Newbies, account setup and manual reconciliation

[Derrick Hudson]

On Sat, Nov 12, 2005 at 03:34:33PM -0600, Jeff Smith wrote:
| Okay, when it comes to accounting I'm about as newbie as they come. You
| have been warned. Neither my wife nor I are what you might call
| accounting savants. For years, money has been the basis of heated
| marital discussion but neither one of us is an authority, so the
| arguments just go round and round.
| 
| I've finally decided to get informed and take a more 'hands on' attitude
| to our money management. Well, truth be told, I've finally decided to
| actually start managing it, rather than just waving goodbye to it as it
| flies out the door. :-)

That sounds like a good plan.  Studies indicate that finances is one
of the top two marital issues.


| There is one area, however, that still befuddles me: Credit cards. I
| have a category of liabilities called "Credit Cards", under which I have
| a separate account for each card we have. In my checking account
| register, I have transfers to those credit card accounts for each
| payment made. These transfers show up in my QIF files from the checking
| account. So far so good.
| 
| I am also downloading QIF statements from my credit card company, which
| gives me all my granular transactions. Nifty. But I'm confused. At the
| moment, I'm posting those credit card QIFs to the same gnucash account
| that I transfer the payments to. The individual transactions get
| allocated to my various expense accounts (food, toys, clothing etc.)

| But I don't understand the accounting principles involved clearly enough
| to be sure how the accounts SHOULD be set up. Do I just post all these
| transactions to the credit card liability account? Or should I set up
| individual "bank accounts" for each card, and transfer money from those
| accounts to the categorized expense accounts for each transaction?
| 
| Any direction on the best way to manage this would be most welcome.

I've never looked at the way a bank or credit card provides the
information, nor do I have any formal accounting training.  However, I
think I've figured out a few things so hopefully I can explain them
well to you.

There are two purposes to accounting.  One is to know what money you
do and don't have, the other is to know where you get money from and
where it goes to.  The former are Assets and Liabilities, the latter
are Income and Expenses.

Assets are things like your bank accounts, investment accounts, and
even your house and car (paypal too).  Liabilities are your credit
cards and loans.  In gnucash, these accounts should match the accounts
you actually have.  Create one account for each account at the bank
and create one account for each credit card.

Income is, naturally, your paycheck.  You may have just one income
account if you have one job, or you may have more if you have more
jobs or other sources of income.  If you sell a lot of stuff on eBay,
for example, you may want to make an "income" account to represent
that.  In practice, the income accounts should reflect the
categorizations you are interested in seeing.  Expenses are nothing
more than categorizations for the things you spend money on.  You
could just have one expense account if that is the level of detail you
want, or you could have many dozens.


The key to understanding account types is to know how they are used.
The accounts themselves don't have much meaning by themselves.  Their
importance is how they are handled by the reports.  The reports are
only useful to the extent that they answer the questions you have.
For example "how much money do I have?"  "how much do I owe?"  "how
much did I spend this month/year/whatever?"  "how much did I spend on
food, gas, entertainment, fees, etc.?"

Any report that focuses on what you do and don't have only considers
the Asset and Liability type accounts.  Any report that focuses on
flow -- where the money came from and went to -- only considers Income
and Expense type accounts.



To demonstrate how these principles are applied, let's walk through a
simplified month.  In this month you will not be paid;  you will buy
food once with a credit card and then you will pay that bill.

Note that I will demonstrate the practice of double-entry accounting.
It really isn't complicated once you see how the pieces work together
and it provides advantages over single-entry accounting.  I'll also
use the informal column labels gnucash provides instead of the formal
debit/credit labels used in the industry.  (I only learned the right
meaning of debit/credit recently and the example will be simpler, I
think, not using them at this time)


So we have the first transaction -- buying food.  This transaction
will have two splits:
    1)  account: Expenses.Food,     expense: $20
    2)  account: Liabilities.VISA,              charge: $20
A basic principle in double-entry accounting is that the total of the
transaction is $0.  As one document put it "money is neither created
nor destroyed, it is only transferred".  This provides a sanity check
that you haven't entered something incorrectly.  So far so good -- we
spent the $20 on food.  The account totals show that you owe VISA $20.
At this point, the Net Worth report will show your liability
increasing and the net decreasing by $20.  So far your assets are the
same -- you haven't taken any money out of the bank yet.

Now we have the second transaction.  The credit card bill came, with a
balance of $20 as our account shows, and we will pay it by writing a
check.  This transaction also has two splits:
    1)  account: Liabilities.VISA,  payment: $20
    2)  account: Assets.Checking,           decrease: $20
This transaction records the writing of the check to pay the credit
card.  If you look at the Net Worth report you'll see that this
transaction doesn't affect your net worth.  You already spent the
money at the store long before writing the check.

Of course you can have more splits on any given transaction.  Suppose
you go to a department store and you buy food and clothes.  Or food,
clothes, and a movie rental.  You would have one split showing the
charge on your credit card, and three splits showing the expenses for
food, clothes, and entertainment.  Of course, that is assuming you
want to track each of those expenses as a separate category.


Based on your description I think you have the right idea.  The credit
card account tracks the activity that is reflected in your monthly
statement.  This activity consists of spending money and paying the
bill.  The spending money actions are connected to expense accounts
and paying the bill is connected to an asset account.


I think the only non-intuitive part of this picture is that many
transactions will increase both account totals.  When you are paid,
your income total increases and so does your bank account.  When you
buy something, the expense increases and so does the credit card
balance.  The explanation is in how the accounts are used.  An income
or expense account does not have any effect on your net worth or total
assets.  Receiving the paycheck really only affects the report of your
total income, not your total assets.  Depositing the paycheck in your
bank account (or recording it as 'cash') is what increases your total
assets and net worth.  Similarly, paying the credit card bill
decreases the account total for both your checking account and the
credit card.  This is because the credit card is a liability, and thus
the number is essentially a negative number:  it's money you don't
have.  By decreasing that number you are decreasing the amount you owe
and thus increasing your net worth.


Does this make sense or am I creating additional confusion?

-D

-- 
The righteous hate what is false,
but the wicked bring shame and disgrace.
        Proverbs 13:5
 
www: http://dman13.dyndns.org/~dman/            jabber: dman at dman13.dyndns.org
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