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Imagine that you manage a fortune. In fact, you probably manage your own, so this is probably not a matter of imagination. But whether you are only responsible for your own fortune, your family's, or the war chest of a large business, it's important to you to make the right decisions -- and important to employees, customers, suppliers, partners, investors, and neighbors, who each have a stake in its success. Double-entry bookkeeping is a tool which helps you make the right decisions by answering important questions about your (or "your") fortune.
You should know what the fortune exists for. Otherwise, you may accidentally tie it up or spend it on the wrong things, so that it cannot be spent on the right things. A fortune is for the happiness of those who have a stake in it, but happiness means different things to different people. Thus the purpose of each fortune is unique. A decision which is right for one fortune may be wrong for another, because it fails to further its purpose. Whatever the purpose, you should understand it well to make good decisions. Until you understand what a fortune exists for, you are not ready to manage it.
You can begin by asking questions of those who have a stake in the fortune. For example, a family fortune provides for a lifetime of basic necessities and for education, travel, and other personal pleasures. A business fortune exists for whatever purpose makes its owners happy, such as increasing their personal fortune, or making the world a better place. To attract investors and employees, a business must also reward those who invest their time or their personal fortunes. You should find out what would make family members or business stakeholders happy by asking them.
As a responsible manager, you should find out the history and present status of the fortune. For example:
To get answers to these questions, you will need some form of record keeping. Let's consider each question in turn, and invent a bookkeeping system which would answer them as we go along. I will use John's Personal Fortune as an example. We'll look at John's records from January 1st through January 15th.
John wants to decide whether he has a large enough fortune. He'll keep track of the total cash value of his fortune, including property and any claims on other peoples' fortunes. These are known as assets. To keep this figure up to date, John will update it when assets are earned, are spent, or change in value. To check its accuracy, he will keep a record of each change.
| date | note | change | value |
|---|---|---|---|
| 1/1 | forward | $1,000+ | $1,000 |
| 1/1 | rent | $100- | $900 |
| 1/7 | groceries | $10- | $890 |
| 1/12 | electric | $20- | $870 |
| 1/15 | paycheck | $500+ | $1,370 |
John updated his records five times. First, he entered the final figure from the last page of last year's record (the forward balance). He updated his records when he spent money for housing and food, and when he was paid money he earned at his job. During the same time period, John loaned his friend Chip $250. In other words, he traded $250 for an agreement with Chip worth $250. John didn't make a record of this because nothing was earned, spent, or changed in value. John sees that his fortune is now $1,370, and can check this figure for accuracy by adding all the amounts together.
It's still hard for John to decide whether $1,370 is large enough. For one thing, he can't tell how much of his fortune is on loan to someone else or tied up in property. Now suppose that John wants to go on a $900 trip. He needs to know whether he has enough cash, or how he can get enough. John will expand his records, dividing the cash value of his fortune into categories according to how convenient it will be to convert into cash, or liquidate. He will update it whenever there is a change in assets in any category. Then he'll calculate his total assets by adding the asset categories together. John's fortune has four types of asset: cash, a checking account, loans he's made (and expects to be repaid), and a small amount of land.
| date | note | change | value | subtotal |
|---|---|---|---|---|
CASH |
||||
| 1/1 | forward | $50+ | $50 | |
| 1/7 | groceries | $10- | $40 | |
| 1/12 | electric | $20- | $20 | $20 |
CHECKING |
||||
| 1/1 | forward | $400+ | $400 | |
| 1/1 | rent | $100- | $300 | |
| 1/4 | Chip | $250- | $50 | |
| 1/15 | payroll | $500+ | $550 | $550 |
LOANS |
||||
| 1/1 | forward | $50+ | $50 | |
| 1/4 | Chip | $250+ | $300 | $300 |
PROPERTY |
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| 1/1 | forward | $500+ | $500 | $500 |
| TOTAL ASSETS | $1370 | |||
Using this system, John recorded his loan to Chip as $250- in checking, balanced by $250+ in loans -- John's first double-entry. This was necessary because the $250 moved from one asset category to another, and he is now keeping track of all his asset categories separately. The net result is that John still sees that his fortune is now $1,370, but now he can also see that it consists of $20 cash, $550 checking, $300 loans, and $500 property, and he can check all those figures for accuracy. John also concludes that it will be easy to get $570 for his trip, but he will have to sell some land and perhaps call in a loan to get the other $330. He also learns that his checking account balance dips dangerously low.
Having recognized that Chip's I.O.U. is an asset, John now remembers the $500 debt he still owes to Chris and realizes that Chris has a claim on his fortune. To decide whether his fortune is large enough, he ought to bear this in mind. He'll subtract his debts from his assets to find out his true fortune, or net worth. So, he appends a "negative asset," or liability, category, to his personal fortune, where he can enter debts (as negative numbers, to remind him that they subtract from his fortune).
| TOTAL ASSETS | $1370 | $1370 | |||
|---|---|---|---|---|---|
DEBTS |
|||||
| 1/1 | Chris | $500- | -$500 | -$500 | |
| TOTAL LIABILITIES | -$500 | -$500 | |||
| NET WORTH | $870 | ||||
John now wants to find out if he's been making good or bad spending decisions. Unfortunately, John's asset records don't include his food, electricity, and other purchases. He ignored them earlier because, though they're valuable, they will be consumed and never turned back into cash. To solve this problem, John will now begin to account for all other purchases. He won't include the new categories in the summary of his personal wealth because these purchases can't be liquidated (except perhaps in a blender). Instead, he'll keep track of them separately. He'll also decide how much he should buy in each purchase category, called a budget, and calculate how much he overspent or underspent (the excess). Despite some misgivings about what he gets in return for his tax money, John includes tax as a purchase category.
| date | note | change | value | subtotal | budget | excess |
|---|---|---|---|---|---|---|
HOUSING |
||||||
| 1/1 | rent | $100+ | $100 | |||
| 1/12 | electric | $20+ | $120 | $120 | $110 | $10+ |
FOOD |
||||||
| 1/7 | groceries | $10+ | $10 | $10 | $30 | $20- |
TAX |
||||||
| 1/15 | payroll | $100+ | $100 | $100 | $100 | $0+ |
| TOTAL PURCHASES | $230 | $240 | $10- | |||
Wherever John used his personal fortune to buy something, the amount is now double-entered (subtracted from assets, and added to purchases). Now, John has all the information he had before, and can also see that he bought more housing and less food than he planned, and that he spent $10 less than he planned overall.
John also realizes something important about his bookkeeping system. Each double-entry makes a record not only of a change to his fortune but also of the reason for the change. For example: he reduced his wealth by $20 (cash) because he bought some electricity (housing); he reduced his easily transformable wealth by $250 (checking) because he converted it to a $250 IOU from Chip (loans).
John reviews his purchase accounts, and decides it would be useful to append an account to keep track of all the work he does to make money, because he could then see the reasons for all changes to his fortune. He could compare the value of his labor (income) to the value of his purchases (expenses) and see how much he overworks (profits), and decide on a labor budget which would alert him if he was working too hard (or not hard enough) to make the money he needs. He enters labor as negative numbers to remind himself to subtract it from purchases -- and because the less work necessary, the better.
| TOTAL PURCHASES (EXPENSES) | $230 | $240 | $10- | |||
|---|---|---|---|---|---|---|
PAYROLL |
||||||
| 1/15 | payroll | $600- | -$600 | -$600 | -$600 | $0+ |
| TOTAL LABOR (INCOME) | -$600 | -$600 | $0+ | |||
| OVERWORK (PROFIT) | -$370 | -$360 | $10- | |||
By accounting for income, John now has a simple way to find out that he made $370 more than he spent, which is close to what he expected. He realizes that if this keeps up he'll be able to save enough to take his trip this year without selling any land. This was useful information and a great relief. He'll use up that extra work by adding a vacation account to his purchase plans.
John has now double-entered every aspect of his wealth except for the amounts carried over from the previous year. All this information is great, but John is a little concerned about how to check his work. It would be a lot of labor to re-add all those columns of numbers; besides, if he's making a mistake it could be the systematic kind, and his sums might be consistently wrong without him knowing it. He thinks that if he takes his net worth now, and subtracts his net worth at the start of the year, the amount ought to be the same as his profit (or loss) between then and now. It's just a different way of adding up the numbers. In fact, since each number is entered in two places, each gets added in two different ways, so this ought to be a good sanity check that the additions were all done properly. He sees he can accomplish this by double-entering his starting assets and debts, the only amounts not already double-entered, into a "starting account." Since he's going to subtract them from his current net worth, he represents each starting asset as a negative number. Besides, this account represents the wealth in John's fortune that he himself has a fair claim on. In this way, it's like any other debt, and other debts are already represented with negative numbers. After a little mental anguish he concludes that the reverse is also true: a starting debt must be represented in this account as a positive number. This account is appended to his other asset and liability accounts.
| NET WORTH | $870 | $870 | |||
|---|---|---|---|---|---|
STARTING ACCOUNT |
|||||
| 1/1 | cash | $50- | -$50 | ||
| 1/1 | checking | $400- | -$450 | ||
| 1/1 | loans | $50- | -$500 | ||
| 1/1 | property | $500- | -$1000 | ||
| 1/1 | debts | $500+ | -$500 | -$500 | -$500 |
| PROFIT | $370 | ||||
The profit figure calculated from his asset and debt accounts perfectly balances the overwork (profit) figure calculated from his income and expense records. John figures that he probably didn't make any math errors.
Satisfied with his work, John shows his books to his accountant, who compliments him for having reinvented double-entry bookkeeping, but points out that accountants use some different terms than John did. For one thing, the "starting account" is usually called the capital account. Also, accountants don't tend to refer to amounts as being "positive" or "negative." Instead, they refer to any increase in debt as a debit and any repayment as a credit, and ledger books have separate columns for debit and credit entry.
Accountants think of all the assets of a fortune as belonging to the owners and investors, and "borrowed" by the fortune to accomplish its purpose. Normal accounting practice is to record all increase in assets, including purchases, as debits (debts). In the same way, increase in liabilities, including work, are recorded as credits (repayments). And, therefore, any decrease in assets is logged as a credit. The capital account is reversed, naturally. Accountants also record the name of the other account where the double-entry occurs (the contra account; reminds one of our Nicaragua money launderers). Accountants point out that this means that every record is made once in a credit column and once in a debit column; otherwise it's being entered wrong. Also, they add the account up both across and down as an additional check of their arithmetic.
To simplify the writing, account names are abbreviated by a number. If you don't know what number to use, you look on the chart of accounts. John applied some of the conventions of standard accounting practice and came up with the following books.
CHART OF ACCOUNTS
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STATEMENTS
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BALANCE ACCOUNTS
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PROFIT AND LOSS ACCOUNTS
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Willie R. Aus der Au, Account Pro 95/NT V-6.6x: User's Manual. [link]
Patrick J. Kissane, Understanding Double-entry Bookkeeping. [link]
Yuji Ijiri, Momentum Accounting and Triple-Entry Bookkeeping: Exploring the Dynamic Structure of Accounting. [link] [alternate]