Wednesday, March 28, 2012

Basic Bookkeeping for Everyone


Personal financial literacy is the first step towards developing true financial security and realizing a dream of quitting a job or having a comfortable retirement. I received an MBA in accounting and now I use my knowledge to help others. In this post, I'll cover some of the basic transactions that an individual is likely to see and how they impact the personal income statement and balance sheet. It is necessary to understand the basics of the personal income statement and balance sheet before reading this post, as some of the meaning may be lost without understanding the financial statements that these transactions affect.

Accountants spend a lot of time thinking about the recognition and economic measurement surrounding a set of business events. Bookkeepers focus on the proper entry of data into the main operational financial records: the general ledger and the general journal.  The journal tracks specific events as they affect different accounts and the ledger keeps track of the balances in each account. Operationally, information first appears in the journal and is then transferred to the ledger. The entries in the journal, creatively called "journal entries," illustrate different events like these:
  • Pay day
  • Taking out a new loan
  • Paying off a loan
  • Prepaying car insurance or health insurance
  • Paying other normal bills
  • Buying/Selling a house or a car
Journal entries are a list of accounts along with a debit or credit amount. Each transaction affects a minimum of two accounts (this is where the term "double entry bookkeeping" originates). The individual parts of a journal entry may affect an account that exists on the income statement or on the balance sheet. A fundamental identity for journal entries is the following:

debits = credits

This confuses a lot of people when they first explore the concept, but it becomes clearer with examples. Let's return to our friend, John Doe...

John gets paid $1500 for working for a week:
                     Dr.    Cr. 
Cash                1050
Tax Withheld         450
     Wage Income           1500 
   (to reflect pay day) 
In this case, we know that our cash in the bank increased by 1050. Cash is an asset that exists on the balance sheet. Tax withheld is either an expense or an asset, depending on your philosophy. In my case, I argue that it is an expense because you ultimately never see it and it doesn't do anything besides hurt your purchasing power. If you consider it an expense, it goes on the income statement; if you consider it a pre-paid expense, then it is on the balance sheet. Wage income is clearly a personal revenue account and exists on the income statement.

Next, John buys a house for $200,000 and pays $10,000 down with a $190,000 mortgage:

                     Dr.    Cr. 
Home              200,000
     Cash                  10,000
     Mortgage              190,000 
   (to reflect home purchase)
In this case, only the balance sheet is affected. The home is recorded for the purchase price, cash is reduced by $10,000, and a new liability, "Mortgage," is created for the principal value of the note. Interest is calculated periodically and is handled in a separate journal entry. We will consider loans for real estate, vehicles, and credit cards in a future post. As a final example, let's look at the purchase of a 6 month health insurance policy:

                             Dr.    Cr. 
Pre-paid health insurance    6,000 
      Cash                          6,000 
   (recorded for purchase of insurance policy) 

The examples above demonstrate the mechanics of transactions that happen at a discrete point in time, but at the end of a period there are entries that need to be made to adjust accounts that have changed due to the passage of time. These include things like interest on loans, changes in pre-paid expenses, accruals of new expenses (e.g. utilities, cable TV, rent in some cases). Below is an example of John's usage of pre-paid health insurance:

For the next 6 months, John would expense a portion of the health insurance policy at the end of the month:
                                 Dr.    Cr. 
Health insurance expense       1,000
     Pre-paid health insurance        1,000 
   (to reflect use of a month of coverage) 
Journal entries aren't typically complicated to figure out, the exercise typically involves identification of accounts and then an evaluation of the amounts that get applied. Assets, losses, and expenses increase with debits and decrease with credits. Liabilities, equity, revenues, and gains increase with credits and decrease with debits. In future posts I will typically directly state that we are increasing or decreasing an account, rather than referring to debit amounts and credit amounts.

Finally at the end of the month, income statement accounts are zeroed out and applied to accounts on the balance sheet (typically personal equity accounts). This allows the balance sheet to reflect the financial position for a person at a point in time (typically at the end of a week, month, quarter, or year). The main closing entry is a credit (or debit) of the difference between income and expense (or expense and income if expenses > income) to the personal equity account on the balance sheet.

Managing personal finances using double entry methods may seem cumbersome, but it allows an individual to stay close to their finances and understand the effects of each transaction on their overall financial and economic position. It also provides a framework for an individual or family to use to evaluate the effects of different possible purchases. Finally, the usefulness of double entry methods is that they allow an individual or family to manage their finances more along the lines that a business would (though businesses and governments are subject to rules that individuals are not).

See Also
Retirement in the 21st Century
The Personal Balance Sheet
The Personal Income Statement


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