Synopsis

It’s valuable to have a basic understanding of accounting if you want to effectively manage your money. But accounting jargon is hard to follow and doesn’t always make sense. So this document tries to make things simple by describing the big picture concepts of accounting by way of a short story.

Meet John

John will be the focus of our story. He is a 33-year-old teacher who makes $40,000 per year. John has one bank account and two credit cards. His bank account has $3,000 in it, but he also has $3,100 in credit card debt. He’d like to go on a nice vacation, but he never feels like he has the money for it. Let’s dig in a bit deeper and see if we can help.

The basics: things you own vs things you owe

John’s starting point (and yours for that matter) starts with what you own and what you owe. In accounting terms, this makes up the bulk of your “balance sheet” (the only remaining piece is your “net worth” which is equal to what you own – what you owe). Today, that’s all that matters. How much money you made or spent in the past doesn’t matter. That’s in the past and led to your current situation. How much you spend in the future should be influenced by your net worth, how much you make, etc. But that’s in the future. The only thing that matters today is how much you own and how much you owe.

In Add Rabbit, you track what you own and owe by “Adding Accounts.” These are typically things like bank accounts, credit cards, etc. There are other types of accounts that we’ll get to soon. But for now, let’s continue to focus on “balance sheet” accounts (again: what you own and what you owe).

We’ve already talked about a few accounts that John has: his bank account and his two credit card accounts. John has $3,000 in his bank account. It doesn’t matter if John earned that money from his salary, received it as a gift, made a return on his investment, etc. He has $3,000 and that is that. John also has $3,100 in credit card debt. It also doesn’t matter how that balance got there. Maybe he splurged on electronics or likes to eat at super fancy restaurants. Regardless of how he built the balance, he has $3,100 in credit card debt. Let’s describe these two types of accounts a little more formally:

• Accounts that track the value of things you own are called assets. E.g., bank accounts, investment accounts, IRA’s, 401k’s, your home, etc. If these accounts are highly liquid, they are considered short-term assets (e.g., a bank account). If they are “illiquid,” we’ll consider them long-term assets (e.g., your house). Just remember: things you own ~= an asset.
• Accounts that track the value of things you owe are called liabilities. E.g., credit card debt, car loans, mortgages, etc. If you owe the money soon (e.g., your credit card bill is due next month), then they are considered short-term liabilities. Otherwise, they are considered long-term liabilities (e.g., your mortgage).

As you may have guessed by the name, the balance sheet is supposed to balance, and as we noted above we balance by subtracting what we owe from what we own. Since John has $3,000 in assets and $3,100 in liabilities, he has a net worth of NEGATIVE $100. Let’s describe the net worth account in a bit more detail as well:

• Accounts that track the value of how much you are worth are called equity accounts. For our purposes, we’ll only have one equity account and it is called, as we discussed, net worth. It will always be equal to what you own minus what you owe.

When you prepare your balance sheet, you get a snapshot of what your financial picture looks like as of a point in time. John’s picture looks like this:

Key # 1: Grow your net worth

Hopefully it’s obvious that your goal should be to grow your net worth! If you always own more than you owe, you’ll never have a problem paying your bills. Right now, John is not in a great position — he owes his credit card companies $100 more than he has in his bank account. If he had to pay the credit card companies today, he wouldn’t even be able to do it. He’d have to declare bankruptcy. Obviously things aren’t that dire because they don’t have to pay their entire bill every month, he’ll make money from his job that can be used to pay down the debt, etc. But he should act as if it were that dire!

Carrying credit card balances means that the credit card companies get to charge him interest. This can become a death-spiral. You should think of interest as money you have to throw in the trash each month. This means you can’t spend it on things you can actually use. It isn’t always bad (e.g., you probably couldn’t buy a house without a mortgage), but you should try to minimize the amount of interest you pay because it is non-productive spending.

The only way John can get out of his predicament is for him to make money (e.g., from his job, investments, whatever) and use it to pay down his credit card debt instead of spending it on other things. For this, we need to understand how money flows into and out of balance sheet accounts. We keep track of the flows in “income statement accounts.” There are two types of income statement accounts:

• Money that you make (from your job, your investments, rental properties, gifts, etc.) gets tracked in income accounts. These inflows increase what you own. E.g., when you get paid, your bank account increases. Income accounts don’t have balances as of a point in time like asset accounts, but you often want to add amounts up over time to understand the flow. For example, when we say that John makes $40,000 per year, we’re adding up his flows for the entire year.
• Money that you spend (on groceries, clothes, gas, doctors, etc.) gets tracked in expense accounts. These outflows reduce what you own (or increase what you owe). Expense accounts, like income accounts, don’t have balances, but you will add them up over some time period to understand the flow. For example, Sara and John spend $300 per month eating at restaurants.

Your “income statement” sums up the inflows and outflows over a certain period of time (e.g., one month, one year, etc.). Looking at your income statement over different periods of time may tell a different story. If you review the flows over a month, things may look good. For example, here is what John’s income statement looked like for last month:

It’s good that he made more than he spent, but think about the situation. He has $3,100 in debt, but he only had $50 extra dollars last month. If he used all his savings to pay off his credit card bill, he would still need to work for another two months just to get back to even (since he has a -$100 net worth and is only saving $50/month)! If he lost his job or an unexpected bill pops up, John is in trouble. Here is what his story looks like over the prior three months:

John spent a bit more on entertainment over the other two months and he had a car problem that needed to be fixed. These slight changes to his prior month routine put him in a position where his debt must grow to maintain his lifestyle. This is untenable on a long-term basis. The key is to make more money than you spend over “long” periods of time.

Key # 2: Make more than you spend over “long” periods of time

You now have all the basic building blocks necessary to start managing your finances. Again, the keys are:

1. Own more than you owe.
2. Make more than you spend.

These two goals tie together. It will be very difficult to own more than you owe if you spend more than you make. And it would be impossible to make more than you spend, yet not own more than you owe. So here’s a shortcut:

That’s it. If you make more than you spend, you will continue to increase what you own. While the concept is easy, the practice is (usually) hard! You’ll need to have a lot of discipline to make sure that you generally spend less than you make. You may need tools like budgets, reports, etc. But that’s what Add Rabbit helps you do!

Appendix: How the balance sheet and income statement relate

We talked about five types of accounts:

• Assets (what you own)
• Liabilities (what you owe)
• Equity (what you are worth; i.e., what you own - what you owe)
• Income (how much you make)
• Expenses (how much you spend)

These are, generally speaking, the only types of accounts you need to know about for personal finance. As we noted above, assets, liabilities, and equity all belong on the balance sheet. Since we always want the balance sheet to balance, we use a trick:

• Assets are naturally represented with positive numbers. If you want to increase an asset balance, you do so with a positive number (i.e., you debit the account).
• Liabilities are naturally represented with negative numbers. Think of it in terms of how much money you owe to someone else. If you want to increase a liability balance, you do so with a negative number (i.e., you credit the account).
• In order to make the balance sheet balance, we also need to represent your net worth as a negative number. This is very unintuitive, and likely why accountants usually refer to debits and credits rather than positives and negatives. But note that if we did not represent your worth as a credit balance/negative number, your balance sheet wouldn’t balance. You can also think of it like this: everything you buy (i.e., your “assets”) must be paid for with either money you already have (i.e., from your “net worth”) or money that you borrow (i.e., what you “owe”).

If you can get past the strangeness in how we represent your net worth, how we treat income statement accounts makes much more sense:

• Income accounts are naturally represented with negative numbers/credit balances. This makes sense when you think about income increasing your net worth. To increase equity/net worth, you need to credit it. The same goes for income.
• Naturally, if you need to increase income with a negative number (i.e., a credit), you do the opposite for expenses. Since an expense reduces your net worth, you increase expenses with a debit/positive number.