1.0 Accounting
An Important Note
The vast majority of accounting in Manage Invest is fully automated. While this
document describes the use of debits, credits and how to build transactions from
them, in reality, when you record purchases, sales and more in Manage Invest, accounting
processes run in the background without the need for you to create the entries manually.
This document is intended to explain the underlying logic and why certain things
happen the way they do.
1.1 Basic Principles of Accounting
Accounting is the process of keeping track of how much we own, what we owe, income
that has flown in and expenses that have flown out. We record every change in an
account. In other words, accounts are the places where we record increases and decreases
in the levels of assets (what we own), liabilities (what we owe), equity (also known
as net worth, which is what would be left over if we sold all assets and paid off
all liabilities), income received and expenses paid. There is generally one account
for each type of event. For example there is an account to record interest payments
received and there is another account to record bank fees we have paid.
There are five different types of accounts:
- Asset
- Liability
- Equity
- Income (also called Revenue)
-
Expense
Asset accounts represent things owned by the entity. This includes
items bought outright using the entity’s own money or items which were purchased
using a loan. Assets are generally split into two groups: current and non-current
assets.
Current assets (also called current accounts in the UK) are broadly defined as anything
of value that is highly liquid or is expected to be converted into cash within a
year during normal operations. Current assets therefore include cash, marketable
securities such as stocks (even if there is no intention of selling them) and debtors
(also known as accounts receivable).
Financial assets are a subset of current assets and include cash and marketable
securities only.
Non-current assets (also called fixed assets) are long term assets, which are not
expected to be consumed or converted to cash in less than a year’s time. Non-current
assets in a typical portfolio include property and its fittings and fixtures.
Non-current assets may be tangible (such as vehicles, buildings and land) or intangible
(such as goodwill, intellectual property rights, trademarks and patents).
Whenever you add a new financial asset in the software, such as stocks, Manage Invest
will create the asset record and a new account in the general ledger of accounts
to represent that holding. A new account is created for each batch of stocks that
is purchased at different times. Each holding is considered a separate asset in
its own right and different holdings with the same code are grouped together by
code within the software. This allows accurate processing of tax deferred income
and greater precision in capital gain calculations. Please see latter sections for
more information related to tax deferred income and capital gains calculations.
An important thing to note about accounts associated with a particular asset is
that they contain an amount that is the cost base of the asset, not the market value
(see section “Cost Base versus Market Value”). Increases in market value can be
an asset themselves, but they are contained in a separate account, called “Increase
in Market Value”. The only time that the balance of an account representing an asset
is the same as its market value is if the market value happens to be the same as
the cost base, which is rare.
Liabilities accounts represent amounts owed to others by the entity.
A typical example would be a loan to the entity or tax owed by the entity.
Like assets, liabilities are also split into current and non-current. Current liabilities
are those which we reasonably expect to discharge (settle) within a year of them
being incurred. Noncurrent liabilities are those which we do not expect to discharge
within a year’s time.
Loans can also be represented as a negative asset. For example, a personal loan
may be represented in your bank’s internet banking as a bank account with a negative
balance. This approach can also be used in Manage Invest.
Equity accounts reflect our net worth, or put another way, they
are the portion of the assets we actually own outright. These accounts are sometimes
referred to as owners’ equity or, in the case of investment portfolios, investors’
equity.
To explain what equity represents, consider the following example: if we buy a property
for $100,000 using only our own money, then we have a physical asset whose cost
base is $100,000 (this is our asset), $0 owing to others (this is our liability)
which means we own the whole $100,000 property (this is our equity).
However, if we bought the same property using $20,000 of our own money and take
a $80,000 loan for the rest, then we have a property whose cost base is $100,000
(this is out asset), $80,000 owing to the financier (this is our liability) and
we are left with $20,000 of the property that we own (this is our equity).
The relationship between assets, liabilities and equity is also
illustrated in the above examples. In the above example we demonstrate that
Equity = Assets – Liabilities. This is more commonly show in a slightly
different format: Assets = Liabilities + Equity. This equation must always hold.
It is true for individual assets, just as it is true for the portfolio of assets
or entity as a whole.
The Balance Sheet (also called Statement of Financial Position) is a listing of
the assets, liabilities and equity of a given entity.
Income (also called Revenue) accounts are used to record receipts
flowing into the entity. It is important to remember that receipts into the entity
in the regular course of operations are income to the entity. This includes contributions
by investors or their employers, dividends and distributions received, interest
received, rent received and many more.
Please note that depending on accounting rules in your location you may be allowed
or even required to record income when it falls due, even if you have not yet received
the cash. This is an accrual entry. Manage Invest is well suited to both accrual
and cash accounting. To find out more about how to deal with accrual entries, please
check the Manage Invest forums or contact support.
Expense accounts are used to record payments flowing out from the
entity. Expenses include payments to third parties, such as bank fees paid or property
repair costs, or a payment out of the entity to investors of the entity. It is important
to note that a capital purchase, that is the purchase of an asset, is not considered
an expense.
Please note that depending on accounting rules in your location you may be allowed
or required to record expenses when they are incurred, even if you have not yet
paid for them. This is an accrual entry. To find out more about how to deal with
such entries, please check the Manage Invest forums or contact support.
Income less Expenses of the entity are its pre-tax
profits for a given period. Income, expenses and the resulting profit or loss are
also what is shown in the Profit and Loss report of an entity.
The General Ledger
All accounts are organised into a hierarchical structure called the General Ledger.
There is one top level account for each account type, being assets, liabilities,
equity, income and expense. Under each of them are several child accounts, which
can in turn have more child accounts. Each subsequent level offers a more specific
categorisation for assets, liabilities, equity, income or expenses. For example,
one of the child accounts of Income is Operating Income (which represents income
from the normal course of operations) which has several child accounts, including
Dividends. Because dividends can be received as cash or reinvested, the Dividends
account has two child accounts called Dividends Received and Dividends Reinvested.
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