The trouble with double-entry...

[Benjamin Carlyle]

On Tue, 2005-02-01 at 11:15 -0600, Rod Engelsman wrote:
> accounting is that it doesn't have the mechanisms to accurately and 
> easily deal with certain real-life situations.  I know this is the kind 
> of statement that would make an accountant squeal, but it's the truth.

I'll start with the stick:
It's not the truth, it's a lack of understanding. You aren't smarter
than 700 years of collective experience. You just haven't grokked that
experience, yet. Any first-year university-level textbook should clarify
things for you if you are willing to read. My personal epiphany came
from reading my brother-in-law's text on the subject. This email will
likely not affect your position but maybe will spark some interest in
greater research. I am not an account, just an interested hobbyist.

> Let's take the whole issue of asset valuation, for instance. 
> Double-entry requires that any change in one account has to be balanced 
> by a change in another. So to reflect the fact that an asset has changed 
> value one has to make a corresponding entry somewhere else. So if I buy 
> 100 shares of XYZ stock and the price subsequently doubles, where does 
> that extra value come from? Is that an income? Because you're worth 
> more, but the only way to make that happen is to have a higher income 
> while the expenses stay the same. But that's not real money, is it? You 
> can't buy groceries with it or pay the rent. And you don't pay taxes on 
> it. And just the reverse if the price goes down. Where did the money go? 
> Does it wreck your budget?

Fluctuations in asset value are normally not reflected in your books. I
repeat: Not reflected. There is a fundamental concept in accounting of
"book value", which is purely historical and doesn't represent the
current value of your assets. Double-entry accounting is not designed to
tell you how much you are worth. It's designed to tell you how much what
you own cost you. This distinction becomes important when accounting for
inventory.

Why the difference? Accounting is a conservative profession. Current
value is highly subjective and can change from day to day. The cost
price is fixed and known. It's reasonable to expect that you can get
back what you payed for for an asset, so that's how much your books
show.

The more complicated truth is that book value "should be" the cost of
your asset or the current value, whichever is less. If you know
something isn't worth what you paid for it anymore (for reasons other
than depreciation, which has little to do with asset worth either) then
you need to account for it. You do this by transferring some of the
asset value to an "Unrealised Losses" expense account. You've then taken
the hit of the expense to your bottom line and you can tell where the
value of your asset went. If you really feel you need to account for
unrealised gains as well, then you can. No one it stopping you, but you
won't be operating consistently with accounting practice.

You will normally do this evaluation of your net worth once every
"accounting period". For publicly-listed companies this is probably
about once a quarter. It can be any length of time. Personally I do this
bookkeeping work once per month, in synch with my pay period. During an
accounting period your accounts are estimates only, and not entirely up
to date.

Now, we could say that with computers we can do better than being
accurate once per accounting period. We could reduce the accounting
period down to once a day or once a minute if we could gather the
relevant information at that pace. Perhaps you could even gather it at a
pace that makes you question the value of a double-entry accounting
system at all.

The main value of double entry account keeping compared to other forms
is that on paper it allows you to compare balances that should add to
zero. When they don't, you know you've made a mistake. Computers don't
make mistakes as often, so maybe double entry isn't actually required.
On the other hand, business and accountants still work this way and
there is little real reason to change things and no better alternative
presenting itself.

> Another real-life situation: Suppose you strike ill and incur a large 
> medical bill. So large, in fact that you have to pay it over time. 
> Logically, that's a liability. So to create the liability you have to 
> incur a corresponding expense. Payments against the liability are 
> transfers that don't change your net worth. But medical expenses are 
> deductible. But you can only claim that part of the bill that you have 
> actually paid. So you're in a situation where it's damn difficult to 
> simultaneously track your net worth accurately (which is really the 
> whole point of traditional double-entry) and account for your deductible 
> expenses.

You have an expense that is incurred all at once as a liability. It's
just like any loan. You pay down your liability as you get the money.
That's fine. It's a normal part of accounting, too. What you're
concerned about is the tax implications.

The trouble here is that you're jumping between two accounting systems.
Businesses are usually required to run on an accruals system. This
forces them to declare every expense as soon as they incur it, rather
than waiting until they've paid it to declare. It makes for less noise
in the business's view of its net worth and makes it easier for
financial institutions, government, and investors to make sense of the
real financial position. Individuals can get the same benefits in
analysing their own accounts by using and accruals system. When we teach
double-entry accounting, we are often teaching the accrual method.

Unfortunately, Individuals are often taxed based on another accounting
system. The cash basis model of accounting does not consider an expense
to have occurred until you've actually paid the bill. It makes it easier
to hide transactions (by just not paying for things on time or by
negotiating long payment periods) and to hide your financial position.
It also makes it harder to interpret your financial position because you
don't always know what's owing. When you deal with the intersection of a
private accrual-based accounting system and a tax-related cash-based
accounting system you do have to step through a few extra hoops. That
may include moving money from one expense account to a special
"tax-related" version of the same account, or may involve an offsetting
account that describes the tax implications of each transaction you
make.

> The whole problem stems from the inability to distinguish between 
> "internal" and "external" liabilities. By that I mean internal 
> liabilities are things like loans and credit cards. While external would 
> be an outstanding bill -- an account payable, I guess. In the example 
> above, if you were to pay the medical bill with a credit card or take 
> out a bank loan, then you could easily and accurately account for the 
> expense for taxes.

In the situation you described above, I would probably account for the
expense by transferring it initially to a medical bill liability
account. Over time, I would transfer money to that account from a
"payable, the hospital" account. Finally, I would pay the bill by
transferring money from my cash account to the payable account.

i.e...
I had a motorbike accident
Expenses:Medical	1000DR
Liabilities:Medical	 	1000CR

I've recieved this month's invoice, $100
Liabilities:Medical	100DR
Payable:Hospital		100CR

I've paid this month's invoice
Payable:Hospital	100DR
Cash				100CR

At this point we have the current balances:
Expenses:Medical	1000DR
Liabilities:Medical	900CR
Payable:Hospital	0CR

If you query for the amount transferred into Payable:Hospital, you'll
see a value of $100.

I actually work (almost) exclusively through payable accounts for bills.
I can see in a single account all of the payments I have made to each
creditor and when those payments were invoiced. This actually achieves
your suggested goal of separating "internal" and "external" accounts.
The payable accounts are external, and the rest are internal.

> Now here's where I screw with 700 years of accounting tradition. I think 
> it's just wrong to equate an account -- real physical account like a 
> bank account -- with a conceptual entity like an expense category. When 
> I pay the rent each month I'm not writing a check to "Rent", but rather 
> to my landlord -- another real palpable entity. In real accounting, who 
> you pay the money to doesn't matter; it's little more than a memo. It's 
> confusing a who or where or what with a why.

Accounting theory is like XML. If it ain't working, you aren't using
enough of it.

-- 
Benjamin Carlyle <benjamincarlyle at optusnet.com.au>