Double Trouble

by Chris Dornan on August 14, 2008

When I was press-ganged elected into the position of treasurer of Monkey Puzzle H. C. I dealt with it with my usual stratagem: procrastination. I had been bored senseless by book-keeping at school and had managed to avoid accounts ever since. This worked for a while, except we were running up an alarming tab with the secretary who was starting to experience mild cash-flow problems. The only alternative to dealing in cash for everything (until we get the building society account moved) is to get the building society to draw up banker’s drafts at £10 a pop, so I had suggested we divert the subs into my account and I operate a petty cash system.  (M.P. is a shell co-op at the moment so this is feasible).

But procrastination and bluster can only get you so far. Fortunately my excellent friends had had the foresight to also press-gang me into taking a double-entry bookkeeping course run by Chris Funnel at the Co-operative Assistance Network (CAN). After a day with Chris the scales fell from my eyes. I had the tools I needed. And indeed I did, and my challenge for this series of articles is to try and explain why it is really worth doing your accounts with the double-entry method.

A professional accountant would probably be able to do quite a good job of keeping the accounts of a small business by just storing the paperwork and logging all the money transactions in a single balance sheet, and many experienced bookkeepers do just this.  However I suspect that in many cases inexperienced amateurs like myself can really benefit from using the double entry method and all of the structuring it providesthat was clearly the considered view of Chris Funnel. In this view the ‘trouble’ would come from not using the double-entry method, but a reluctance to use it may reflect a fundamental misunderstanding of the way accounts really workdouble trouble indeed!

The double-entry method is actually very simple.  Its main problem is unfamiliarity; it asks us to do things in a way that is not obvious until we have had some practice with it.  But those strange ways, ways that we naturally resist, are just the kind of structure we need, so it is really worth giving the double-entry method a go.  In these articles I will try to make it appear less strange by building it up from first principles with simple examples.  By the end you should be able to understand how I constructed the Monkey Puzzle accounts and decide whether it is appropriate for yourself.

Of course this can all be done on paper but a spreadsheet is a mighty handy aid. I will explain how I constructed the Excel spreadsheet used to construct the M.P. accounts (the summary sheet from the 4th August is shown above).

A Bit of History

The first person to write about the double entry method was Luca Pacioli, a fifteenth century Italian Franciscan Friar and collaborator with Leonardo da Vinci. We shouldn’t be so surprised that the accounting method that underpins modern commerce should emerge among the Italian merchants as mediaeval Europe was starting the transition to modernity. As the natural philosophers would harness mathematics to master nature (people like Kepler and Galileo), so mathematics would be applied to ordering human affairs too, providing one of the pillars of the emerging nation states.

All of which is meant to charge you up with a sense of respect for this rather elegant system. Being a computer scientist I can appreciate these things! (You may be suspecting at this stage that my depravity and perversion knows no bounds; you might be right.)

The Great Game

Double entry book-keeping is like a game. You can’t really explain the individual moves in their own terms but have to see how they operate in play before there is any opportunity to make sense of them. So let us start by playing the game of working out whether Monkey Puzzle is making a profit. (Here I mean profit in the accounting sense; Monkey Puzzle, like all housing co-operatives is a non-profit organisation.)

We need some accounts and money to play with. But the double entry method has lots of accounts and no money. (I said this was going to be perverse and I wasn’t joking—those Italian merchants were fiendishly clever.) Or at least no net money as all the money should add up to zero.

These accounts are for the year 2008 so I will create an account for representing the money brought forward into 2008 from 2007 and then pump the money from that account into the accounts active at the start of the year. To simplify matters, I will ignore the capital in the pound shares leaving us with only the building society account which thankfully started the year £102.37 in the black, so I start by crediting the CF07 account and debiting the Bank account by £102.37.  Thus we have our first two accounts with their first transctions.

CF07
1/1/2008 C/F from ‘07 £102.37
Bank
1/1/2008 C/F from ‘07 -£102.37

Crediting the CF07 ledger may make sense but, to those unfamiliar with the double-entry method, debiting a bank account to set us up in credit seems exactly wrong. This is because we are used to receiving statements from the bank which are always (naturally enough) presented from the bank’s point of view, telling us whether we have credit with the bank or not.  That programming to see things from the bank’s point of view was deeply entrenched and difficult to resist when I first came across this system. But for the great game of working out the profit and loss for the co-op in 2008 we need to set things up differently, where only the accounts that strictly belong to the co-op are in credit when the co-op is in credit and the exact reverse for all the other accounts, belonging as they do to other parties.

The tendency to see the money in the bank as ours (dang it) is strong so I am going to spend the rest of this article explaining why this perverse (and beautiful) system is as it is.

The reason the bank’s accounts can’t be assigned to the co-op here is because the bank transactions don’t actually effect our profit and loss. Bank transaction effect cash-flow, of course, and are critical to the running of the venture, and must be managed properly, but they don’t actually drive profit and loss. To see this consider a situation where a business has raised invoices for £10,000 in December, at the end of the financial year, but received the payments in January. The question is this: does the £10,000 turnover happen when the invoices were raised or when the payment is made? In which year do we make the profit? We obviously can’t count them both. The convention is–and it is a convention–that the profit is made when the invoices are issued. For this reason the bank has to be regarded as another debtor (when we are in the black) and the bank account is presented from our side–when we have money in the bank it means that the bank is in our debt and the bank account is shown to be negative.

Putting this together consider the symetry of the following simple but artificial scenario, where Peter is our baker and we are in credit with Peter to the tune of £100 pounds—we have £100 pounds in the bank.  But wait this is just the same as saying that Peter owes us £100 pounds and we owe Paul £20 pounds.  And naturally we instruct Peter to pay Paul £20 pounds to cancel our debt, reducing Paul’s debt to us by £20 in the process.

Bank (Peter)
1/1/1970 Balance C/F -£100
2/1/1970 Pay Paul £20
2/1/1970 New balance
-£80
Paul
1/1/1970 Debt C/F £20
2/1/1970 Pay off Debt -£20
2/1/1970 New Balance
£0

We normally think of this as paying Paul from our bank account but the above is absolutely equivalent; which way you think about it is merely conventional.

The key point is that our normal way of thinking about it is well adapted to worldly conventions, but the way we are presenting here ismuch better adapted for working out profit and loss as it is undesrstood by the world of finance where neither of these accounts are ours and where the payment doesn’t affect effect the calculation of the profit and loss of the business.  We are only robbing Peter to pay Paul. Before the payment their combined position was that they owed us £80 pounds, and the same is true afterwards.

If you are not used to this way of thinking you are probably still resisting.  Resistance is futile!

Some more realistic examples help, which is where we turn our attention next.

Next instalment: The Monkey’s Expenses.

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