Financial Accounting
For developers with non-financial backgrounds, TigerBeetle's use of accounting concepts like debits and credits may be one of the trickier parts to understand. However, these concepts have been the language of business for hundreds of years, so we promise it's worth it!
This page goes a bit deeper into debits and credits, double-entry bookkeeping, and how to think about your accounts as part of a type system.
Building Intuition with Two Simple Examples
If you have an outstanding loan and owe a bank $100, is your balance $100 or -$100? Conversely, if you have $200 in your bank account, is the balance $200 or -$200?
Thinking about these two examples, we can start to build an intuition that the positive or negative sign of the balance depends on whose perspective we're looking from. That $100 you owe the bank represents a "bad" thing for you, but a "good" thing for the bank. We might think about that same debt differently if we're doing your accounting or the bank's.
These examples also hint at the different types of accounts. We probably want to think about a debt as having the opposite "sign" as the funds in your your bank account. At the same time, the types of these accounts look different depending on whether you are considering them from the perspective of you or the bank.
Now, back to our original questions: is the loan balance $100 or -$100 and is the bank account balance $200 or -$200? On some level, this feels a bit arbitrary.
Wouldn't it be nice if there were some commonly agreed-upon standards so we wouldn't have to make such an arbitrary decision? Yes! This is exactly what debits and credits and the financial accounting type system provide.
Types of Accounts
In financial accounting, there are 5 main types of accounts:
- Asset - what you own, which could produce income or which you could sell.
- Liability - what you owe to other people.
- Equity - value of the business owned by the owners or shareholders, or "the residual interest in the assets of the entity after deducting all its liabilities."1
- Income - money or things of value you receive for selling products or services, or "increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims."1
- Expense - money you spend to pay for products or services, or "decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims."1
As mentioned above, the type of account depends on whose perspective you are doing the accounting from. In those examples, the loan you have from the bank is liability for you, because you owe the amount to the bank. However, that same loan is an asset from the bank's perspective. In contrast, the money in your bank account is an asset for you but it is a liability for the bank.
Each of these major categories are further subdivided into more specific types of accounts. For example, in your personal accounting you would separately track the cash in your physical wallet from the funds in your checking account, even though both of those are assets. The bank would split out mortgages from car loans, even though both of those are also assets for the bank.
Double-Entry Bookkeeping
Categorizing accounts into different types is useful for organizational purposes, but it also provides a key error-correcting mechanism.
Every record in our accounting is not only recorded in one place, but in two. This is double-entry bookkeeping. Why would we do that?
Let's think about the bank loan in our example above. When you took out the loan, two things actually happened at the same time. On the one hand, you now owe the bank $100. At the same time, the bank gave you $100. These are the two entries that comprise the loan transaction.
From your perspective, your liability to the bank increased by $100 while your assets also increased by $100. From the bank's perspective, their assets (the loan to you) increased by $100 while their liabilities (the money in your bank account) also increased by $100.
Double-entry bookkeeping ensures that funds are always accounted for. Money never just appears. Funds always go from somewhere to somewhere.
Keeping Accounts in Balance
Now we understand that there are different types of accounts and every transaction will be recorded in two (or more) accounts -- but which accounts?
The Fundamental Accounting Equation stipulates that:
Assets - Liabilities = Equity
Using our loan example, it's no accident that the loan increases assets and liabilities at the same time. Assets and liabilities are on the opposite sides of the equation, and both sides must be exactly equal. Loans increase assets and liabilities equally.
Here are some other types of transactions that would affect assets, liabilities, and equity, while maintaining this balance:
- If you withdraw $100 in cash from your bank account, your total assets stay the same. Your bank account balance (an asset) would decrease while your physical cash (another asset) would increase.
- From the perspective of the bank, you withdrawing $100 in cash decreases their assets in the form of the cash they give you, while also decreasing their liabilities because your bank balance decreases as well.
- If a shareholder invests $1000 in the bank, that increases both the bank's assets and equity.
Assets, liabilities, and equity represent a point in time. The other two main categories, income and expenses, represent flows of money in and out.
Income and expenses impact the position of the business over time. The expanded accounting equation can be written as:
Assets - Liabilities = Equity + Income − Expenses
You don't need to memorize these equations (unless you're training as an accountant!). However, it is useful to understand that those main account types lie on different sides of this equation.
Debits and Credits vs Signed Integers
Instead of using a positive or negative integer to track a balance, TigerBeetle and double-entry bookkeeping systems use debits and credits.
The two entries that give "double-entry bookkeeping" its name are the debit and the credit: every
transaction has at least one debit and at least one credit. (Note that for efficiency's sake,
TigerBeetle Transfers consist of exactly one debit and one credit. These can be composed into more
complex multi-debit, multi-credit transfers.) Which
entry is the debit and which is the credit? The answer is easy once you understand that accounting
is a type system. An account increases with a debit or credit according to its type.
When our example loan increases the assets and liabilities, we need to assign each of these entries to either be a debit or a credit. At some level, this is completely arbitrary. For clarity, accountants have used the same standards for hundreds of years:
How Debits and Credits Increase or Decrease Account Balances
- Assets and expenses are increased with debits, decreased with credits
- Liabilities, equity, and income are increased with credits, decreased with debits
Or, in a table form:
| Debit | Credit | |
|---|---|---|
| Asset | + | - |
| Liability | - | + |
| Equity | - | + |
| Income | - | + |
| Expense | + | - |
From the perspective of our example bank:
- You taking out a loan debits (increases) their loan assets and credits (increases) their bank account balance liabilities.
- You paying off the loan debits (decreases) their bank account balance liabilities and credits (decreases) their loan assets.
- You depositing cash debits (increases) their cash assets and credits (increases) their bank account balance liabilities.
- You withdrawing cash debits (decreases) their bank account balance liabilities and credits (decreases) their cash assets.
Note that accounting conventions also always write the debits first, to represent the funds flowing from the debited account to the credited account.
If this seems arbitrary and confusing, we understand! It's a convention, just like how most programmers need to learn zero-based array indexing and then at some point it becomes second nature.
Account Types and the "Normal Balance"
Some other accounting systems have the concept of a "normal balance", which would indicate whether a given account's balance is increased by debits or credits.
When designing for TigerBeetle, we recommend thinking about account types instead of "normal balances". This is because the type of balance follows from the type of account, but the type of balance doesn't tell you the type of account. For example, an account might have a normal balance on the debit side but that doesn't tell you whether it is an asset or expense.
Takeaways
- Accounts are categorized into types. The 5 main types are asset, liability, equity, income, and expense.
- Depending on the type of account, an increase is recorded as either a debit or a credit.
- All transfers consist of two entries, a debit and a credit. Double-entry bookkeeping ensures that all funds come from somewhere and go somewhere.
When you get started using TigerBeetle, we would recommend writing a list of all the types of accounts in your system that you can think of. Then, think about whether, from the perspective of your business, each account represents an asset, liability, equity, income, or expense. That determines whether the given type of account is increased with a debit or a credit.
Want More Help Understanding Debits and Credits?
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Let us help you get it right. Contact our CEO, Joran Dirk Greef, at joran@tigerbeetle.com to set up a call.
- IFRS. Conceptual Framework for Financial Reporting. IFRS Foundation, 2018. https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2021/issued/part-a/conceptual-framework-for-financial-reporting.pdf↩