Comment by RedNifre

6 hours ago

Here is my explanation for "software people who understand databases". The structure of the explanation will be as follows:

  1. Explain how you would do simple accounting with a database
  2. Point out which indices you'd create for performance
  3. Show how the "double entry" part of double entry accounting is about the indices

1. The way you'd do accounting in a database is with two tables: One table for accounts (e.g. your checking account, or the supermarket account, which you don't own) and another table for transactions. The transactions move an amount of money from one account to another, e.g. from your checking account to the supermarket account. Or if you use it for budgeting, you might split your checking account into a groceries account, a rent account etc. (think "categories").

2. For performance, you would create indices based on the accounts in the transaction table, so you could easily check what's going on e.g. in your groceries account or how much you spent at the supermarket.

3. Double entry accounting was formalized in the 15th century, way before computers became a thing, but bound paper books were already somewhat affordable. The way you'd do accounting is like this: During the business day, you would write down your transactions as they happen, into a scrapbook, similar to the transactions table mentioned above. At the end of the day, you'd do the "double entry" part, which means you take your "index" books where each book is about one account and you transcribe each transaction from your scrap book into the two books of the two accounts that are mentioned in the transaction, e.g. if you spent $10 from your groceries account into the supermarket account, you'd double enter that transaction both into your "groceries" book and into your "supermarket" book. Then, when you want to check on how much you spent at the supermarket in a particular month, you could easily look it up in the supermarket book (this would be very tedious when using the scrap book). These account centered books are like the indices in the database mentioned above.

So the double entry part is about clever index building for making it easier and faster to understand what's going on in your accounting system.

6 comments

RedNifre

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thehours  6 hours ago

How are investments modeled in this system? e.g I buy $100 of an index fund which can fluctuate in value.

  • rmunn  6 hours ago

    Not an accountant, so if I get it wrong someone please correct me. But index fund shares are an asset: something you own. So is your car, your house (if you own it), and your computer. When you buy an asset, you paid a certain price for it. When you sell it, you pay a different price. Until you sell it, though, you don't actually have the money, so it hardly matters what its value is until you sell it. If you buy $100 of an index fund and a year later it has grown by 10%, you don't actually have $110 yet until you sell it. So you just track that you have a certain number of shares of the fund. Let's say each share sells for exactly $20 when you bought them, so you have exactly 5 shares. Later the share price is $22, but you don't have $110 yet, you still have exactly 5 shares. When you sell them, then you'll have $110.

    So you record two entries:

    January 1st, 2025:

      -$100 checking account
  +5 shares VFINX at $20 ea

    January 1st, 2026:

      -5 shares VFINX at $22 ea
  +$110 checking account

    At this point you have "realized" ("made real") $10 of profit from this asset. You bought it for $100 and sold it for $110, so the IRS wants you to pay taxes on the $10 profit you made. (This is capital gains tax). Until you sold them, some people would consider you to have $10 profit in "unrealized capital gains", but you did not actually have that profit until you sold the shares. This is important to remember, because if you start counting on that $10 profit but then the share price drops because the economy took a hit, suddenly you don't have $110 worth of shares, you have $90 worth of shares, and you'll make a loss if you sell them now. (This is one of the reasons why only the economically illiterate would propose a tax on "unrealized capital gains": that means taxing people for income they have not actually received, but merely could theoretically receive. Which is both immoral and stupid.)

    Hope this explanation helps a little. And as I said, if I got something wrong, please correct me and explain how I was wrong; I'm not an accountant. I understand the basic principles, but it's entirely possible I was off on some detail or other.

    • WorldMaker  4 hours ago

      A fancy term of art for all this is "cost-basis accounting". Your (double entry) account tracks only the cost basis (how much you have spent and when you spent it for what commodity) not the current price. Current price fluctuates with the market and you can track the price as well to build an unrealized gain/loss statement. This sort of statement is not an account, it's a report on an account. (And yeah, "unrealized" means what it says that it isn't real money in your accounts, just money you potentially could make if you sold/converted/traded what was in your accounts.)

    • rmunn  5 hours ago

      I feel I should also mention one more thing. The fact that you don't have the money until you sell the shares is also why "net worth" can be a highly misleading concept. (All numbers in the following example are fictional and made up on the spot, BTW). Billionaire Gill Bates, whose net worth is reported to be $20 billion, does not actually have 20 billion dollars. He has $5 million (million, not billion) of actual dollars in his bank account(s), but the rest of his net worth is in assets: he owns 200 million shares of MegaSoft Corp, whose share price is currently $100 per share. If MegaSoft Corp's shares suddenly drop in value (say, because a hacker group announces that MegaSoft's Doors 12 OS is full of, well, backdoors and suddenly nobody wants to buy it anymore) and now their shares are selling for $90, then Gill Bates's net worth will become 18 billion dollars instead of 20 billion. Did he "lose" 2 billion dollars in one day? NO. He never had those dollars. The "net worth" calculation is just the theoretical amount of money he could make if he sold all his shares.

      And in fact, he could never actually make that amount of money by selling all his shares, because if he did put 200 million MegaSoft shares on the market, he'd never be able to find buyers for all of them at the current share price, and he'd be forced to drop his asking price by quite a bit before he managed to sell all 200 million shares. Not to mention the fact that if he tried to sell his entire holdings of MegaSoft Corp, many people would wonder what he knows about MegaSoft's long-term prospects, and would be afraid to buy those shares, driving the share price down even further. Gill Bates would be lucky to make $5 billion, let alone his theoretical net worth of $20 billion, if he were to suddenly sell all his shares. (If he sold them in a trickle over the course of ten years, he might well make the full $20 billion in the end, but not if he dumped them all on the market at once).

      This is why (well, it's just one of the many reasons why) net worth is misleading. It's a theoretical number, but the actual amount of wealth someone has in practice entirely depends on market conditions at the moment they need the money, as well as how urgently they need it. (If the market is low right now, can they afford to wait six months for it to recover? Or do they need the money tomorrow and have to sell at a lower-than-ideal price?)

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