FinanceFerret/equity

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The examples below might be a good illustration of the proverb "Neither a borrower nor a lender be", since if these characters had simply paid each other off right away instead of letting the situation become more tangled, there would be no need for complex accounting.

There are certain situations where it arises, nonetheless:

  1. In small business partnerships, the partners will often spend money on the business without expecting payback in the short term; it is vital to be able to keep track of this.
  2. One sometimes runs into individuals who are less than fastidious about keeping track of their borrowings and expenditures. In this case, it is vital to be able to keep track of the borrowings and repayings of money amounts so that you can state, quickly and definitively, how much you are owed, rather than deferring the calculations until you have time -- by which time the situation has grown yet more complex.
  3. In cohabiting a household, often the expenses and borrowings/lendings come too quickly to allow simple payback; you don't want to be running to the bank five times a day with checks for tiny amounts.

Example 1

Let's say you're trying to keep track of how much you owe Fred. Fred lends you $100, so you set up a "Fred" account on your money manager program. You enter the $100 as a debit on the "Fred" account, so your "Fred" balance is -$100; it's clear enough that you owe "Fred" $100.

Next week, you give Fred $25. You enter this as a credit on the "Fred" account, and your money manager now shows a balance of -$75. So far so good.

The week after that, however, you buy Fred a hammer for $20, and Fred says to take it off your debt. But you've already entered the transaction in your money manager -- you used your check card to pay for the hammer, so you entered a check card debit on the "My Bank" account, paid to "Joe's Hardware". Possibly you could edit the transaction so the money went directly into the "Fred" account... but then when you want to see all the money you've spent at Joe's Hardware, the $20 hammer won't show up. "So what?", you think -- "It wasn't really my $20 anyway; it was Fred's." So you make the change.

This causes a minor problem later on, when the bank shows a payment to "Joe's Hardware" and your records show a payment to "Fred" instead, but you figure it out. Several months later, this causes another problem when Fred claims you still owe him $20, and your "Fred" balance shows zero. Fred claims you never gave him the $20 you show on June 1. After hunting around for a bit, you finally remember that the $20 didn't actually go directly to Fred; it went into a hammer which you then gave to Fred.

This is the sort of confusion which accounting software is supposed to prevent -- so the software clearly isn't doing everything you need.

Example 2

You have a personal bank account ("My Bank") and a business bank account ("Biz Bank"). They each have $500 in them. You buy $100 of supplies for your business, using your personal account (maybe the business account lacks a check card, or you didn't have it with you, or the CFO won't let you charge directly from the business account). You enter this as a $100 debit in "My Bank", leaving a balance of $400, and a $100 credit to Biz Bank... except that would give "Biz Bank" a balance of $600 (which would be inaccurate), and nowhere would it show that the business owes you $100.

So you set up a separate account called "Biz Owes Me", and put the $100 deposit in there -- but again, this causes problems later when you're trying to figure out where the $100 actually went.

And there's even greater confusion when the CFO writes you a $100 check, drawn on the business's bank account, which you deposit in your bank account. This clearly has to be debited from "Biz Bank" and deposited to "My Bank" -- but it also needs to reduce the amount in "Biz Owes Me".

What This Means

In the standard accounting practice of Double-entry book-keeping (I'm not sure their examples are quite right, but the explanation is otherwise clear enough), every transaction has two parts -- where it comes from, and where it goes to. If I buy a hammer, I release some cash (my net balance decreases) and the hammer store gets it (their net balance increases).

As the above examples -- especially #2 -- would seem to indicate, certain transactions imply a third part: If I buy a hammer for you, I lose some cash, the hammer store gets some cash, and you owe me.

Technical Interpretation 1

The data design I eventually arrived at for handling this involves a record for each end of the transaction -- one record each for source, destination, and equity; I am calling each of these "ends" a "TransPart". The Equity transpart may be omitted if the transaction results in no net change in equity (e.g. I buy something for myself). The destination transpart may be omitted if we aren't tracking transactions for that particular destination, e.g. I buy something at a store I'll probably never visit again; a notation in the source transpart should be enough to identify the transaction for reconciliation purposes, and if we want to track that purchase as part of a category (e.g. "vacation expenses" or "convenience stores"), then it may be assigned to one or more Categories (which are very similar to Equity accounts except that every penny must go into exactly one Equity account but that same penny can go into multiple Categories).

Technical Interpretation 2

I'm thinking it might make more sense to do this a different way. The "equity account" concept seems subtly wrong -- if only because it is asymmetrical (one cash account counts as positive and the other counts as negative).

2a

Perhaps each cash account should have an equity account attached, and that account should only be for positive equity (or negative -- one or the other, but not both) -- and negative equity would be recorded in the equity account attached to the cash account at the other end of the transaction.

2b

Perhaps there shouldn't be separate equity accounts, but rather each transaction should include an (optional) equity amount, representing debt/credit.

A gives B $10 in trade for merchandise:

  • A's cash -= $10
  • B's cash += $10
  • A & B equity: no change

A loans B $10:

  • A's cash -= $10
  • B's cash += $10
  • A's equity += $10
  • B's equity -= $10

Need to show how this would work with the examples at the top of the page.