A BRIEF ACCOUNTING PRIMER
Personal and business money affairs are more difficult to keep track of than most people are willing to admit. Computer systems certainly help, but they only help those who are willing to make a plan and stick with it. It is most definitely worth the hassle. In finances, ignorance is not only not bliss, it is a good way to get into trouble. The good news is that genius is not required. The terminology can be more than a little confusing, but you can learn it and everything else by diving in and doing it.
For those starting from scratch, let me define a few things. An account is just a tally of where the money came from or went to like the register in your check book. Take your checking account for example. An accountant might assign it an "account number" of 100 and an account description of "Primary checking account". By the way, account numbers are now called account identifiers because they are no longer necessarily numbers. In QuickBooks, you have the option to omit them. When money comes out of your checking account, it has to go into another account if you are doing accounting. If you wrote a check to the grocery store, the account for the groceries might be called 500 – Living Expenses. Accounts are going to be grouped into one of four general classes: where did it come from, where did it go, where did you stash it, and what do you owe or income, expenses, assets, and liabilities. If you have some money left over at the end of the month, and you'd better, you either kept it in your checking account, an asset, or used it to pay down debt such as a charge card balance, a liability. This is a hard concept for an awful lot of people. Paying down debt is pretty much the same thing as depositing the money in a checking account, but with the wonderful added benefit of reducing interest you have to pay. If you can get into that mind set, that paying down debt is often (not always, it depends on the interest rate) far and away your best investment, you'll be ahead of the pack. Of course, there's this problem that you have to have liquidity, i.e. cash or something that can be quickly converted into cash, just to survive, so you have to balance it out.
The difference, or in the 70's on computers the sum, between your assets and liabilities is your net worth if you are a person. If the books are being done for a company, it's called retained earnings (RE), but it's basically the same thing. Peachtree demands a retained earnings account, and you had better set it up first. QuickBooks does not. But whether or not you define it, it exists. RE should change in precise lockstep with how you receive or spend money. If it doesn't, you are not accounting for something, and those somethings can be awfully big and dangerous yet easy to overlook. Your car, an asset, is aging. As it ages, its value declines. This is called depreciation. If you really do your accounting carefully, you will have an expense account for depreciation and periodically deduct some from the value of your car and put it into the depreciation account. That makes your RE or net worth go down. Sooner or later, the repair bills on your car are going to total as much as payments on a new car and it will make more sense to get a new one.
A list summarizing your income and expenses is a profit and loss or income statement, and the difference (or, again, during one brief period, the sum with the sign changed) of income and expenses is your profit. A list summarizing your assets and liabilities is a balance sheet. If retained earnings is included in the list of liabilities, assets will exactly equal liabilities because the retained earnings is defined as exactly what is needed to make them equal. A trial balance shows that the change in the profit and loss equals the change in the balances, and that the debits equal the credits. It means you have accounted for everything in some sense. Some people use single-entry systems where you can post to just one account. A trial balance is important to show you always made the offsetting entries. QuickBooks and Peachtree are both double-entry. You can't save a transaction unless it has the source and destination accounts with equal amounts. Accountants say the debits have to equal the credits, and for both QuickBooks and Peachtree, they will. But not Intuit's Quicken.
The terminology "debits and credits" is outmoded. I mean that. It seems to amuse accountants that they have a confusing terminology that others don't quite seem to get, but that just means they are failing in one of the chores. You have to convey the information to others in a way that they can understand. But if you read this long-winded discourse, you are going to know your debits from your credits.
Imagine you are sitting in an office in Europe centuries ago. Someone comes in and gives you money to guard for them. The rule was to mark it on your books by your cash as "to have" and also by their name as "to owe". In Spanish, it is still "to have" (haber) and "to owe" (deber). Somehow, in English, the "to have" got changed to "to lend" as in the word credit. Millennia ago, the money changers got the idea that they could turn around and make loans at interest with that money marked "to have", even though it is in reality someone else's. It works really slick until a whole lot of people want their money back only to discover the bank doesn't "haber" it. The "to owe" part is still debit, and that's pretty close to "deber".
Now, fast forward to computers. When the earlier programs were written, the credit and debit nomenclature got left off. Let's construct a basic ledger for a hypothetical person and do the accounting like it was done on computers in the early 70s. This person (she's Alice - I don't want accountants using debits and credits, but it's fine for information people to use Alice and Bob as they have for decades. Recently, a Scientific American article committed the heresy of using Buzz instead of Bob.), anyway, Alice works to make money so we'll set up an income account called WORK. Alice has to pay for food, so we'll set up an expense account called LIVING. She owns a car, so we'll set up an asset account called CAR, and another for her pocket change called CASH. She owes money on the car, so the liability account we'll call DEBT. It's a good car, worth about $8000, but her principal balance on the DEBT is about $7000. When we write this all down at the start of a new year (or month, or day), before she earns or spends anything, we have:
WORK $0
LIVING $0
CAR $8000
CASH $0
DEBT -$7000
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RE $1000
The debt (here only, it changes later except on some Peachtree reports) is shown as negative and is often written as $(7000) instead of -$7000. You get to choose which. You can also print negative numbers in red or with the minus sign following. Alice has something she can sell for $8000. If she did that, she'd have to pay off the debt, and Alice would then have $1000 left over. So that's Alice's net worth. Not to worry. Alice wakes up and pays attention to her accounting and gets filthy rich later. At this point, the programmers and accountants parted ways. When Alice got paid $100 back in the early 70s, the computer subtracted the $100 from the work account and added it to the cash account. Alice made a profit.
WORK -$100
LIVING $0
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PROFIT $100
CAR $8000
CASH $100
DEBT -$7000
======
RE $1100
Note that the profit is the sum of WORK and LIVING but with the sign changed. But that income account is negative. That doesn't look right. It didn't look right to a lot of investors, either. But let's go on. Now Alice buys $50 dollars worth of food. We subtract $50 from the cash and put it to the LIVING account.
WORK -$100
LIVING $50
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PROFIT $50
CAR $8000
CASH $50
DEBT -$7000
======
RE $1050
Note the food decreased her net worth. Now Alice has to make a car payment. We subtract $50 from the cash and add it to DEBT. DEBT becomes less negative.
WORK -$100
LIVING $50
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PROFIT $50
CAR $8000
CASH $0
DEBT -$6950
======
RE $1050
Note that the car payment did NOT reduce Alice's net worth. Poor Alice, she's back to being penniless. But her net worth is $50 dollars greater, and she is showing a profit of $50. If we left things just like that and only worried about the programmers, the term credit would always mean subtract and debit would mean add. Actually, inside the computer, it still does. It's just the report that prints out differently. The problem is that dang minus sign that the investors were not used to. So the rule became that income and liability accounts would always be printed as the negative of what was in the computer. That turned the report mostly all positive. A negative number is unusual and stands out, and that's good. But if you are looking at such a report, you can't just say a credit decreases a balance. It still decreases expenses and assets, but increases income and liabilities.
Now consider your bank. To it, your checking account is a liability (negative) because it owes you the money in the account. When you write a check, the bank pays it and owes you less money. It makes, from its standpoint, your account LESS negative. This is where you can get really confused. To make a big negative number less negative, you add to it. To the programmer, to add is to debit. Some banks send out statements with the checks listed as debits. To you, your money is an asset. When you write a check, you reduce how much money you have. You subtract from, or credit, your account (CASH) and add to, or debit, your expense account (LIVING). The bank statement may label checks as debits, yet you have to read those as credits. See why I think that's confusing? It's not only this business of subtracting a negative number; it also depends on which side of the desk you are sitting. Why not just call it withdrawals and deposits? Why not specify a source account and a destination account? Why not irritate accountants? Why not change banks? Actually, that last one is sort of dumb, just like it would be if you used a difference in basic terminology to choose between QuickBooks and Peachtree.
Things get hairier when you get paid. You add to or debit your checking account (and the bank calls it a credit). But wait - that income account! You know if one side is a debit the other side has to be a credit, and that means subtract, doesn't it? That makes the income account more negative. Ah, but it will print out as positive. It really does go more negative in the computer, but you never see it. In QuickBooks, there are many more things you never see.
So what to do with all these debits and credits? You know one account gets debited and the other credited. You know one account goes down. If the wrong account goes down, switch your debits and credits! Don't worry about it. And pray that at least banks will quit using that terminology on their statements.
All right, when you subtract a negative number from an amount, you change the sign and add. Got it? Good. I don't. I still sometimes get confused even though my degree is in mathematics, and even though I've been doing this for decades. So don't feel bad. You'll make whatever software package you select work for you.
