookkeeping stems from the general ledger, and all financial statements start with entry bookkeeping.
Keep visiting us over the next few weeks for more insights into the world of financial statements, and watch this space for our Financial Statements for Dummies book, coming soon.