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The fundamental theory of accounting - money is a conserved quantity

The purpose of accounting is to keep a record of transactions that provide information on spending habits, confirm the accuracy of records kept by financial institutions, and record information germane to tax filing. Unless you are the Federal Reserve or a counterfeiting artist, money is a conserved quantity meaning it is neither created nor destroyed. All transactions are therefore transfers of money from one account to another.

[Decrease in account #1 from] \( = \) [Increase in account #2 to]

Or written more sensibly, the change in value in the "to" account is equal to the negative of the change in value in the "from" account.

\(- \Delta\) [Value from] \( = \) \(\Delta\)[Value to]
Money as a conserved quantity, a fundamental theory of accounting.

[Caption] Money is neither created nor destroyed, money is transferred from one account to another. Green, yellow and red arrows indicate transactions that cause an increase, no change, or a decrease in net worth respectively. Most people pay most of their expenses with their wallet (cash) or credit card except for their rent which typically requires a check. Miscellaneous income (sold couch on craigslist, birthday money, found $10 on the side of the road, etc) is usually received as a check or as cash. Having such records makes it easy to calculate one's net worth and savings rate, \(S = 1-\frac{E}{I}\).

Accounting terms of art

general ledger: a list of all financial transactions that take place during the life of a company

accounts payable: the group of transactions (or the department within a business managing the group of transactions indicated by red arrows)

accounts receivable: the group of transactions (or the department within a business managing the group of transactions) indicated by green arrows

The general ledger of a company is the work product of the accounting department. The general ledger of each person or family is usually not recorded from the beginning of each lifetime. It is important to remember that almost every day we are all writing to our general ledger with our actions regardless of whether we are maintaining the accounting files necessary to record it. For those not keeping records, it is as though they are writing the story of their financial lives every day and burning each old page as the sun rises on a mysterious new day. Unable to recall how they arrived here, they write another page to their general ledger and repeat the process in the morning.

The rest of us keep records according to a model like the one pictured above. Transactions (arrows above) move wealth between wealth containers, income sources, and spending categories. Some transactions raise your net worth, like receiving a paycheck ($2,000 from employer to bank account, green arrow. Some transactions do not change your net worth such as an ATM withdrawal ($200 from bank account to wallet, yellow arrow) or paying off a credit card ($1000 from bank account to credit account). Others, including quotidian expenses like groceries and utilities, lower your net worth ($150 from credit card to groceries, red arrow).

Tricky signs on income and credit cards

In this model, you are tracking your employer's bank balance as it changes with your paychecks. Therefore, the sign on the income will be negative. Your employer pays you, the bank balance of your employer goes down. Most commercial packages tag accounts listed as income sources and display the balance with the sign reversed but if you are writing your own software or using homemade Excel sheets you will need to remember this.

Also, remember that your credit card balance in this model will have the opposite sign it has on your statement. The statement from Visa says how much you owe them, not how much of your wealth is stored on the card.

What needs to be recorded; what needs to be seen

Accounting has two parts - records and reports. The records are a database of transactions. The reports are transactions listed by account, with appropriate signs on the values, and either a running total since the beginning of time (wealth containers) or a total filtered by a date range (groceries, we want to know how much we spent last month, not since the beginning of time). Accounting software sometimes helps us generate records (by automatically importing information from bank accounts for example) but more importantly, it allows us to turn the database of records into reports.

The purpose of accounting software, visual graphic

Lots of tools are capable of doing this conversion from records to reports - home built Excel or Python scripts, Mint, Quicken, YouNeedABudget.com, EveryDollar, Personal Capital etc. Regardless of the tool, for each transaction five things must be recorded:

© MC Byington