Double-Entry Accounting
You’re looking to keep better track of your finances. You likely have various accounts—bank accounts, mutual funds, credit cards, and more—where money flows in and out. These are all financial accounts tied to you, and each can be monitored individually. Most personal finance apps operate on this principle. You’re probably familiar with several apps that track expenses, investments, and bank activity.
This approach works for simple cases, but consider a property investment. Money goes in upfront—possibly from a loan—followed by ongoing expenses and rental income. Eventually, the property might be sold. Determining whether it was a good investment isn’t straightforward. Paying for a house from your own money is different from taking a loan to pay for it. Your bank balance might be the same in both cases, but the value of the property on your books is different.
Double-entry accounting takes care of this by moving money between accounts. In the case of a loan, money would come from a Liability account. In case of your own money, the original money would have come from an Income account. The concept takes some getting used to. It's not difficult, just different. Once you understand the basics, double-entry accounting will make financial tracking and planning much simpler. And we have enough examples for you to practice and apply.
To understand double-entry accounting, we start with transactions.
Transactions
Let's say you had a coffee at CuTokai Coffee, a local coffee shop around you. And paid for it by transferring money from your bank account to merchant's account. In double entry accounting, you keep track of both accounts, instead of just yours.
So, each transaction is from one account to another. This is an important part of double-entry account. Money is always moved between accounts, never created or removed. Even money that you earn, comes from an account.
All the money is tracked in accounts. And double entry accounting has built enough tools and conventions to derive a lot of value out of this. In other words, interesting things happen based on the accounts on both sides of the transaction. Next we will look at accounts in some detail.
Accounts
In the coffee example you had transaction from your bank account to merchant's account. Now, if you are going to 3 different cafes, would you have 3 different accounts? Likely, for you personal finance, you don't need that kind of detail. Instead, you might want to represent all cafe's with a single account, Coffee. Or if you don't care about tracking coffee expenses, maybe you can use Food account. Or even a catch-all account called Expense.For practical considerations on how to use double-entry accounting, see... This is an important point in personal finance. The accounts you use, depends on what you want to get out of it.
If you want to track every single detail, you can create accounts for each individual establishment/person you deal with. If you rather only have a birds-eye view, you can have few accounts like Income, Expense, etc. Or anything in between. You create accounts based on the level of detail you want to track.
Irrespective of how much details you track, you probably are interested in your overall financial situation. To understand the overall flow of money, accounts need to be categorized.
Account Categories
Finance as a field as decided on 5 top level categories. Income, Expense, Asset, Liability and Equity. Originally developed for company finances, it works well for personal finance also. Here is a visual to help you understand them.
Where is Equity? I skipped it intentionally. It's a fallback category. Only categorize an account as Equity if it can't be categorized into any other. More on this, later. For now, let's look at the four main categories. We will start with Income and Expense. They are simpler to understand.
Income
There are two ways your networth can grow. Either new money comes in, or your assets value increases. Income captures new money coming in. This is your salary, money you make out of your side businesses, or money from interest etc. How do you capture value growth? We will come to it when we discuss Assets category. Here is a transaction which shows transfer from income to asset account.
Expense
Now, let's consider the other end of account categories. Expense. This is where your money vanishes. Coffee, Food, Trip to Indonesia, Entertainment, Education. The money for this mostly comes from Asset account like your bank account. But could be liability account also, like your credit card account.
Assets
Asset is what you have. Money in bank, Debt instruments, Stocks, Mutual Funds etc. Or things you own like, gold, house, car etc.
Interesting thing about them, is that they can grow (or depreciate). If you keep your money as cash (cash under the pillow), then there is no growth. In fact, with inflation, your cash might be loosing value. If you keep it in FD, you get interest. If you buy a car, it's still an asset, but depreciating (it's resale value reducing) with time.
Many investments like stocks, gold, mutual funds etc are commodities (their unit price changes with time). Here you are buying some quantity of the asset, at some price. As time goes by, the price of the asset might change. When you sell the quantity, you get money based on price at that point. FinBodhi allows you to keep track of these changes in value (at daily granularity). We will come back to this in Account Type section.
E.g. Let's say you buy 10 Fesla stocks for 2000$. 5 years later, you check the price, and it's 3500$. Your initial investment grew by 15,000$ in 5 years. When you sell, the unit price describes the change in value.
Let's briefly consider the importance of assets in personal finance. At the starting of your career, likely, you won't have many assets. As you work, you accumulate assets (move money from income to assets). These assets themselves (if you make wise investments), could also grow in value. You also keep a portion of your assets liquid, as a buffer for unexpected events. Towards the later stages of your life, you hope to have enough assets so that the growth from assets sustains your lifestyle. This is the essence of what you are trying to achieve personal finance.
Liabilities
The counterpart of Assets is Liabilities. This is what you owe others. E.g. loan from bank, credit card (spend money now, pay later), etc. Many of the loans, like bank loan, would have interest associated with them. In personal finance you typically track the loan amount, and payments made towards it. Your payment would be more than what you borrowed because of interest. Each payment typically has two components: principal (which reduces your liability) and interest (which is an expense).
For example, if your monthly payment is $1000, maybe $700 goes toward principal and $300 toward interest. The $700 reduces your loan balance, while the $300 is recorded as an interest expense.
This is useful for accurate calculation of interest you are paying. We will discuss the topic of interest, little later in the guide.
Equity
What about Equity? Why was it not there in the model? Equity in personal finance (and business, although with a different meaning) is whatever can't be categorized into the other four. Let's say you started tracking your bank account. You only have transactions for last year. If you import those transactions, FinBodhi won't show you the correct balance, because it doesn't know the balance that you started with, a year back. So, you might add a transaction dated year back, which moves the balance to bank. But moves from where? You don't want the other account to show up in your reports. This is where Equity comes in. You move money from Equity.
Equity is also used for adjustments and corrections. Found an error from 3 years ago? Instead of trying to recreate history, you can make an adjustment through equity. Think of equity as your "adjustment account" - it's there when you need it, but only use it if there is no other option.
To summarize, account categories allow us to record the significance of accounts in terms of where the value is. Often, the value of the account, is the money held in it. But it's not uncommon to have value captured as ownership of commodities.
Account Types
Commodities are things whose price changes with time. Stocks, mutual funds, gold, silver, house, car etc. You buy them at some price. While you are holding them, the price might change, and when you sell, you likely would sell it at a different price.
Now, while you are holding a commodity, you might want to know what you would get if you sold them. Your networth (if you converted everything to cash, how much do you have) might change significantly, based on the changes in price of the assets. This is where tracking the price comes into picture. For some assets (Indian stocks, mutual funds, gold bonds etc.), FinBodhi supports price tracking. For others, you could manually update the prices (e.g. current price of property you own).
Valuing accounts
Now that we have looked at account categories and account types, let's look at valuing accounts in a little more detail. There are two ways your assets can grow. New money, or price of a commodity increasing. This is the foundation of how assets are valued. And same applies to liabilities. Let's look at some examples for both these cases.
Cash Return
For instance, if you take a Fixed Deposit, the money you get is new money (deposited by bank, at the end of term, to your account). Another example of where you get cash as value for an asset is rent payment from a house you have leased.
Commodity Price
You buy something. Hold it for some time. Sell it at a different price.
Calculating Return Rate (XIRR)
How do you calculate returns for the money you make out of assets? The way this is done is to first map out all the inflows and outflows from the asset/liability account. And then pass them to xirr calculator. The inflow/outflow of money to an account is called cashflow.
When all the relevant cashflows happen with the account, it's straightforward to calculate xirr. E.g. with a mutual fund, all the money moves through the mutual fund account (with the increase in unit price).
But there are other cases, like FD, where the interest flow itself might have happened with another account. E.g. you book an FD, bank deposits interest every quarter, and after sometime, you get back the FD money. Here the interest is flowing to another account. Here is how it would look in terms of transactions.
Note that interest is received at the Bank and not FD account. From an accounting perspective, this is the correct approach. But if we want to calculate returns from FD, we need to gather all flows of money related to the FD. This is where account relation comes into picture. It's a way to group together all the related cashflows, for calculating xirr of an asset/liability. You can set Income:FD Interest as a relation, in settings page of Asset:FD. FinBodhi uses this to calculate the returns.
Thanks to accurate cashflow accounting with double entry, once we know which accounts are associated with an asset, we can calculate interest rate for even complicated assets, like House. FinBodhi will calculate xirr for you, once relations are configured.
Conclusion
This concludes our brief exploration of double-entry accounting, from personal finance perspective. You don't have to be afraid of trying things out. With FinBodhi, you can always click on Try Demo on signup page to create anonymous account and try things there. And even otherwise, you can always edit back the changes.
Also, we didn't have to think about credit, debit etc. From our perspective, they are unnecessary jargon which just complicates the topic, and confuses everyone. We just care about money moving between accounts, and the category and type of the accounts. To summarize.
- Money always moves between accounts.
Account categories will help you understand the flow of money. Here is a summary of the account categories.
Type Example Balance Direction Tracked? Asset Bank, Cash, Wallet Positive Yes Expense Rent, Coffee, Food Positive Yes Income Salary, Freelance Negative Yes Liability Credit Card, Loans Negative Yes Equity Opening Balance Adj. Ignore No - Link accounts to calculate return rate.
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