Double entry accounting basics - recommendations


C

Chris Lawrence

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
 
P

PeterSaxton

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:
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.
- 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.
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!
- 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.
In double entry bookkeeping it is an asset but you may need to treat
it as a negative liability in your accounting software.
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.
It's up to you but I wouldn't use "payments" in a Profit & Loss
Account. I would use "ISA interest receivable".
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.
Don't use an adjustments account.
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.
Good idea. You don't want to try to understand an accounting software
program at the same time as trying to understand bookkeeping.
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?
Look for books by Frank Wood.
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 thatI
will be able to pull out data to analyse.

Cheers,
Chris
At the beginning you want to come up with an opening balance sheet.
Then read Frank Wood and that will explain everything from there.
 
Ad

Advertisements

R

Ronald Raygun

Chris said:
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
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.
 
R

Ronald Raygun

Chris said:
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.
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".
- 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.
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.
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.
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.
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.
Yes.
 
Ad

Advertisements

C

Chris Lawrence

PeterSaxton said:
Look for books by Frank Wood.
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
 

Ask a Question

Want to reply to this thread or ask your own question?

You'll need to choose a username for the site, which only take a couple of moments. After that, you can post your question and our members will help you out.

Ask a Question

Top