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-*- mode: org; fill-column: 60 -*-

What you need to know about accounting

(and) Why this will help you be a better engineer

Introduction

  • Why are we talking about accounting?
  • What practical use do you get from this?
  • How is accounting related to computer science in any way?

Rapid intro to double-entry bookkeeping

Accounting is both very simple and very complex. You can learn the basics of accounting in 5 minutes.

Case in point: Double-entry bookkeeping (the standard way people have been doing accounts) was created in the early 1300s. (Probably earlier!)

I think any programmer can write a simple accounting system in a couple of hours.

Basic terminology

AccountA place where you hold money
TransactionTransfer from one account to another
Journal or LedgerList of transactions for an account

First Rule of Accounting Thermodynamics

  • Every transaction should take money from a source account and move it to a destination account
  • Money cannot be created or destroyed — just transferred.
  • Just like energy :)

01.ledger

Second rule: accounts are virtual

  • You can make up accounts if you need to!
  • In the earlier example, we had two ‘accounts’
    • ‘Bank account’
    • ‘Salary account’
  • These names do not mean anything. You give them meaning.
  • Please note: accounts start with zero balance.
  • Current value of your accounts is the effect of all the transactions applied to it.
  • But, there are naming conventions in place that you should know about. Just like any programming language, really.

01.ledger

Third rule: Thou shalt balance your accounts

  • At any given time, if you add up your account balances, it should be zero.
  • Else you have made a data entry mistake!

02.ledger

Fourth rule: Organise your accounts!

  • Your accounts can form an hierarchy
  • Parent account, child accounts, etc
  • Balance of parent account is sum of balances of all its child accounts

03.ledger

Concepts of accounting

Why did we bother to do all of this? Do those rules seem counter-intuitive to you? To understand this, you have to understand the history of accounting.

A thought exercise

Ask yourself this:

  • Who is the user of an accounting system?
  • Why do they use an accounting system?

And then think about:

  • How much information does this person have?
  • Do you maintain accounts for yourself or also for the people you have business dealings with?

Context

This system arose out of a need to track transactions when you have imperfect data.

Accounting is fundamentally private. You do not know what some merchant you are doing business with has in their books. You only keep track of accounts from your point of view!

In my opinion: this is accounting’s biggest flaw and also its biggest strength.

(I’m no accountant though, so this is an outsider’s perspective!)

You use accounts to keep track of information that’s relevant to you.

Different people have different sets of accounts.

This is a distributed system!

Shared Vocabulary

Over time, people started to come up with accounting standards: shared (and precise) vocabulary in order to communicate an idea clearly.

This told people how to structure their accounts.

Example: This lets a banker understand a merchant’s books, so they can decide whether it’s safe to give them a loan.

Example: This lets accountants move from company to company, and be able to understand what’s happening

Credit / Debit

Traditional accounting systems actually try to avoid negative numbers. They use the words credit or debit instead.

Credit / debit have different meaning when applied to different contexts, and different people.

(I myself get confused about this, often, and have avoided usage of these terms)

Standard Accounting Heads

You will usually see accounts divided into 5 headings:

Equity (or Capital)Typically your opening balances
AssetsWhat you own
LiabilityWhat you owe someone else
IncomesWhat you earn
ExpensesWhat you spend

Also, you may run into ‘accounting equations’ like:

Assets - Liabilities = Equity + (Income - Expenses)

or, simplified,

Assets - Liabilities = Equity

Example of this: 04.ledger

Accrual based accounting

This is a fun topic.

Thought exercise:

  • If you are selling something, when do you actually show the transaction?
  • Is it when you make the sale, or when you receive the money?

‘Accrual basis’ is the standard everyone uses. This means that you should account for a sale when you make it, not when you receive it.

You use a ‘receivables’ category in your accounts to show this is money that’s yours, but not actually in your hand.

See 05.ledger for an example.

Detailed Example

Enough theory! Let us take a more detailed example.

05.ledger

Why is this useful?

There are standard reports:

  • Balance sheet, which reports assets vs liabilities

    Use: hledger -f 05.ledger balancesheet

    This tells you what you are worth, basically.

  • P&L, (also called income statement)

    This gives you a view on your income vs. expenses.

    Are you earning more than you are spending, or vice versa.

    Use: hledger -f 05.ledger incomestatement

  • Cashflow Statement

    This shows you how much cash you have in hand.

    Basically, assets - receivables

    You may have money on paper, but can you actually afford something?

    For a business, there is a big difference between their income and their cashflow. They may on paper have a lot of profit (and may need to pay tax on it), but may not actually have any money on hand!

Learnings from an engineering perspective

Standards matter, Simplicity matters

1% of accounting is learning how it works.

99% of accounting is understanding the standards that people have built on top of it.

Accounting follows a lot of rules, but the core on which it is built is small.

A lot of computer systems are built the same way :)

Immutability

Basically, once you have written a transaction in a ledger, it is final. You cannot erase it, you cannot undo it.

If you do want to undo it, you will add a ‘reverse transaction’.

You can think of accounting in functional programming terminology. Each transaction is a fact, and the balance of an account is the result of doing ‘map / reduce’ type work on top of it.

(As a company, if you keep modifying your accounts, you would probably end up in jail for fraud.)

Replicated Ledgers, knowing half the story

You do not know the whole truth. You only know your side of the story.

For every real world transactions, different systems will represent it in different manner.

Your accounting system could say:

2017/02/01 Salary received
    Assets:Bank:HDFC         100,000.00
    Income:Salary:Cleartax  -100,000.00

While your company’s account could say:

2017/02/01 Distribute salary to all employees
    Expenses:Salary:Employee 1     100,000.00
    Expenses:Salary:Employee 2     100,000.00
    Assets:Bank:Current Account   -200,000.00

The bank’s internal accounts would probably say something else.

In the real world, you do not have perfect knowledge. You just have your version of the truth, which may differ from others’ version.

This is basically a distributed system.

Getting people to agree is a hard problem to solve.

Accounting solves this by using things like transaction identifiers (what do you think a bill number or an invoice number is?), and frequent reconciliation.

Accountants will try to make sure that your comapny’s accounts (books of accounts, virtual) is matching the bank accounts (real money) on a periodic basis.

This is a job computers can excel at!

Example: Bank account systems

How do you think the banking system actually works?

  • Say that you have Rs. 20,000 in your bank
  • You go to an ATM withdraw Rs 10,000
  • You have outstanding credit card dues worth Rs 12,000
  • You have set up ‘autopay’ for your card
  • The card bill is due today
  • The auto-pay transaction triggers at midnight

What should happen?

  • It depends on the bank in question
  • Your bank may not yet know that you have withdrawn Rs 10,000, and may make a transfer of Rs 12,000 for your card payment
  • Your balance may go in negative
  • Some other process at the bank would see this, and then automatically reverse the transfer
  • Things may get more complex as multiple banks enter the picture. Sometimes transactions get reversed, sometimes you have to pay a fine, etc.

This seems crazy, but this is how the world works :)

Think of it as:

  • git add
  • git commit

Your transaction may not be ‘final’ until some reconciliation process happens.

You can relate this to the CAP theorem if you prefer:

  • Banking would go for Availability (do not stop business)
  • and Partition Tolerance (banks have physically separate branches, different banks have different systems, some may not always be online)
  • while sacrificing Consistency (you could withdraw more than you have)

References