What Are the Two Accounting Systems?
If you own your own business, you know how important it is to keep track of your finances. It is how you track whether you are making or losing money and what changes need to be made to increase your profits while maintaining customer satisfaction. A lot goes into tracking finances, though, and you have to figure out which accounting services will work best for you to promote growth. Where do you begin?
A good place to start is choosing an accounting system to use for your business. From there, you can figure out some of the smaller details concerning your finances.
What Is an Accounting System?
An accounting system is a combination of the ways in which your business tracks its finances. Specifically, it records business transactions and groups them into reports that business owners can then use to make decisions about improving their business and profits. There are three elements of an accounting system and two types of accounting systems.
The 3 Elements of Accounting Systems
The three elements of accounting systems are identification, measurement, and communication.
- Identification: This element evaluates the way your business’s capital resources are being used. Specifically, it focuses on your revenues and expenses.
- Measurement: This element analyzes the financial performance of your business in previous days, months, and years. It looks at the value of everything you checked during identification.
- Communication: This element focuses on turning what you gathered from identification and measurement into documents that can be shared with the leaders of your business so that decisions to improve finances can be made.
These elements work together to give you a more well-rounded picture of how your business is doing financially. Now that we’ve looked at the elements that accounting systems are composed of, let’s look at the two main types of accounting systems themselves.
What Are the Two Types of Accounting Systems?
The two types of accounting systems are single-entry accounting and double-entry accounting. They vary in complexity, price, and what is recorded in each.
This system is the simpler of the two and is most often used by small businesses and non-profit organizations with no employees or few financial transactions. In fact, this system doesn’t require much formal training or high-quality software. All it requires is a single log to record your transactions. Usually these logs will consist of the amount spent in the transaction, whether it was the business’s expense or income, the date, a description of the transaction, and how much money your business has after the transaction is made.
While this system does save time and money because the process is simpler and doesn’t require an accountant or the best accounting software out there, it is important to note that tax authorities generally don’t recognize this type of system for reporting purposes. Because the log is so basic, balance sheets and statements cannot accurately be compiled. Without these items, business owners have a harder time making financial decisions because they can’t get the full picture from their log.
This system also leaves more room for error. With less detailed financial reports, it proves more difficult to check for bookkeeping problems or even fraud and theft.
This system works better for those with bigger businesses or for businesses with more financial transactions because it is much more detailed than single-entry accounting. It is called double-entry because every transaction within your business requires an entry under both the debit and credit sides of your log. The debit side records increases in assets or an expense account and decreases in liability, equity, and revenue accounts. The credit side records decreases in assets and expense accounts and increases in liability, equity, and revenue accounts. Let’s take a look at what each of these terms means to better understand what you put in each category.
- Asset: What a business owns that holds value. If worse comes to worst, these are the things that could be sold if your business needed more money (like office furniture, company vehicles, and land).
- Expense: Money you spend for your business.
- Liability: What you owe to another person or business.
- Equity: The difference between your assets and liabilities. If it were an equation, it would read as assets = liability + equity
- Revenue: The money your business earns through sales.
Let’s look at a double-entry accounting system example to make it a bit clearer. Let’s say you own a gardening store. You buy a shelf to better organize the way your plants are sorted. When you track this expense, you include it on the debit side of your log because it is an asset that your business now owns. However, you also have to include it on the credit side because you owe that money to another business. The debit and credit sides of your log should always match.
While the double-entry accounting system is more complex, costly, and time-consuming than the single-entry system, it allows for a more accurate overview of your business’s financial health. From this system, the appropriate financial records and statements can be created to help with business decisions. This method also allows for better error and theft prevention because logs are more detailed.