Fundamentals of Double Entry Accounting
Introduction
As developers, we often find ourselves working on applications that handle money in various ways. Whether building a fintech application or integrating financial features into our startups, understanding the core principles of accounting is crucial. This is especially true when it comes to double-entry accounting, a system that has grown and imprved over hundreds of years.
In this prelude, we'll dive into the fundamentals of double-entry accounting, setting the stage for our more detailed exploration in the following parts of this series. Let's break down the key concepts that form the foundation of this robust financial tracking system.
What is Double Entry Accounting?
Double-entry accounting is a method of bookkeeping that records each transaction in at least two different accounts. The core principle is simple yet powerful: every transaction must show both where the money came from (the source) and what it was used for (the use). This dual-aspect recording ensures that the books always balance, providing a clear and accurate picture of an entity's financial state.
The Accounting Equation
At the heart of double-entry accounting lies the fundamental accounting equation:
Assets = Liabilities + Equity
This equation represents the balance sheet of any entity and must always hold true. It's the foundation upon which the entire double-entry system is built.
The way that transactions are entered into the accounting ledger ensures that this equation is always maintained. In the course of our blog post series we will see how this is true and also how a technical implementation of a ledger might look that maintains these riles.
Account Types: Debit Normal vs Credit Normal
In double-entry accounting, accounts are classified into two main types:
- Debit Normal Accounts: These represent funds you own or uses of money. Examples include assets and expenses.
- Credit Normal Accounts: These represent funds you owe or sources of money. Examples include liabilities, equity, and revenue.
This classification is important because it determines how transactions affect account balances.
Transactions and Entries
A transaction is an event that has a monetary impact and is recorded in the ledger. Each transaction consists of at least two entries, with each entry corresponding to an account. For example, when a company buys inventory with cash:
Transaction: Purchase inventory for $1000 Entry 1: Debit Inventory (Asset) $1000 Entry 2: Credit Cash (Asset) $1000
This transaction shows both the use of funds (increase in inventory) and the source of funds (decrease in cash).
Debits and Credits: More Than Just Additions and Subtractions
One of the most confusing aspects of double-entry accounting for newcomers is the concept of debits and credits. Contrary to common belief, these don't simply mean additions and subtractions. Instead, they refer to the side of the account (left or right) on which an entry is recorded.
The effect of a debit or credit on an account's balance depends on the account type:
- For Debit Normal Accounts:
- Debits increase the balance
- Credits decrease the balance
- For Credit Normal Accounts:
- Credits increase the balance
- Debits decrease the balance
This system ensures that the total debits always equal the total credits across all accounts, maintaining the balance in the accounting equation.
In the next part, we'll dive into the practical implementation of a double-entry accounting system, discussing data models, transaction immutability, and strategies for ensuring data consistency and integrity.