Accounting
California Accounting
A New Domestic Accounting Model based on Domestic Well-Being
Summary of Rationale and Technical Introduction
California Netralid.com - Other articles on Domestic Well-Being Accounting (DWBA) have hinted about the new ideas upon which this new domestic accounting model is based. In this article, the rationale, ideas and concepts are summarised, based on the coverage in a new book 'Accounting for a Better Life'.
Accounts
At its simplest, an account is just a list of transactions relating to some area of financial activity or interest. The most familiar form of account is the bank statement that customers periodically receive from their bank.
The first important thing to appreciate is that accounts are for accumulating information about value. We are so used to bank and credit card accounts which are all about currency that people sometimes do not realise that accounts are equally useful for accumulating transaction details relating to, for example, our home, our car(s) - one account for each car - our investments, etc.
Accounts will usually have two columns, one for increasing (+) amounts and the other for decreasing (-) amounts.
The next important concept is to appreciate that there are two distinct, overarching types of accounts that we can use in our sets or books of accounts. One is called an asset account and the other is a liability account.
The asset type account as its name infers, typically relates to storing transactions for assets such as bank accounts, houses, cars, etc. The idea behind this is that positive amounts entered into the + column of an asset account signify increasing value; so £500 entered into the + column of an asset account implies an increase in value of £500. However accountants will also have in their business accounts, what I call working accounts for home accounting, as other accounts of the asset type which are not strictly for an asset such as a car or home. Examples include accounts for asset acquisitions and for depreciation.
That other overall type of account is a liability account. It is used for accumulating debts and/or liability. Now we have the reverse concept in that increasing amounts e.g. £300 in the + column of these types of accounts imply more debt or more liability, whilst a decrease of £200 represents less of a debt. You might think more debt means less value but it all depends on the purpose for which a liability account is being used. Again, accountants mostly use liability type accounts for holding true debt amounts but again, have a need for other accounts of the liability type to mediate certain transactions. I refer to these as working accounts in home accounting as they do not relate to any true debts of a person or household; examples of these are for accumulating temporary information about asset acquisitions and growth in the value of a home.
Another area for confusion here relates to the names for column headings used in the different software packages available to support accounting; in business, the convention is that debits (the + column for asset accounts and the - column for liability accounts) are traditionally in the left-hand column of each account, with the credits on the right (the - column of asset accounts and the + column of liability accounts). This convention is not always adhered to in some software packages, together with not always using the headings, debit and credit.
Double Entry and the Accounting Equation
The last bit of theory to mention which lies at the heart of DWBA accounting is so-called, double entry. This concept appears confusing to people because it has two aspects. First, it is an accounting concept which relates to an approach for taking into account (there's an appropriate phrase!) all the financial aspects of some financial entity. In business, an entity might be a department or a division, a sole-trader or even a whole plc. For domestic accounting, such an entity would most often be an individual or a household. The point is that the accounts supporting any of these entities consider or model the totality of the financial aspects of the entity. As such, the accounts will be able to capture and make visible both the static and dynamic aspects of the entity finances. The practical effect is that a set of double entry accounts (the books) requires an account to store the total financial value of the entity as well as usually, some accounts for accumulating periodic changes in terms of increases and decreases to this overall value. The result is what is termed a balanced set of accounts, related to an accounting equation.
The other common use of the word double entry is related to the bookkeeping techniques for implementing this form of accounting which requires two (double) entries in the accounts for each new transaction, in order to maintain the required balance.
What do we mean by balance? Well balance is the key to double entry and it comes from balances in accounts, as maybe related in some way in this equation; the so called accounting equation.
If we consider a household, it might consist of a collection of assets - a home, a car, three investments and a consolidated bunch of unspecified appliances. We could set up 6 accounts to represent all these assets and assuming there were no liabilities of the personal debt sort - an unlikely assumption - we could say that our domestic wealth equals the sum of the balances of those 6 asset accounts. Here is a statement, which is not yet a true equation:
The sum of all Asset a/c balances = our Domestic Wealth
Now if we had some debts, perhaps a mortgage on the house and a loan for the car, we could set up two more accounts (of the liability type) to hold these two debt amounts.
Since we owe two amounts for these debts to some financial organisations, we have to earmark the appropriate amounts to be repaid from the value of our assets, in order to derive the changed new value of our domestic wealth, so we can show this in another statement:
All Asset a/c balances - All Liability a/c balances (of the debt type) = our Domestic Wealth
The crucial point about the double entry system is that we need to setup an additional account in order to store the amount of our changing domestic worth. I call it a Domestic Wealth account.
Now, instead of a statement, we have an equation which is balanced:
All Asset a/c bals - All Liability a/c bals (of the debt type) = Domestic Wealth a/c bal
The next issue is what type of account do we need to hold the domestic wealth - asset or liability?
When you think about it, the amount of the domestic wealth represented by the assets less the debts is owed to the eventual beneficiaries of the household or individual's estate. It should therefore logically, reside in a liability account.
Now we can tidy the equation up by putting all the asset type accounts on one side with all the liability type accounts on the other; the result is with appropriate changes to the signs:
All Asset a/c balances = All liability (debt) balances + the Liability (DW) a/c balance
Let's imagine a situation where an individual starts up with £20,000 in a bank. For that individual to establish a double entry accounting system, we need an asset account for the bank account and since there are no debts, just a domestic wealth account; a double entry is required for the initial transaction, with £20,000 debited to the asset account for the bank and the same amount credited to the liability account for domestic wealth. In the accounting equation, we can see the result as:
Asset a/c bals £20,000 = All liability (debt) bals 0 + Liability (DW) a/c bal £20,000
Let's see how we handle buying a car with a loan of £2,000. By breaking it down into steps, we first consider receiving a loan - so receive (debit) bank with £2,000 and setup a new liability type account for the loan company and credit it with the same £2,000 - with this effect in the equation:
Asset a/c bals £22,000 = All liability (debt) bals £2,000 + Liability (DW) a/c bal £20,000
Still balanced at £22,000 on each side!
Now we buy the car for £7,000 using the £2,000 from the loan and the extra £5,000 from the bank assets. We also need to setup a car account to receive the value of the purchased car. The end result from the equation perspective is still a balanced equation:
Asset a/c bals £22,000 = All liability (debt) bals £2,000 + Liability (DW) a/c bal £20,000
The asset a/cs are now made up of Bank (£22,000 - £7,000) and car a/c £7,000 with no change in overall value on the asset side but a distribution in values across the asset accounts.
Another thought about double entry is that any single entry made to a balanced equation (set of balanced accounts) must unbalance it! The only way to retain balance is, from the maths perspective, if we add something to an account on one side then we must add the same amount to an account on the other side; or if we add something to an account on one side we must reduce by the same amount, in an account somewhere else on the same side. This in effect, if you work it out, is what the accounting rule says in that a debit posting must be balanced with a credit posting.
As we buy food, drink and clothing, pay utility bills and purchase holidays, we will see reductions or credit in our asset account for bank or, if we pay by credit card, equivalent credit entries to increase our debts in the liability type account for each credit card. These are termed expenses and will lead to an equivalent decrease in our domestic wealth. It should be obvious that if we post credits as the first part of each expense transaction, we will need corresponding debit entries to balance them. Increasing debits imply an asset type account so that will be the sort of account that we need for these increases. By the same logic, income such as salary or pension will be first entered as increases or debit entries in our bank account and must be balanced by credit entries in a new account for domestic increases - increases that are credit entries occur in liability type accounts so this is the sort of new account we need to setup for accumulating changes for increases to domestic wealth.
Non Double Entry Accounting
Traditionally, accounting for personal and home use has not made use of the principles of double entry; and the software packages that support home accounting are not usually geared up to properly support it. The reason is partly because when people ventured into home accounting, they tended to start with activities such as reconciliation of checking accounts and simple budgeting. For this, they tended to only require setting up accounts for one or two areas, mainly related to bank accounts. With this, as useful as it is, there is no concept of seeing the total picture, with the static and dynamic views of the financial state of affairs.
Business versus Domestic Accounting
When I first decided to start 'doing' my own home accounts many years ago, I believed that since business accounting had evolved over such a long time to be able to so successfully satisfy business managers' needs to manage business finances (and there was a legal requirement for them to do so) there must be something special in business accounting that I could look for, to be able to help people better manage their personal and home finances. As described elsewhere, I discovered that business accounting methods themselves were of little help because of the wrong focus (profits for capital gain) and that the actual accounts, reports and associated business ratios were also, understandably, entirely inappropriate.
In thinking about alternatives, I realised there were some features that could be extracted from business and with modification, be used effectively to help manage home finances.
Reports
With the double entry system we can obtain a static view or 'snapshot' of the state of the finances of a business and this is called a Balance Sheet. This shows the assets, liabilities and capital value on any particular day.
Most of the entries in the business Balance Sheet come from balances in the accounts which can be easily extracted from a Trial Balance which is simply a list of all the balances for all the accounts in our books.
The structure and contents of the Domestic Balance Sheet (DBS) highlight the major components of the domestic assets and liabilities in order to derive the new value of Domestic Wealth. Rather like the net profits being brought into a business balance sheet, the domestic version shows the Total Domestic Change (TDC) as the contribution to Domestic Wealth over the past period.
Now, the important issue is what does the TDC consist of? We probably know that the business equivalent of profit or loss is exposed in the two accounts - the Trading account and Profit & Loss account. These two accounts highlight the dynamics of the financial situation; the changes over some period.
For business, the focus is on profits and so these accounts concentrates first, on the higher level aspects of the business with opening stock, the purchases made to augment this stock and the closing stock value.
The next account called the Profit & Loss account shows the impact of other increases and decreases which usually reduce the gross profit to some lower value, called the net profit.
The individual accounts required by business have no place in home finances as we are not primarily interested in profit.
The new Focus - Domestic Well-Being
What should the financial focus be for a home finances? Well I gave much thought to this and over some years and developed a new focus with an associated approach and methods, based on what I eventually termed, Domestic Well-Being.
In short, yes, homesteaders do want to increase their worth or value, but not usually for 'profits sake'. People want to increase their wealth to pay for things that tend to occur in a progression throughout a lifetime; like better homes, education perhaps, hobbies, luxuries and provision for those retirement and eventually, declining years when income is drastically reduced.
In general, home finances in the earlier years of a lifetime are such that there is never enough to go round. Everything is a question of priorities and balance. What should be the best distribution of our expenditure to ensure that we can obtain the best possible balance or compromise, with the income at our disposal?
My solution was to come up with a structure that best presented the major areas of domestic finances about which decisions could be made on how best to allocate funds - those alternatives and their prioritisation. So I needed a way that could be used to classify increases and decreases as and when they occurred, as well as for presenting the figures in an appropriate way after they had been accumulated. This presentation had to support the decision making that would be needed to best optimise future spending. It had to be done in a way that could achieve this best balance across the competing priorities so as to maximise Domestic Well-Being. It was therefore DWB that became the new focus for domestic accounting; and it could be identified in terms of a structure for both bookkeeping - capturing the transactions; and accounting - reporting, analysing and the subsequent decision making for future financial activity, implemented perhaps through budgeting.
The Domestic Well-Being Statement
The Domestic Well-Being Statement (DWBS) is the domestic version of the Trading account and the Profit & Loss account and is used to present the derivation of the Total Domestic Change (TDC) over some period. It represents the second of my adopted features from business accounting.
This report simply shows the structure for DWB and is obtained in Microsoft Money with one click to run a pre-stored report. The edited version combines the details for the current and previous years to assist with comparisons.
In summary, the report shows the three top-level Categories of the structure as the Basics, Discretionary and Others groups of transactions, each divided into Increases and Decreases. These categories might be considered as similar to business accounting nominal codes.
Within these groups there are successively lower level groups of sub and sub-sub categories. For example, the Basics included Essentials, Responsibilities and Family, each with further sub-categories below.
The Discretionary group, where obviously there is some amount of discretion or choice as to whether decreases and increases occur in its component sub-categories, includes Nice-to-Have, Investment for the Future (IFF) and Luxuries.
What amazed me when it was first developed was the fantastic visibility it provided on the home finances, especially showing the distribution and makeup of the many expense items.
Financial Ratios
The third feature that I adopted from business accounting is the use made of financial ratios.
You will appreciate that a ratio is simply a comparison of two figures expressed as a quotient, usually in decimal or percentage format. In business over time, certain key quantities and their comparison in the form of ratios have taken prominence as a key to both information dissemination (for shareholders, investors, management boards, auditors etc.) and to various levels of management as a basis for control. Those two components of a ratio, the numerator and denominator, can both be considered as candidates for achieving change.
Over 30 business ratios slim down to few that most people have heard of, such as the different forms of margins and the ratios associated with profitability and liquidity; and of course virtually none of them relate to home finances!
From my experience, I knew that the figures I had exposed for domestic finances must have some potential for assisting in the management and control of home finances. The issue was which figures and in particular, which groupings of pairs of figures as ratios might be informative.
The Stages of Domestic, Financial Life
My other experience was with life; now 68, I realised looking back on my lifetime of interest in home finances, I could distinguish six fairly distinct stages of financial life. By this, I mean that there was a significant enough change in some aspect of personal finances across the stages that might warrant some form of indicator or measurement being useful. For your interest, I call these stages:
- Early Adulthood
- Early Maturity
- Middle Life
- Retirement
- Declining Years
The Domestic Financial Factors
Briefly, the more important ratios over some period are (where the abbreviations relate to figures in the DWBS):
Basic Cost of Living Factor (BDD/THI) - a measure of the amount spent on basic necessities, out of total household increase.
Well-Being Contribution Factor (DDD/THI) - a measure of the amount spent on discretionary extras, out of total household increase.
Future Affordability Factor (IFF/TDI) - a measure of financial commitment to future well-being, out of total domestic increase.
Feel Good Factor (IFF/DDD) - a measure of how much went on future well-being, out of total discretionary decrease.
Domestic Wealth Factor (TDC/ODW) - for positive TDC the domplus, or for negative TDC the domicit, contributing to growing or diminishing domestic wealth respectively, as a proportion of old domestic wealth. This is the nearest comparison to business profit or loss.
To start with, lacking any reservoir of accumulated figures, the value of these ratios or factors as I call them for home use, will only be of use internally in a household over time, as a means of measuring and looking for changes. With a base of figures, then there would be the possibility of comparison with others and the similarity to business norms.
Value for these five factors give 'shape' to a financial situation and if displayed in the format of a star or radar diagram, could also offer useful indicators that could help to predict problem areas or states of stability or instability about a set of finances.
With an accumulation of values for the domestic factors, either by simulation or by capture after creation by individual home owners, it would become feasible to create and provide further useful charts. With such information, the home owner would be able to determine if the individual figures from the accounts appeared to lie within the expected domestic norms.
Other Graphics
A picture speaks a thousand words. This is no truer than when considering displays of financial information. Such graphical charts are the fourth set of business features of the sort of products that can easily be created with general purpose accounting software packages such as MS Money, especially if double entry accounting is used.
Financial Control
For home finances, control is both feasible and realisable and is only limited by the extent to which homesteaders wish to go. It all comes back to a need for a sense of responsibility.
The analysis should first look at distribution and balance. Are the proportions being spent on the Basics a fair amount compared to the total increases?
The information obtained from your end-year results should reveal some fundamental facts. Have you been able to afford anything over and above the basics? If yes, did the amounts enable a reasonable allocation to discretionary decreases; and what about luxuries?
Your accounts and this new set of accounting methods will give you the data and information to enable you to pick up warnings.
What sort of warnings might you want? In today's climate of a financial debt crisis, probably the most important warning you would look for is one relating to the likelihood of such a pending crisis for you. You would want to know if your decreases are getting too close to your increases, or even exceeding them. You would want to know if your reserves are being depleted, possibly on funding that excess of decreases over increases. You should be looking to see the amount of short-term and long-term liabilities you have; and how their proportions compare to the total value of assets. You would want to know about your liquidity; how well you are able to realise funds in the short term to meet your known commitments. You obviously do not want to sell your house or car just to pay the bills.
On a less dramatic but more important note, you need to know about the proportion of contributions being made to future well-being; and if positive, does the amount being put aside represent a reasonable proportion of your increases?
Conclusion from Adapting Business Accounting Concepts
In order to implement the features I have extracted from business accounting, I needed to be able to use the concepts of double entry.
Simplification
In undertaking home accounting with double entry, the main difficulties related to knowing where I was in relation to individual accounts and the entering of transactions. By this, I mean that when looking at a single account register on the computer screen, it never appeared obvious to me what sort of account I was looking at and into which column of the account, the next posting should be made.
Over time, I realised that the key to understanding the answers to this dilemma lay with the accounting equation. I needed a way to always be able to associate any account with its place in the accounting equation - asset or liability - and to which account it should be associated in order to achieve double entry balance.
Like many amateur accountants I often had problems with reconciling the concept of debts in accounts for mortgages and loans, with a so-called liability related to an amount in a capital or domestic wealth account. To me, domestic wealth was a 'good' liability - more was better - whilst the mortgage and loans were 'bad' liabilities or debts that had to be repaid; and more was not better, but worse! I resolved this by considering all the accounts that were associated with domestic liability as quasi-liabilities - good liabilities; the amounts or the balances of liability held in these accounts, I considered as 'good' liabilities. They were given the letter Q in the appropriate prefixes.
There are a total of four accounts that fell into this quasi group which consisted of the Domestic Wealth account (LQ DW), the Domestic Changes account (LQ DC), the Categorised Increases account (LQ Cat Inc) and the Categorised Decreases account (AQ Cat Dec).
The majority of the changes to domestic wealth over any period come from the decreases associated with expenses such as food, drink, clothes, utilities, holidays etc - virtually all of the Basics and Discretionary decreases. These also end up in the LQ DW account via the LQ DC account but because of the way I handle most of the double entry postings, they arrive via those two quasi accounts for Categorised Increases and Decreases.
Implementation
I initially chose one of the earliest versions of a generalised accounting software packages called MS Money. Being generalised, it provided the capability to create accounts as needed, with any name you chose.
It also had good integrated query and reporting capabilities, together with the concepts of payees, categorisation tags and support for budgets as well as for stocks and shares.
In thinking about the implementation of double entry, MS Money was not designed primarily for double entry. If it was, it would have some journal-like arrangement similar to dedicated double entry accounting software, whereby each transaction is associated in some way with the two accounts involved in the double entry. Then, via a key-click or later batch updating, the two individual postings would be made to the appropriate two accounts.
This does not mean to say however that this software package cannot be used for double entry postings. All it requires is that after adding the necessary extra accounts, that two entries are posted for each transaction entered.
One form of categorisation available in MS Money is its Income and Expense tags. Money comes pre-loaded with tags associated with home finances so that for example, with a simple account (non-double entry system) for reconciliation with bank statements, each transaction could be associated with an appropriate tag, such as wages, food, etc.
Income and Expense are the terms used in MS Money to relate to the accounting terms of debit and credit; Perhaps trying to be helpful to home accountants, MS Money has differing column headings for the increases and decreases across all the various types of accounts that can be created.
In trying to find a way to implement the tagging I needed to associate transactions with the DWB structure, as well as achieve double entry to support the concepts of static and dynamic reporting, I came up with a method that achieved both; without the need to enter transactions with hundreds of double postings.
The 1st halves of the appropriately, categorised double entries accumulate in the accounts where they were entered, mostly bank or credit accounts but that is unimportant. At the end-of-period by running a single report, the sum of the amounts of the 1st half entries can be easily exposed, contributing separately to increases and decreases to domestic change. By then entering just two more postings, one for the total of the 1st half increases and another for the total of the 1st half decreases, balance is re-established.
Summary of the Approach
The main features that I have adopted from business accounting are the ability to create balance sheets for static views, to capture the financial changes over a period for the dynamic aspect, to define ratios/factors as a comparison of useful and significant figures from the balance sheet and the changes, as well as the use of graphical reports to enhance visibility and meaning.
As a thought about setting up your own DWB accounting, my book describes the background and theory, together with the details and prototypes for accounts, categories, reports and graphics on a bonus CD, for implementing the accounts on MS Money.
Regarding implementation on dedicated double entry accounting software packages, I have not yet discovered any that are sufficiently general-purpose to enable the creation of accounts of your own choosing, together with your own details of categorisation.
As a final thought on simplification, life in the accounting world can be made much easier for domestic accountants, if the terminology is simplified as much as possible. It will be important not to remove too much of the distinction between some of the technical words but I have found that I have made life much easier for myself, by simplifying, wherever possible.
An understanding of one idea - double entry - and the following, six key words, will get you through with flying colours: asset, liability, debit, income, credit and expense; and my version of the domestic accounting equation, account prefixes and a couple of 'memory joggers', will tie all these features together.
Also, take a look at the author's website on Domestic Well-Being Accounting, together with sample products and a growing list of tutorials at www.dwba.co.uk; the full rationale and technical introduction with supporting charts and graphics is at:
http://www.dwba.co.uk/pages/DWBA_Technical_Introduction.htm
0 Comments: