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 found 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; basically it smooths out the variances found in financial transactions by allowing accountants to accrue future revenues and expenses to balance against coinciding current revenues or expenses.
Luca Pacioli invented the double-entry bookkeeping system for Venetian merchants during the Italian Renaissance. His system used closing year-end entries and a trial balance to prove his general ledger balanced, which is a system still used in today’s accounting offices. Pacioli also wrote numerous documents about essential financial information and transactions found in common business operations.
Pacioli’s double-entry bookkeeping system is the basis for 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 the 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 allows for accountants to easily detect errors since out-of-balance accounts on the general ledger will quickly be reflected on financial statements.
Financial transactions are recorded in two separate accounts in the doubly-entry bookkeeping system. Each journal entry includes a debit and a credit that balance each entry as they are posted, keeping the general ledger balanced throughout the accounting period. This accounting system also relies on accounts receivable and accounts payable, which represent sales and collections made by extending credit from vendors and customers.
While double-entry bookkeeping keeps all debit and credits balanced in the general ledger, it may not present an accurate representation of a company’s cash flow. If used in tandem with the accrual accounting method, double-entry bookkeeping distorts the company’s on-hand 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 accrued cash that the company doesn't actually have yet or accrued expenses the company hasn't actually paid yet.
To rectify a distorted cash-flow picture, companies must prepare a statement of cash flows, which takes certain accounting items and reverses their effect in the cash account. This statement then provides the company with a clearer picture of their current positive or negative cash flows. The cash flow statement has become an important piece of information for investors willing to invest their cash into the business. Investors may be less willing to invest in companies with a consistently negative cash flow because companies will need outside financing to continue their operations.
