Double entry accounting basics - recommendations

Discussion in 'UK Finance' started by Chris Lawrence, Dec 14, 2008.

  1. This weekend I've been playing with GnuCash, the free open-source
    accounting package. I want to learn how to use it to track my finances,
    everything from the current account to stocks. It uses double-entry
    accounting which I've not encountered before, and I understand the
    concept no problem.

    However it's clear that I don't know enough about accounting best
    practices to use this system properly. I'm finding that when I don't
    understand something, I cannot tell whether it's a feature of GnuCash or
    this method of accounting in general. I've read the double-entry
    accounting basics in the GnuCash user manual and completely understand
    the concepts, but the correct way of translating them into real-life
    situations is not obvious.

    For example when creating some new accounts in GnuCash, the balance is
    taken from an 'opening balances' equity account. Straight away I am
    wondering:

    - is this specific to GnuCash, due to the way it's internally
    structured, or is this a normal practice in double-entry accounting, eg
    in pen and paper books. For example one spreadsheet I saw set up
    opening balances and stated that they were NOT part of the double-entry
    system, contrary to the way GnuCash does it.

    - if I create a credit card account and the account is currently in
    credit (due to cash back), the credit card has a negative balance. How
    is that correctly created in GnuCash specifically, and in double-entry
    bookkeeping in general. Is it a negative opening balance, or is opening
    balances considered a negative 'source' of money to start with. I hope
    you see what I mean.

    Another example, if I receive a load of interest on a cash ISA, I can
    add that to the ISA account as a transaction, as that is how it is paid.
    But where is the offset correctly supposed to be recorded? Should
    there be a universal "Interest payments" account, or perhaps it would
    just be an "ISA Interest payments" account, or perhaps there's another
    way of recording this.

    If I just had an "adjustments" account, that would appear to solve it,
    but of course that could then contain anything, which rather defeats the
    integrity. Therefore I have stopped trying to learn GnuCash for now, as
    I cannot be sure whether I am actually learning double-entry bookkeeping
    best practices or just GnuCash peculiarities.

    I want to learn some best practices and then put them into use in
    spreadsheets to ensure that I understand where things are supposed to go
    to and come from. Once I'm happy with that later on, then I'll revisit
    GnuCash and learn GnuCash things.

    So does anyone have any recommendations for books or courses, perhaps
    DVDs or website subscriptions, to learn some basic best practices about
    this system as it applies to finance in the UK?

    For reference the GnuCash accounting intro which I read, and which
    hopefully hasn't filled my head full of crap, is below. Are these 5
    account types universally used this way or are there some assumptions
    going on here? It makes sense, but in the absence of higher knowledge
    it's impossible to know how accurate all this is. That's what I would
    like to fix.

    http://www.gnucash.org/docs/v2.0/C/gnucash-guide/basics-accounting1.html

    My engineering brain is telling me that at some point I need to write
    down every kind of transactional account that I hold, decide what type
    of account it is (ref the 5 types), determine how to correctly consider
    opening balances and external inputs (such as interest), and then simply
    apply the transactions and let it roll. Do people concur? From that I
    will be able to pull out data to analyse.

    Cheers,
    Chris
     
    Chris Lawrence, Dec 14, 2008
    #1
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  2. Chris Lawrence

    PeterSaxton Guest

    It depends.
    If you decide to track a new account that you didn't track before then
    the new account should be "Equity"
    You should be setting up all your accounts at one point in time and
    the "Opening Balances Equity" account should equal zero if you include
    an "Equity" account.
    It's normal practice but you have to make sure you have a set of
    accounts that balance first before you even start using accounting
    software - unless you really know what you are doing!
    In double entry bookkeeping it is an asset but you may need to treat
    it as a negative liability in your accounting software.
    It's up to you but I wouldn't use "payments" in a Profit & Loss
    Account. I would use "ISA interest receivable".
    Don't use an adjustments account.
    Good idea. You don't want to try to understand an accounting software
    program at the same time as trying to understand bookkeeping.
    Look for books by Frank Wood.
    At the beginning you want to come up with an opening balance sheet.
    Then read Frank Wood and that will explain everything from there.
     
    PeterSaxton, Dec 15, 2008
    #2
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  3. There is a bit of a mistake in this guide, and I hope you've spotted it.
    It tells you about the basic "Accounting Equation", i.e.:

    Assets - Liabilities = Equity

    but when it extends this to take in income and expenses, it gets it
    wrong. Well, it doesn't really, see below at [##], but the equation
    as stated can seem incompatible with the text, and can be a barrier
    to a newcomer's comprehension of the concepts. That is to say their
    mistake isn't really in the equation, but in the way it is introduced.
    It states:

    Assets - Liabilities = Equity + (Income - Expenses)

    Obviously (a newcomer would think) the plus sign there should be a
    minus sign, i.e. it should read:

    Assets - Liabilities = Equity - (Income - Expenses)

    Without that minus sign there would be no need for the brackets,
    after all, and as the text correctly points out, income serves to
    increase your net worth (which is what equity is) and this clearly
    implies that they must have opposite signs if they appear on the
    same side of the equals sign. Or does it?


    I don't think it's all that helpful to treat Equity as an additional
    fundamental account type. In effect it's just another kind (a special
    case) of Liability, and so this leaves you with just four fundamental
    types of account.

    The next thing you need to understand is what makes these four types
    fundamentally different. This four way split is brought about by two
    orthogonal (i.e. independent) distinctions.

    The first, and most obvious, of these is one of sign, i.e. intuitively
    you tend to think of assets and of income as being in some sense
    positive, and of liabilities and expenses being in some sense negative.
    Confusingly, this is one example where intuition leads you astray, and
    it's really the other way round: Income must have the same sign as
    liabilities, and expenses the same sign as assets. So if income is
    positive, assets must be negative. It should become clear shortly
    why this is so.

    The other fundamental distinction is a temporal one. Basically assets
    and liabilities are in some sense permanent, whereas income and expenses
    are temporary. More precisely, income and expenses always relate to a
    certain *period of time*, while assets and liabilities always relate to
    a single *moment in time*. So income and expense accounts always begin
    each period with a zero balance, and at (or just before) the end of a
    period they are made zero again, for the start of the next period, by
    transferring the balances to the equity account.

    In particular, if you look at the two moments which define the
    beginning and end, respectively, of some specific period, then it is
    clear that the assets minus liabilities at the beginning of the period
    (at moment 1), plus the income minus expenses during the period, must
    equal the assets minus liabilities at the end of the period (at moment 2):

    Assets1 - Liabequity1 + Income - Expenses = Assets2 - Liabequity2

    Having said earlier that Equity is just a special case of Liability,
    in this equation I have used the pseudo-term "liabequity" as shorthand
    for "Liabilities including Equity".

    Now, in the very beginning, when a virgin set of accounts first starts
    up, it does so with a clean slate, with no equity, no assets, and no
    liabilities. Hence, if we take moment 1 to be this beginning, then:

    Assets1 = 0
    Liabilities1 = 0
    Equity1 = Assets1 - Liabilities1 = 0
    Liabequity1 = Liabilities1 + Equity1 = 0

    and if we take moment 2 to be the end of the first period of the
    entity (be it a business or just a private household) described by
    our accounts, then we find that the above equation:

    Assets1 - Liabequity1 + Income - Expenses = Assets2 - Liabequity2

    becomes:

    0 - 0 + Income - Expenses = Assets2 - Liabequity2

    or:

    Income - Expenses = Assets2 - Liabequity2

    If we now split off equity from "liabequity" again, then this
    equation becomes:

    Income - Expenses = Assets2 - (Liabilities2 + Equity2)

    which can be rearranged as:

    Assets2 - Liabilities2 = Equity2 + (Income - Expenses)

    This agrees with original form [##] above, i.e. the plus sign
    which a newcomer may have doubted is correct after all.


    One more thing: Accounting (or bookkeeping) abhors negative
    numbers. It doesn't use them. It uses the terms Credit and
    Debit instead. Credits are generally used to represent income,
    and debits are for expenses, and therefore assets are always
    debits, while liabilities (and equity) are credits.

    The "Principle of Balance" mentioned in the guide is best
    represented by the mantra "For every credit there must be a
    debit (and vice versa)". This is where the "double" in double
    entry comes from.

    So when you pay a gas bill, for example, you debit your "gas"
    account (which is an expense account) and credit your "bank"
    account (which is an asset account). The mantra applies not
    only within sets of accounts but also between them. Thus you
    should not let the opposite "sign" of entries on your bank
    statement fool you. The credit entry in your "bank" account
    within your bookkeeping system will correspond to a debit entry
    in your bank statement, since your account with your bank mirrors
    its account with you.
     
    Ronald Raygun, Dec 15, 2008
    #3
  4. It is normal practice. Consider the set of accounts for a small business.
    For simplicity let's say it's a sole tradership. Its accounts start with
    a clean slate, with zero balances in all its accounts, and then the owner
    puts some money into the business, by way of startup capital so that the
    business can buy some assets and/or stock for sale. He may open a bank
    account in the name of the business, and when he puts cash or pays a
    personal cheque into the business account, the bookkeeping entries in
    the business accounts are (1) to debit the "bank" asset account with the
    amount in question and (2) to credit an equity account with the same
    amount, generally this will be an account called "capital introduced".
    A credit card account is just another form of bank account. Although in
    general a bank account is usually "in credit" (as the bank statement would
    report) (and is therefore an asset, and thus represented by a debit balance
    in your accounts)), and a credit card account is usually "in debit" (and
    is thus a liability account and holds a credit balance), there is no reason
    why a "bank" account should not at times show a credit balance (when you
    overdraw it) or why a "credit card" account should not show a debit balance
    (due to this cash back, or if at some point you overpay for some reason).

    But don't think of negative balances. Traditionally each account is shown
    with two columns of numbers, one for debits and one for credits. So for
    something like a bank account, which will have money both going in and out,
    you don't have positive and negative entries in a single column, but you
    have debit entries in one column and credit entries in the other.
    You will have a number of income accounts and a number of expenses accounts,
    in addition to asset and liability accounts. You will maintain an asset
    account to track your cash ISA holding, and you will maintain an income
    account to track interest you receive. Whether you have one interest income
    account for each source of interest, or just a single one for all sources,
    is neither here nor there, but when interest is paid to you by the ISA
    provider, then if it is just added to the ISA itself, then the transaction
    is that you credit the amount to your interest account. The corresponding
    double entry is to debit the amount to the asset account for the ISA itself.
    If, instead, the ISA interest were paid into a current account, then you
    would debit that instead.
    Yes.
     
    Ronald Raygun, Dec 15, 2008
    #4
  5. Thanks Peter and to everyone else who responded with comments to my
    questions. I have purchased Business Accounting volumes 1 & 2 (11th Ed)
    by Frank Wood, and will work through them over the next few months.

    Cheers,
    Chris
     
    Chris Lawrence, Dec 21, 2008
    #5
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