When you fill in the tax registration form, some of you will have a choice between two methods to determine your profit: single-entry or double-entry bookkeeping.
This article will explore the basics of double-entry accounting, the benefits of using this method, and a few examples of how you might apply this to your business.
What is bookkeeping?
Let's start with the ground zero. What is bookkeeping in the first place? Bookkeeping is the process of recording all financial transactions of a business, which is essential for tax reporting and financial management. Whether you're a freelancer, a sole trader, or running a company, maintaining accurate records of income and expenses is mandatory.
Still, we have to admit that the only reason we do bookkeeping in the way and form we do is government requirements. Freelancers, entrepreneurs, and founders should only use bookkeeping as the central source of truth and turn it into insightful business reports, graphs, and tables.
Single-entry bookkeeping: record as you go
Single-entry bookkeeping, or "Einnahme-Überschuss-Rechnung" in German, is a straightforward method for small businesses with manageable business processes.
Single-entry accounting is a process by which transactions are recorded once as either revenue or expense. All income and expenses are recorded and sorted by date. It means that you record for what you have received or spent money.
How it works: In this system, you record each transaction once, noting the date, amount, and purpose. For instance, when a client pays for your web design services, you record the revenue received.
Who should use it: This method is only suitable for freelancers and sole traders with an annual turnover of less than €600,000 or a profit below €60,000. It's recommended for those starting out or managing smaller-scale operations.
Benefits:
Easier to learn and implement.
Less time-consuming.
Adequate for businesses with straightforward financial transactions.
Double-entry bookkeeping: 2FA verification for business activity
Double-entry bookkeeping, or "Betriebsvermögensvergleich," is a more intricate system that provides a complete financial picture of your business.
The double bookkeeping method is a system in which your business income and expenses are recorded twice. Every financial transaction gets two entries, a "debit" and a "credit" to describe whether money is being transferred to or from an account. Each accounting entry affects two different accounts: for example, if you sell a cup of coffee, your cash account goes up (debited), and your inventory account goes down (credited).
When making these journal entries in your general ledger, debit entries are recorded on the left, and credit entries on the right. All these entries get summarized in a trial balance, showing the account balances and totals of your total credits and debits. If done correctly, your trial balance should show that the credit balance is the same as the debit balance.
There's one more common accounting term you should know here: chart of accounts, which is a comprehensive list of all your accounts (what kind of transaction in your business is an asset, what's a liability, what's an equity, etc.).
In addition to revenue and expense accounts tracked in single-entry accounting, double-entry accounting also tracks liability, asset, and equity accounts. It is, therefore, suitable for small and medium enterprises.
Types of accounts used in a double-entry system
The dual accounting method uses five types of accounts. These include assets, liabilities, equity, revenue, and expenses. Understanding these accounts helps understand the effect of a particular transaction. The accounting equation, Assets = Liabilities + Equity, must stay balanced.
Assets: Assets are resources your business owns, such as cash, accounts receivable, inventory, equipment, and prepaid expenses.
Liabilities: The financial obligations your business owes to another party, such as debt, accounts payable, and unearned revenue.
Equity: Equity is the difference between assets and liabilities. It includes capital, retained earnings, and owner investments.
Revenue: These are business earnings from sales of the company offerings.
Expenses: The expense account records the cost of running a business, such as rent or payroll expenses.
Who Should Use It: This method is compulsory for larger businesses exceeding the thresholds for single-entry bookkeeping. It's also preferred by businesses with an extensive equipment list (purchasing a laptop and a camera is not an extensive list), seeking detailed financial insights, and those with complex financial transactions.
Key Features:
Dual Recording: Each transaction is entered as a debit in one account and a credit in another.
Types of Accounts: Involves assets, liabilities, equity, revenue, and expenses.
Balancing the Books: Ensures the accounting equation (Assets = Liabilities + Equity) always balances.
Benefits:
Provides a comprehensive view of your business's financial health.
Essential for businesses with diverse or complicated financial activities.
Facilitates detailed financial analysis and planning.
Making the choice (without the choice)
Complexity: Single-entry is simpler; double-entry is more complex but offers greater detail.
Business Size and Type: Freelancers and small sole traders often find single-entry sufficient, while larger entities may require or benefit from the double-entry method.
Future Growth: Starting with double-entry might be wise if you anticipate rapid growth or increased complexity in your business transactions.
Single-entry bookkeeping is definitely more straightforward to learn and easier to use. Usually, beginners decide upon this option. Remember that freelancers can always opt for single-entry bookkeeping. Meanwhile, sole traders can only opt for single-entry bookkeeping if their turnover is less than 600'000€ per year or their profit is less than 60'000€ per year.
In Germany, the choice between single-entry and double-entry accounting isn't simply a matter of preference but often a legal requirement. For instance:
Freelancers and sole traders often opt for single-entry accounting if their turnover is below 600,000 € or their profit is under 60,000 € annually.
Companies are typically required to use double-entry accounting to comply with German commercial and tax laws, providing a detailed financial overview necessary for audits and financial analysis.
Should I use double-entry?
If your business is a very simple sole proprietorship—one that doesn't have any inventory, doesn't have any debts, has no employees, and does not have many accounts to keep track of—a single-entry system should suffice for your accounting needs.
If your business is any more complex than that, most accountants will strongly recommend switching to double-entry accounting.
Why? Double-entry provides a much better view of your finances than the single-entry method ever could.
Double-entry accounting also decreases the risk of bookkeeping errors, increases the transparency of your finances, and generally adds a layer of accountability to your business that single-entry can't provide.
If you want your business to be taken seriously—by investors, banks, potential buyers—you should use double-entry.
Here are the key benefits of the dual accounting method:
Reduces accounting errors: Double-entry bookkeeping reduces errors compared to the single-entry method because transactions are recorded in two accounts, helping minimize accounting mistakes.
Prevents fraud: This system also prevents fraud because each transaction has a visible record on both sides, which must balance.
Improves reliability: A double entry is more reliable than a single entry because it provides a clear view of your business finances. It enables you to know the exact state of your accounts at any time.
Boosts cash flow management: Double-entry bookkeeping provides an accurate view of your accounts receivable and payable. It lets you easily manage cash flow, identify slow-paying clients, and chase overdue payments.
Simplifies financial reporting: The entry system simplifies financial reporting as it provides accurate records and helps identify and correct errors quickly before they affect subsequent transactions.
Helps in financial decision-making: The dual accounting method provides valuable insights into your business's financial operations. It helps make informed decisions in setting financial goals or taking advantage of business opportunities. It leverages technology to assess the financial health of your business through data-driven solutions.
Enhances comparisons: This bookkeeping system lets you easily compare financial activities between two periods. It helps to identify areas that need improvement in the future and makes projections for budgeting.
Accounting examples
You might be anxious about how to conduct journal entries twice and what accounts to debit or credit. Below are single-entry and double-entry examples with transactions recorded in one, two, or more accounts for the balance.
Example 1 (single-entry)
A customer paid for your services.
Revenue: 1200 €
Example 2 (single-entry)
You purchased a Microsoft Office subscription.
Expense: 36 €
Example 3 (double-entry)
You purchased equipment, like a laptop, for 3,000 €.
Equipment Account: 3,000 € (Debit)
Cash/Bank Account: 3,000 € (Credit)
Example 4 (double-entry)
If your business pays a utility bill of 3,500 €, the asset account decreases (cash) while the expense account increases. You will, therefore, debit utility expenses and credit cash.
Utility bill: 3,500 € (Debit)
Cash: 3,500 € (Credit)
Example 5 (double-entry)
Assume that your company purchased an inventory worth 100,000 €. You paid 60,000 € in cash; the remaining balance was on the account. To journalize these entries, you calculate the amount on account (100,000 € - 60,000 €) = 40,000 €. You debit the inventory at 100,000 €, credit cash at 60,000 €, and credit accounts payable at 40,000 €.
Inventory: 100,000 €
Cash: 60,000 €
Accounts Payable: 40,000 €
Example 6 (double-entry)
Towards the end of the last financial year, a particular company declared dividends of 43,000 €. This company should debit retained earnings and credit the dividend payable. If the company paid the dividends two months later, then the company debits dividends payable and credits cash.
Retained earnings: $43,000 € (Debit)
Dividends payable: $43,000 € (Credit)
Implementing Double-Entry Accounting
With the advent of modern accounting software, many of which are tailored to German tax regulations (like Norman), implementing double-entry accounting is more straightforward than ever. These tools automate much of the process, ensuring compliance and accuracy.
Most popular accounting software today uses the double-entry system, often hidden behind a simplified interface, so you generally don't have to worry about double-entry unless you want to.
A double-entry accounting cheat sheet
It can take some time to wrap your head around debits, credits, and how each business transaction affects each account and financial statement. To simplify things, here's a cheat sheet for how debits and credits work under the double-entry bookkeeping system.
Debits:
Increase an asset account or decrease a liability account or equity account (such as owner's equity).
Increase an expense account.
Decrease revenue
Are always recorded on the left side
Credits:
Increase a liability or equity account or decrease an asset account.
Decrease an expense account.
Increase revenue
Are always recorded on the right side
Conclusion
Single-entry and double-entry bookkeeping are more manageable than they seem. Choosing a system that aligns with your business needs and capabilities is key. Remember, proper bookkeeping keeps you compliant with German tax laws and empowers you with the knowledge to make informed financial decisions for your business.
Whether you opt for the simplicity of single entry or the thoroughness of double entry, embracing bookkeeping as a part of your entrepreneurial journey is a step towards greater financial clarity and success.