This chapter will discuss some useful concepts for organizing your accounts. Since GnuCash does not impose any specific account tree layout, you are free to design your account structure in any manner you wish. However, there are a few basic accounting concepts which you will probably want to follow when designing your accounts to maximize their utility. As we saw in the previous chapter, accounting is based on 5 basic account types: Assets, Liabilities, Equity, Income and Expenses. We will now expand on our understanding of these account types, and show how they are represented in GnuCash. But first, let's divide them into 2 groups, the balance sheet accounts and the income and expense accounts. The three so-called Balance Sheet Accounts are Assets, Liabilities, and Equity. Balance Sheet Accounts are used to track the changes in value of things you own or owe. Assets is the group of things that you own. Your assets could include a car, cash, a house, stocks, or anything else that has convertible value. Convertible value means that theoretically you could sell the item for cash. Liabilities is the group of things on which you owe money. Your liabilities could include a car loan, a student loan, a mortgage, your investment margin account, or anything else which you must pay back at some time. Equity is the same as "net worth." It represents what is left over after you subtract your liabilities from your assets. It can be thought of as the portion of your assets that you own outright, without any debt. The two Income and Expense Accounts are used to increase or decrease the value of your accounts. Thus, while the balance sheet accounts simply track the value of the things you own or owe, income and expense accounts allow you to change the value of these accounts. Income is the payment you receive for your time, services you provide, or the use of your money. When you receive a paycheck, for example, that check is a payment for labor you provided to an employer. Other examples of income include commissions, tips, dividend income from stocks, and interest income from bank accounts. Income will always increase the value of your Assets and thus your Equity. Expenses refer to money you spend to purchase goods or services provided by someone else. Examples of expenses are a meal at a restaurant, rent, groceries, gas for your car, or tickets to see a play. Expenses will always decrease your Equity. If you pay for the expense immediately, you will decrease your Assets, whereas if you pay for the expense on credit you increase your Liabilities. This section will show how the GnuCash definition of an account fits into the view of the 5 basic accounting types. But first, let's begin with a definition of an account in GnuCash. A GnuCash account is an entity which contains other sub-accounts, or that contains transactions. Since an account can contain other accounts, you often see account trees in GnuCash, in which logically associated accounts reside within a common parent account. A GnuCash account must have a unique name (that you assign) and one of the predefined GnuCash "account types". There are a total of 13 account types in GnuCash. These 13 account types are based on the 5 basic accounting types, the reason there are more GnuCash account types than basic accounting types is that this allows GnuCash to perform specialized tracking and handling of certain accounts. There are 7 asset accounts (Cash, Bank, Stock, Mutual Fund, Currency, Accounts Receivable, and Asset ), 3 liability accounts (Credit Card, Accounts Payable, and Liability, ), 1 equity account (Equity), 1 income account (Income), and 1 expense account (Expense). These GnuCash account types are presented in more detail below. The first balance sheet account we will examine is Assets, which, as you remember from the previous section, refers to things you own. To help you organize your asset accounts and to simplify transaction entry, GnuCash supports several types of asset accounts: Cash Use this account to track the money you have on hand, in your wallet, in your piggy bank, under your mattress, or wherever you choose to keep it handy. This is the most liquid, or easily traded, type of asset. Bank This account is used to track your cash balance that you keep in institutions such as banks, credit unions, savings and loan, or brokerage firms - wherever someone else safeguards your money. This is the second most liquid type of account, because you can easily convert it to cash on hand. Stock Track your individual stocks and bonds using this type of account. The stock account's register provides extra columns for entering number of shares and price of your investment. With these types of assets, you may not be able to easily convert them to cash unless you can find a buyer, and you are not guaranteed to get the same amount of cash you paid for them. Mutual Fund This is similar to the stock account, except that it is used to track funds. Its account register provides the same extra columns for entering share and price information. Funds represent ownership shares of a variety of investments, and like stocks they do not offer any guaranteed cash value. Currency If you trade other currencies as investments, you can use this type of account to keep track of them. The register is similar to the stock register, except that you enter exchange rates instead of prices. Accounts Receivable (A/Receivable) This is typically a business use only account in which you place outstanding debts owed to you. It is considered an asset because you should be able to count in these funds arriving. Asset For personal finances, use this type of account to track "big-ticket" item purchases that significantly impact your net worth. Generally, you can think of these as things you insure, such as a house, vehicles, jewelry, and other expensive belongings. For all GnuCash asset accounts, a debit (left-column value entry) increases the account balance and a credit (right-column value entry) decreases the balance. (See note later in this chapter.) The second balance sheet account is Liabilities, which as you recall, refers to what you owe, money you have borrowed and are obligated to pay back some day. These represent the rights of your lenders to obtain repayment from you. Tracking the liability balances lets you know how much debt you have at a given point in time. GnuCash offers three liability account types: Credit Card Use this to track your credit card receipts and reconcile your credit card statements. Credit cards represent a short-term loan that you are obligated to repay to the credit card company. This type of account can also be used for other short-term loans such as a line of credit from your bank. Accounts Payable (A/Payable) This is typically a business use only account in which you place bills you have yet to pay. Liability Use this type of account for all other loans, generally larger long-term loans such as a mortgage or vehicle loan. This account can help you keep track of how much you owe and how much you have already repaid. Liabilities in accounting act in an opposite manner from assets: credits (right-column value entries) increase liability account balances and debits (left-column value entries) decrease them. (See note later in this chapter) The final balance sheet account is Equity, which is synonymous with "net worth". It represents what is left over after you subtract your liabilities from your assets, so it is the portion of your assets that you own outright, without any debt. In GnuCash, use this type of account as the source of your opening bank balances, because these balances represent your beginning net worth. There is only a single GnuCash equity account, called naturally enough, Equity. In equity accounts, credits increase account balances and debits decrease them. (See note later in this chapter) The accounting equation that links balance-sheet accounts is Assets = Liabilities + Equity or rearranged Assets - Liabilities = Equity. So, in common terms, the things you own minus the things you owe equals your net worth. Income is the payment you receive for your time, services you provide, or the use of your money. In GnuCash, use an Income type account to track these. Credits increase income account balances and debits decrease them. As described in Chapter 2, credits represent money transferred from an account. So in these special income accounts, when you transfer money from (credit) the income account to another account, the balance of the income account increases. For example, when you deposit a paycheck and record the transaction as a transfer from an income account to a bank account, the balances of both accounts increase. Expenses refer to money you spend to purchase goods or services provided by someone else. In GnuCash, use an Expense type account to track your expenses. Debits increase expense account balances and credits decrease them. (See note later in this chapter.) When you subtract total expenses from total income for a time period, you get net income. This net income is then added to the balance sheet as retained earnings, which is a type of Equity account. (Insert a chart that shows common accounts and recommended account types for these) Remember the terms debit and credit discussed in Chapter 2? Contrary to popular belief and even some dictionary definitions, accounting debits and credits do not mean decrease and increase. The only constant definition of debits and credits is that debits are left-column entries and credits are right-column entries. In fact, debits and credits each increase certain types of accounts and decrease others. In asset and expense type accounts, debits increase the balance and credits decrease the balance. In liability, equity and income type accounts, credits increase the balance and debits decrease the balance. For example, debits increase your bank account balance and credits decrease your bank account balance. Wait a minute, you might say, a debit card decreases the balance in my checking account, because I take money out of it. And when the bank gives me money back on something, they credit my account. So why is this reversed in accounting? Banks report transactions from their perspective, not yours. Their perspective is exactly opposite to yours. To you, your bank account represents an asset, something you own. To the bank, your bank account represents a loan, or liability, because they owe you that money. As explained in this chapter, asset and liability accounts are exact opposites in the way they behave. In a liability account, debits decrease the balance and credits increase the balance. When you take money out of your bank account, the balance in your account decreases. To you, this is a decrease in an asset, so you credit your bank account. To the bank, this is a decrease in a liability, so they debit your bank account. Let's go through the process of building a common personal finance chart of accounts using the information we have learned from this chapter. A chart of accounts is simply a new GnuCash file in which you groups your accounts to track your finances. In building this chart of accounts, the first task is to divide the items you want to track into the basic account types of accounting. This is fairly simple, let's go through an example. Let us assume you have a checking and a savings account at a bank, and are employed and thus receive a paycheck. You have a credit card (Visa), and you pay monthly utilities in the form of rent, phone, and electricity. Naturally, you also need to buy groceries. For now, we will not worry about how much money you have in the bank, how much you owe on the credit card, etc. We want to simply build the framework for this chart of accounts. Your assets would be the bank savings and checking account. Your liabilities are the credit card. Your Equity would be the starting values of your bank accounts and credit card (we do not have those amounts yet, but we know they exist). You have income in the form of a salary, and expenses in the form of groceries, rent, electricity, phone, and taxes (Federal, Social Security, Medicare) on your salary. Simple, isn't it? Now, we must decide how you want to group these accounts. Most likely, you want your assets groups together, your liabilities grouped together, your Equity grouped together, your income grouped together, and your expenses grouped together. This is the most common way of building a GnuCash chart of accounts, and it is highly recommended that you always begin this way. Start with a clean GnuCash file (do not select any predefined accounts) and build this basic starting account structure (File -> New Account...). Account name Assets (account type Assets, parent account New top level account) Account name Liabilities (account type Liabilities, parent account New top level account) Account name Equity (account type Equity, parent account New top level account) Account name Income (account type Income, parent account New top level account) Account name Expenses (account type Expenses, parent account New top level account) The Basic Top-level Accounts This image shows the basic top-level accounts. We can now add to this basic top-level tree structure by inserting some real transaction-holding sub-accounts. Notice that the tax accounts are placed within a sub-account named "Taxes". You can make sub-accounts within sub-accounts. This is typically done with a group of related accounts (such as tax accounts in this example). Account name Checking (account type Bank, parent account Asset) Account name Savings (account type Bank, parent account Asset) Account name Visa (account type Credit Card, parent account Liabilities) Account name Salary (account type Income, parent account Income) Account name Phone (account type Expenses, parent account Expenses) Account name Electricity (account type Expenses, parent account Expenses) Account name Rent (account type Expenses, parent account Expenses) Account name Groceries (account type Expenses, parent account Expenses) Account name Taxes (account type Expenses, parent account Expenses) Account name Federal (account type Expenses, parent account Expenses:Taxes) Account name Social Security (account type Expenses, parent account Expenses:Taxes) Account name Medicare (account type Expenses, parent account Expenses:Taxes) Account name Starting Balances (account type Equity, parent account Equity) The Basic Chart of Accounts This image shows a simple chart of accounts. Save this chart of accounts somewhere, as we will continue to use it in the later chapters. You have now created a chart of accounts to track a simple household budget. With this basic framework in place, we can now begin to populate the accounts with transactions. The next chapter will cover this subject in greater detail.