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Sunday, January 15, 2012

Accounting: The Arcane Art

It’s like a story from Lovecraft: Accounting. The mere utterance of the word can scare people. Many simply do not wish to hear. Like a witch, the accountant is feared for her knowledge and excluded from society. So what the hell is this about? And, why would you care?

Accounting is the art of keeping track of what you do with your money. The primary purposes being to figure out whether your finances are doing ok, and if not, where to start improving. That’s why you care. The reason why people usually cower in fear when the Words are used is because the whole thing is so old that a lot of the words and general habits used are so antiquated as to be confusing. I’ll try to explain this in a way that makes more sense. Well, it does make sense to me, let’s hope it does for you, too.

As a side node: I’ll add the German names for the different concepts here as well. If you are not German, ignore them.

Double-Entry Bookkeeping (Doppelte Buchführung)

This is the best way of managing bookkeeping and the basis for financial accounting since the 15th century (hence why everything surrounding it feels so antiquated). It’s a pretty simple concept that usually is explained in such convoluted ways that no one understands anything. Let’s see if I can do better than that.

The basic idea of double-entry bookkeeping is that money does not come out of nowhere, and it does go into nowhere, either. You always need to know where it came from and where it went. So every time you add some money to, say, your bank account, you also have to note down where it came from (say, your employer). And if you remove it from your bank account, you have to note down where it went (for example, to the restaurant).

In double-entry accounting, you create a conceptual account (as opposed to a “real” bank account) for each of those places: You have an Employer account, a Bank account, and a Restaurant account. If you earn 500 EUR, your Employer account is reduced by 500 EUR, while your Bank account is increased by 500 EUR. And when you buy a meal for 10 EUR, your Bank account is reduced by 10 EUR and the Restaurant account is increased by 10 EUR. Because each transaction thus causes two entries to be made, it’s double-entry. That’s it.

Scary Negatives and Other Antiquated Antics

It’s time to explain some Accounting Antics. This is important to understand some of the weird traditions and phrases that are in use in accounting.

Basic rule: Negative numbers are scary. Remember when I told you that double-entry bookkeeping was invented in the 15th century? Back then, people were positively scared of negative numbers (pun intended). Hence why they put in a lot of effort to avoid negative accounts. To avoid negative numbers, accountants simply split things into two accounts. In one account they treat all entries as positive, and in the other as negative. To get the total sum, you subtract the sum of the second from the first (mathematically, they put the sign from the individual entries to the account itself). Depending on how your brain works, this simplifies things. Or makes them more complicated.

As a direct consequence of this, accounts do not simply have one column for the values you transfer to or from an account, but two—one for the positive and one for the negative values. Which column means which transaction is totally confusing due to the sign issues. To make matters worse, the two columns are named Credit and Debit (Soll und Haben), which sound like they might have a meaning, but don’t. The names are there for historical reasons. As a book I read remarked, it would be better and make just as much sense to call them “left” and “right.” So, don’t let the two columns and those names confuse you. It’s simply an account. With a value. The value goes up and down.

Account Types

Now that we understand that we have lots of difference accounts, a very understandable question would be why we did that. The reason is also quite simple: Having all money—our income, what we own, and our expenses—in our bookkeeping system allows us to get a much better overview of what is going on. To understand that, we have to take a closer look at the different types of accounts we have. There are two basic types.

Assets & Liabilities (Aktiva und Passiva, auch Bestandskonten)

The stuff we own. Mainly, our money on bank accounts—checking accounts, saving accounts, credit cards, and whatnot. Assets are positive, liabilities are negative. The latter are what you owe someone else. For example, that bank loan, but also common credit cards. Assets are positive, liabilities are negative. Scary negative numbers means accountants usually make this two different accounts.

Strictly speaking, your cash would also belong here, but because keeping track of cash is such an effort, it’s often easier to simply assume that cash has already been spent, and to treat that account as an Expense account (see below). If you like, you can also track other types of assets than liquid funds here. The detail level, as with all accounts, is completely up to you: The more detailed you get, the better your understanding of your finances will be, but the more work it will be to keep track of everything.

Income & Expenses (Erträge und Aufwändungen, auch Erfolgskonten)

These accounts track what we did with our money. Income accounts are where it comes from, like wages or interest on saving accounts. Expense accounts are where it went to, like restaurants, grocery stores, or travel tickets. Expenses are positive, income is negative.

As with the assets and liabilities, the detail level is completely up to you. It’s easy to get lost in detail, though. Before creating another account, always ask yourself what question you actually want to answer with that account. See the next sections for this.

Most good accounting programs allow you to arrange your accounts in a tree, not only in a flat list. This means you can have more general accounts with more specialized accounts below, where the parent account keeps a sum of all its child accounts. This helps in arranging your accounts as well as getting a general overview. For example, you can have a Bank account in your assets with a separate account for all your different actual bank accounts below it. The sum of the Bank account gives you a quick overview of the money assets you have, while the subaccounts give you more detailed ideas on where those are exactly.

Are We Doing OK?

I said initially that the first purpose of this endeavor is to figure out whether we’re doing ok. Now that we’ve set up all these accounts, how do we do that?

Enter the financial statement (Bilanz). This is a snapshot overview of what we own at a given point of time. To get that overview, we take a look at our Assets & Liabilities accounts. The global sum of the accounts will give you a single-glance overview of your current net worth. A closer look at the sub-accounts of either will tell you where exactly your money and your debts are. Finally, if you compare the asset reports of two different points in time, you can see if your total assets are increasing, decreasing, or staying the same. If they are decreasing, you likely have a problem. If they are not, you are likely doing ok.

There are some details to keep an eye out for. For one, not all assets are equally accessible. It's nice if, in theory, you have plenty of money to afford an expense, but if in practice most of it is tied up in an investment you can't liquidate for the next ten years, that expense might have to wait a bit still. Also, when comparing two points in time, keep unusual expenses in mind.

For companies, laws actually prescribe what accounts need to be there for the financial statement. Luckily, for private people, we can just make our own.

What to Improve?

If you figured that you have a problem, or just out of general curiosity, you might want to figure out where to improve your financial situation.

Enter the profit and loss statement (Gewinn- und Verlustrechnung). This is an overview of where, over the course of a specific amount of time, our money came from and went to. To get that overview, we take a look at our Income & Expenses accounts. The sum of those accounts will be the same as the sum of the Assets & Liabilities accounts (figuring out why is a homework question). But a detailed look at them will not tell you where your money is, but instead where it came from and where it went to.

Typical Accounts

The next question you have to ask yourself is what accounts you want to create. Remember, you can create accounts on demand and adjust them later even (we’re in the digital age, no paper books anymore), so don’t go overboard with your initial setup. Most accounts are pretty straightforward: Assets:Checking Account, Assets:Savings Account, Income:Wages, Expenses:Gym, etc. What follows is a list of special accounts that might be bit unintuitive at first.

Credit Card
This is, strictly speaking, a liability account (you owe something to someone else). I usually put that under normal assets because I want it to be with the bank I have the credit card from.
Debts that other people owe you are a kind of asset. This is one of the very handy features of the double-entry accounting—you can always tell your friends how much they owe you, and even give them a full history of why it is that much.
Initial Balances or Equity
When you set up your accounting, you need to get the initial values for your bank accounts from somewhere. That could be considered an income account, but that can look confusing on the income analysis. The general trick is to create a completely unrelated account next to Assets, Liabilities, Income and Expenses, named Equity or Initial Balances. You create it, pull the money from there, and forget about it in the future. It’s irrelevant.
Cash is of course an asset, but outside of special big expenses, it’s a pain to track all the minor transactions. I just make an Expense account called Cash, and every time I get money from an ATM, I put it there. Basically, I consider it spent right away.
Recurring vs. One-Time
Large one-time expenses like vacations or large purchases, or one-time income like an inheritance, easily skew the income and expense analysis. Businesses spread such expenses over multiple accounting periods for this reason, but unless you want to put in that effort, a simpler method is to group your accounts into one-time and regular accounts.
Tax-Deducible Expenses
Always wanted to make an income tax statement with full tax deduction, but hated the effort? Make an account for all the transactions you can deduce from your tax, and just use it. At the end of the year, you have a very simple complete overview of what you can put in your tax statement.

Triple-Accounting. Quadruple-Accounting. Quintuple…

One last thing. So far, we’ve considered all transactions to have two parts: The account where the money comes from and the account where it goes to. Now consider buying a book for 5 EUR and a CD for 10 EUR on Amazon. Your bank account gets charged 15 EUR, but you’d really like to keep track of how much money you spend on books apart from how much money you spend on music. How can we handle that?

Easily. A transaction can have any number of source and destination accounts. The values just have to sum up to zero. So in the example above, you create a transaction that reduces your bank account by 15 EUR, but puts 5 EUR into your Expenses:Books account and 10 EUR into your Expenses:Music account. This balances up, and it simply works.

These transactions are called Split Transactions.

GNU Cash

Theory done. Now, as we’re not in the 15th century anymore, we skip the part with the paper and books and get GNU Cash. That’s one of the few tools that don’t treat the user as a dumb idiot and actually make double-entry accounting visible (most other tools do use double-entry accounting beneath the cover, but try to hide it, which usually just adds confusion). It can also use HBCI and OFX to directly import transactions from your bank, and even learn which accounts to automatically associate them to. It’s awesome.

Start GNU Cash and follow the wizard to create a very basic account hierarchy. There are a lot of possible account hierarchies to pick from, but you only need the basic one. Don’t let the rest confuse you. Also, don’t get confused about the tons of different account types GNU Cash has. They’re all the same as our four basic types above. The only difference between them is whether they invert the sign (to avoid displaying Scary Negative Numbers) and how they name the columns (because “left” and “right” apparently aren’t that intuitive after all). Finally, the account types affect how they show up in the reports. GNU Cash has a lot of automated reports that make getting an overview of your finances really easy, and the types make it easier for the reporting tools to know how to treat the account.

A typical workflow with GNU Cash is to start the application, pull transactions directly from your bank, and check where GNU Cash intends to put them. If it can’t figure it out on its own, or if you disagree with the proposal, simply change the accounts, save, done. Takes about 5 minutes a day.

Now go forth and track your finances!